11 Best fair value measurements under IFRS 13

11 Best fair value measurements under IFRS 13

Several IFRS standards provide guidance regarding the scope and application of the fair value option for assets and liabilities. Here they are from 1 to 11…….

1 Investments in associates and joint ventures

Investments held by venture capital organizations and the like are exempt from IAS 28’s requirements only when they are measured at fair value through profit or loss (FVPL) in accordance with IFRS 9. Changes in the fair value (FV) of such investments are recognized in profit or loss in the period of change.

The IASB acknowledged that FV information is often readily available in venture capital organizations and entities in similar industries, even for start-up and non-listed entities, as the methods and basis for fair value measurement are well established. The IASB also confirmed that the reference to well-established practice is to emphasize that the exemption applies generally to those investments for which fair value is readily available.

2 Intangible assets

Subsequent to initial recognition of intangible assets, an entity may adopt either the cost model or the revaluation model as its accounting policy. The policy should be applied to the whole of a class of intangible assets and not merely to individual assets within a class, unless there is no active market for an individual asset.

The revaluation model may only be adopted if the intangible assets are traded in an active market; hence it is not frequently used. Further, the revaluation model may not be applied to intangible assets that have not previously been recognized as assets. For example, over the years an entity might have accumulated for nominal consideration a number of licenses of a kind that are traded on an active market. 11 Best fair value measurements under IFRS 13

The entity may not have recognized an intangible asset as the licenses were individually immaterial when acquired. If market prices for such licenses significantly increased, the value of the licenses held by the entity would substantially increase. In this case, the entity would be prohibited by IAS 38 from applying the revaluation model to the licenses, because they were not previously recognized as an asset. 11 Best fair value measurements under IFRS 13

The revaluation model may be applied to measure an intangible asset only subsequent to the asset’s initial recognition and measurement at cost. The method cannot be used at initial recognition to record an intangible asset at a value other than cost. Recording assets acquired in a business combination at fair value is not the application of the revaluation model. It is a method of determining the “cost to the group” of individual assets acquired in a business combination. 11 Best fair value measurements under IFRS 13

The revaluation model may also be applied to an asset acquired by way of government grant and measured on initial recognition at a nominal amount. The nominal amount could be nil if the asset was received free of charge. 11 Best fair value measurements under IFRS 13

The only valuation basis permitted is FV determined by reference to an active market. The definition of active market, which is consistent with IFRS 13, is a market in which all of the following conditions exist: 11 Best fair value measurements under IFRS 13

• the items traded in the market are homogeneous (similar in kind or nature); 11 Best fair value measurements under IFRS 13
• willing buyers and sellers are always available; and 11 Best fair value measurements under IFRS 13
• prices are publicly quoted. 11 Best fair value measurements under IFRS 13

An active market exists for only a few types of intangible assets and the revaluation model can only be used where such a market exists. IAS 38 notes that depending on the jurisdiction, there may be active markets for such items as freely transferable taxi licenses, fishing licenses, or production quotas. An example of a production quota might be emission rights, for which an active market is likely once a scheme is fully operational. 11 Best fair value measurements under IFRS 13

An active market cannot exist for brands, newspaper mastheads, music and film rights, patents, or trademarks, because each such asset is unique. Although such unique intangibles may be bought and sold, the prices are negotiated between individual buyers and sellers rather than quoted on an active market. Such purchase and sale transactions are fairly infrequent.

The price paid for an asset in one transaction may not be a good guide to the fair value of another asset. An example might be the purchase and sale of the brand name of a specific consumer product. The price paid is not a reliable measure of the fair value of another brand name as the asset is unique and there is no active market.

There is no requirement for valuations to be performed every reporting period. However, revaluations should be made with sufficient regularity that the carrying amount does not differ materially from fair value at the balance sheet date. 11 Best fair value measurements under IFRS 13

The frequency of revaluations, therefore, depends on movements in the fair value of the intangible asset. If an intangible asset’s fair value differs materially from its carrying amount, a new valuation is needed. Market prices for some intangibles may experience significant and volatile movements, such that annual valuations are needed. Intangibles with relatively stable market prices may not require such frequent valuations. 11 Best fair value measurements under IFRS 13

A material change in value might be defined as one that would reasonably influence the decisions of a user of the accounts. As a policy of revaluation is allowed only when there is an active market for the assets, market values should be relatively easy to obtain and keeping such values up to date on an annual basis should also be straightforward.

3 Property, plant, and equipment

IAS 16 31 describes the revaluation model for property, plant, and equipment. It should be possible to measure the PPE’s fair value reliably. The revaluation value should be the fair value at the date of revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. Revaluation have to be made with sufficient regularity to keep up-to-date and relevant. 11 Best fair value measurements under IFRS 13

If a single item of property, plant, and equipment is revalued, then the entire class of property, plant, and equipment to which that item belongs should be revalued. Thus, adopting a policy of revaluation may be costly and involve complex record keeping. 11 Best fair value measurements under IFRS 13

However, an entity may define classes of assets that are narrower than land, buildings, and plant and machinery, provided that they meet the definition of a class according to IAS 16. IAS 16 37 Definition – A class of property, plant and equipment is a grouping of assets of a similar nature and use in an entity’s operations.

The definition does not permit classes of assets determined solely on a geographical basis, but is otherwise reasonably flexible. An entity can adopt meaningful classes that are appropriate to the type of business and assets it holds. Separate disclosures must be made, however, for each class of assets. 11 Best fair value measurements under IFRS 13

For example, each class of assets must be presented as a separate category in the table of movements in property, plant, and equipment in the notes to the financial statements. This requirement may limit the adoption of many narrowly defined classes of assets. 11 Best fair value measurements under IFRS 13

One of the requirements of IAS 16 is that valuations should remain up-to-date. The guidance does not specifically require valuations to be performed every year or every reporting period.

As previously mentioned, the guidance sets out the general principle that revaluations should be made with sufficient regularity so that at the end of the reporting period the carrying amount does not differ materially from fair value. 11 Best fair value measurements under IFRS 13

This imposes no specific time interval for valuations, but rather the interval is determined by the movements in fair value. 11 Best fair value measurements under IFRS 13

A material change in value might be defined as one that “would reasonably influence the decisions of a user of the accounts.” It is a matter of judgment, which is ultimately the responsibility of management. 11 Best fair value measurements under IFRS 13

However, in making that judgment, management would probably consult its appraisers and consider, among other things, factors such as changes in the general market, the condition of the asset, changes to the asset, and its location. Management should consider the combined effect of all the relevant factors. 11 Best fair value measurements under IFRS 13

4 Investment properties

IAS 40 permits an entity to adopt either the fair value model or the cost model as its accounting policy and to apply that policy to all of its investment properties except for investment properties backing liabilities that pay a return linked directly to the fair value of, or returns from, specified assets. 11 Best fair value measurements under IFRS 13

This specific policy choice will be applicable mainly to insurers and similar entities. Its purpose is to mitigate the accounting mismatch that arises where such an entity uses different measurement bases for assets and liabilities. Such entities are able to elect to fair value investment property assets where the investment return on such assets is directly linked to returns on policyholder liabilities, without having to fair value all investment properties. 11 Best fair value measurements under IFRS 13

When an entity has adopted the fair value model, the IASB believes that it should not subsequently change to the cost model. IAS 8 allows a change of policy only if the change will provide reliable and more relevant information about the effects of transactions, other events or conditions. IAS 40 notes it is highly unlikely to be the case for a change from the fair value model to the cost model.

When the cost model is chosen under IAS 40, an entity may not carry any of its investment property at fair value, but it may still adopt a policy of revaluation for its owner-occupied property if it wishes, as these properties are accounted for under IAS 16. However, the fair value model under IAS 40 and the revaluation model under IAS 16 have different accounting impacts. Under IAS 40, gains and losses arising on changes in fair value should be recognized in profit or loss in the period in which they arise. 11 Best fair value measurements under IFRS 13

Under IAS 16, a revaluation surplus is credited to other comprehensive income and accumulated in equity under the heading of revaluation surplus. An exception is a gain on revaluation that reverses a revaluation decrease on the same asset previously recognized as an expense. Gains are first credited to profit or loss to the extent that the gain reverses a loss previously recognized in profit or loss. 11 Best fair value measurements under IFRS 13

The revaluation surplus included in equity may be transferred directly to retained earnings when the surplus is realized (usually when the asset is derecognized). The transfer is made through reserves and not through the income statement. The entire surplus relating to an asset may be transferred when the asset is retired from use or disposed of or may be transferred as the asset is used. 11 Best fair value measurements under IFRS 13

The amount transferred is the difference between depreciation based on the asset’s revalued carrying amount and depreciation based on the asset’s original cost. This amount may, therefore, be transferred from revaluation surplus to retained earnings each year, by means of a reserve transfer. 11 Best fair value measurements under IFRS 13

5 Noncontrolling interests in an acquiree

Noncontrolling interest represents the equity (or net assets) of a subsidiary that is not attributable to the parent and its subsidiaries. Noncontrolling interest can be measured in a business combination in one of two ways, with a choice made individually for each business combination. Noncontrolling interest can be measured at either:

• fair value; or 11 Best fair value measurements under IFRS 13
• the noncontrolling interest’s proportionate share of the acquiree’s net identifiable assets. 11 Best fair value measurements under IFRS 13

As part of its 2010 improvements to IFRS, the IASB clarified that the choice of measuring noncontrolling interests at fair value or at the proportionate share of the acquiree’s net assets applies only to instruments that represent present ownership interests and entitle their holders to a proportionate share of the net assets in the event of liquidation. All other components of noncontrolling interest are measured at fair value unless another measurement basis is required by IFRS. 11 Best fair value measurements under IFRS 13

The IASB made this amendment because some noncontrolling interests (e.g., share options) do not have a present ownership interest and so their share of net assets is zero. The IASB concluded that allowing the noncontrolling interest to be measured at zero would not reflect the economic interest that the noncontrolling interest has in the entity.

When the noncontrolling interest is measured at fair value, it is recognized at an amount that includes the noncontrolling interest’s goodwill (column 4 below). Goodwill is the residual of the elements of a business combination. Therefore, when the noncontrolling interest is measured at fair value, goodwill includes the noncontrolling interest’s share as well as the parent’s share (column 3). 11 Best fair value measurements under IFRS 13

When the noncontrolling interest is measured at its proportionate share of the acquiree’s net identifiable assets, it does not include the noncontrolling interest’s goodwill (column 2). In addition, total goodwill does not include any amount related to the noncontrolling interest (column 1). 11 Best fair value measurements under IFRS 13

These two bases are illustrated below, which shows that total acquired net assets recognized (including goodwill) is higher under the fair value method as a result of recognizing goodwill attributable to the NCI. 11 Best fair value measurements under IFRS 13

Measurement of noncontrolling interest at fair value and proportionate share under IFRS 11 Best fair value measurements under IFRS 13

	Noncontrolling interest measured based on Proportionate share			Noncontrolling interest measured at Fair value
				Controlling and Noncontrolling interest Goodwill	Noncontrolling interest
	Controlling interest Goodwill	Noncontrolling interest
		Consideration transferred			Consideration transferred
	Identifiable net assets			Identifiable net assets
		Previously held interest			Previously held interest

An entity might consider the points in the table below to decide whether to measure noncontrolling interest at fair value. 11 Best fair value measurements under IFRS 13

Proportionate share method—NCI measured at proportionate share of identifiable net assets	Fair value method—NCI measured at fair value
Net assets (including goodwill) and equity are lower at business combination date.	Net assets (including goodwill) and equity are higher at business combination date.
NCI is purchased after the business combination— greater reduction in parent’s share of equity.*	NCI is purchased after the business combination— smaller reduction in parent’s share of equity.*
Total impairment of goodwill is smaller.**	Total impairment of goodwill is greater.**

*Assumes that the consideration paid for the purchase of the NCI is greater than its carrying amount. 11 Best fair value measurements under IFRS 13
**The recognition of goodwill impairments is not affected by how NCI is initially measured; only the amount is affected, because goodwill is grossed up for impairment-testing purposes when NCI is measured at the proportionate share of net assets.  11 Best fair value measurements under IFRS 13
The amount charged to the parent’s share of income is the same – the additional amount charged when NCI is measured at fair value will be included in the amount of profit or loss allocated to the NCI in the income statement.

6 IFRS 9 fair value option for financial assets

Under IFRS 9, an entity can, at initial recognition, irrevocably designate a financial asset as measured at fair value through profit and loss (FVPL) if doing so eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as ‘an accounting mismatch’) that would otherwise arise from measuring assets or liabilities or recognizing the gains and losses on them on different bases. 11 Best fair value measurements under IFRS 13

7 IFRS 9 fair value option for own use contracts

An entity may apply the fair value option irrevocably to contracts to buy or sell non-financial items that qualify for the “own use” exception on initial recognition if it eliminates or significantly reduces an accounting mismatch. 11 Best fair value measurements under IFRS 13

These are contracts that can be settled net or by exchanging financial instruments, or when the non-financial item is readily convertible to cash but were entered into for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale, or usage requirements. 11 Best fair value measurements under IFRS 13

This will eliminate a common mismatch for non-financial entities, such as entities in the utilities industry. This choice can be made on a contract-by-contract basis.

8 IFRS 9 fair value option for financial liabilities

Under IFRS 9, an entity can, at initial recognition, irrevocably designate a financial liability as measured at FVPL when doing so results in more relevant information, because either:

• it eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as “an accounting mismatch”) that would otherwise arise from measuring assets or liabilities or recognizing the gains and losses on them on different bases; or 11 Best fair value measurements under IFRS 13
  
• a group of financial liabilities, or financial assets and financial liabilities is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity’s key management personnel.

Furthermore, financial liabilities can be designated at FVPL if they contain one or more embedded derivatives unless: 11 Best fair value measurements under IFRS 13

• the embedded derivative does not significantly modify the cash flows that otherwise would be required by the contract, or 11 Best fair value measurements under IFRS 13
  
• it is clear with little or no analysis when a similar hybrid (combined) instrument is first considered that separation of the embedded derivative(s) is prohibited, such as a pre-payment option embedded in a loan that permits the holder to pre-pay the loan for approximately its amortized cost. 11 Best fair value measurements under IFRS 13
  

IFRS 9 changes the accounting for financial liabilities that an entity chooses to designate at FVPL. 11 Best fair value measurements under IFRS 13

Except for loan commitments and financial guarantees, changes in fair value of such liabilities related to changes in own credit risk are presented separately in OCI, while all other fair value changes are presented in the income statement. However, this does not apply if the recognition of fair value changes due to own credit risk in OCI would create or enlarge an accounting mismatch.

The decision to designate a financial asset or a financial liability at fair value through profit or loss in these situations is similar to an accounting policy choice where the policy selected is one that provides more relevant information. However, unlike an accounting policy choice, the designation need not be applied consistently to all similar transactions (IFRS 9.B4.1.28).

The designation can be applied on an asset-by-asset or a liability-by-liability basis, with the result that an asset or liability may be accounted for using the fair value option while other holdings of the same type may not. For example, assume an entity expects to issue a number of similar financial liabilities amounting to CU100 and acquire a number of similar financial assets amounting to CU50 that will be carried at fair value. 11 Best fair value measurements under IFRS 13

Provided the criteria are satisfied, the entity may significantly reduce the measurement inconsistency by designating at initial recognition all of the assets but only some of the liabilities (for example, individual liabilities with a combined total of CU45) at fair value through profit or loss. The remaining liabilities amounting to CU55 can be carried at amortized cost.

The option can be applied only to whole instruments and not to portions, such as a component of a debt instrument (that is, an entity may not designate changes in value attributable to one risk such as interest rate risk and not designate changes due to credit risk) (IFRS 9.B4.1.32). 11 Best fair value measurements under IFRS 13

This is because it may be difficult to isolate and measure the portion of a financial instrument if the portion is affected by more than one risk; the amount recognized in the balance sheet for that portion would be neither fair value nor cost; and the fair value adjustment for the portion may move the carrying amount of an instrument away from its fair value.

9 Accounting mismatch

IFRS 9 imposes a mixed measurement model under which some financial instruments are measured at fair value and others at amortized cost; some gains and losses are recognized in profit or loss and others initially in other comprehensive income. This combination of measurement and recognition requirements can result in inconsistencies (sometimes referred to as an “accounting mismatch”) between the accounting for an asset (or group of assets) and a liability (or group of liabilities). 11 Best fair value measurements under IFRS 13

An accounting mismatch occurs when assets and liabilities that are economically related (that is, share a risk) are treated inconsistently.

This could occur when a financial asset (whose contractual cash flows represent solely payments of principal and interest (SPPI)) is held in a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets (with most changes in fair value recognized directly in other comprehensive income), while a related liability is measured at amortized cost (with changes in fair value not recognized). 11 Best fair value measurements under IFRS 13

In such circumstances, an entity may conclude that its financial statements would provide more relevant information if both the asset and the liability were measured as at fair value through profit or loss. 11 Best fair value measurements under IFRS 13

Use of the FV-option may eliminate measurement anomalies for financial assets and liabilities that provide a natural offset of each other because they share the same risk, but when hedge accounting cannot be used because none of the instruments is a derivative. More importantly, even if some of the instruments are derivatives that could qualify for fair value hedge accounting, classification of both items at fair value through profit or loss avoids the designation, tracking, and assessing of hedge effectiveness that hedge accounting entails.

Thus, use of the fair value option as an alternative to hedge accounting can significantly reduce the accounting mismatch. However, under the FV-option, the entire change in fair value would be recognized in profit or loss, not simply the change in fair value attributable to the risk that is hedged by an offsetting derivative. As a result, the amount reported in profit or loss under the FV-option is unlikely to be the same as the change in fair value of the hedging derivative. This may lead to greater profit or loss volatility.

The IASB has not established a percentage, or “bright line,” test for interpreting “significant” in the context of an accounting mismatch. However, the Basis for Conclusions of IFRS 9.BCZ4.63 makes it clear that an effectiveness test similar to that used for hedge accounting is not required to demonstrate that a reduction in an accounting mismatch is significant. This means judgment is required to determine when the fair value option should be applied. 11 Best fair value measurements under IFRS 13

In this regard, management should look at the objective of the proposed designation as “at FVPL.” Comparing the accounting impact—that is, the measurement basis and the recognition of gains and losses—of all relevant items (including, for example, any funding that it is not proposed to be designated at FVPL) before and after the designation will give an indication of whether an accounting mismatch has been eliminated or significantly reduced. 11 Best fair value measurements under IFRS 13

Because there is no prescriptive guidance on when to apply the FVO to eliminate an accounting mismatch, additional disclosures are required to provide information on the factors considered and judgments applied in making a determination that the FVO eliminates an accounting mismatch. 11 Best fair value measurements under IFRS 13

Although it is necessary to demonstrate that there is an accounting mismatch, the extent of evidence needed to identify the accounting mismatch for which the fair value option is to be used need not be extensive. It may be possible to use the same evidence for a number of similar transactions, depending on the circumstances – for example, by identifying a particular kind of accounting mismatch that arises from one of the entity’s chosen risk management strategies. It is not necessary to have the extensive documentation required for hedge accounting, but the entity does need to provide evidence that the fair value option was designated at inception. 11 Best fair value measurements under IFRS 13

Designations as at fair value through profit or loss should be made at initial recognition and once made are irrevocable. For practical purposes, the entity need not enter into all of the assets and liabilities giving rise to measurement or recognition inconsistencies at the same time. A reasonable delay is permitted provided that each transaction is designated as at fair value through profit or loss at its initial recognition and, at that time, any remaining transactions are expected to occur (IFRS 9 B4.1.31 ).

10 IFRS — FVO to designate a credit exposure at FVPL

The credit risk of a financial instrument, such as a loan or loan commitment, is a risk component that does not meet the eligibility criteria to be designated as a hedged item. The spread between the risk-free rate and the market interest rate incorporates credit risk, liquidity risk, funding risk, and other unidentified risk components and margin elements. Credit risk cannot be isolated, and so does not meet the “separately identifiable” criterion. 11 Best fair value measurements under IFRS 13

Credit derivatives, such as credit default swaps that are used to hedge credit risk, are accounted for at FVPL, while credit exposures are usually measured at amortized cost or are unrecognized (such as, loan commitments). When there is credit deterioration, gains are recognized on the credit derivative, while the impairment on the hedged item is measured on a different basis, which results in P&L volatility that does not reflect the credit protection obtained. 11 Best fair value measurements under IFRS 13

There is an option to designate the financial instrument (or a proportion of it) at FVPL. This option is available only when credit derivatives are used to manage all (or a part of) of the credit risk on the instrument and if: 11 Best fair value measurements under IFRS 13

• the name of the credit exposure (for example, the borrower or the holder of a loan commitment) matches the reference entity of the credit derivative (“name matching”); and
• the seniority of the financial instrument matches that of the instruments that can be delivered in accordance with the credit derivative.

This fair value option is different from the irrevocable option for “own use” contracts, since this can be elected (with concurrent documentation) at initial recognition, subsequently, or even while the hedged credit exposure is unrecognized (for example, in the case of a loan commitment). However, if a financial instrument is designated at FVPL after its initial recognition, or was previously not recognized, the difference at the time of designation between the carrying amount, if any, and the FV is recognized immediately in P&L.

11 Group of financial liabilities or assets and liabilities managed on a FV basis

An entity may manage and evaluate the performance of a group of financial liabilities, or financial assets and financial liabilities in such a way that measuring that group at FVPL results in more relevant information. Therefore, in order to designate financial instruments at FVPL, the designation should be based on the manner in which the entity manages and evaluates performance, rather than on the nature of those financial instruments. 11 Best fair value measurements under IFRS 13

An entity should designate all eligible financial instruments that are managed and evaluated together (IFRS 9 B4.1.35). However, designation under this criterion must meet the following two requirements. 11 Best fair value measurements under IFRS 13

• The financial instruments are managed and performance is evaluated on a fair value basis in accordance with a documented risk management or investment strategy
• Information about the group is provided internally on that basis to the entity’s key management as defined in IAS 24 (for example, the entity’s board of directors and chief executive officer)

The requirement that a group of financial assets and liabilities be managed and its performance evaluated on a fair value basis means that management should evaluate the portfolio on a full fair value basis and not on a risk-by-risk basis. For example, an entity that originates fixed interest rate loans and manages the interest rate risk of this portfolio based on the fair value attributable only to interest rate changes will be unable to use the FV-option. 11 Best fair value measurements under IFRS 13

This is because the fair value concept is a broader notion than hedge accounting, such that evaluating the portfolio’s performance for only some risks is not sufficient. Therefore, an entity’s risk management policy and the resulting management information should look at the entire change in fair value and not for only some risks to justify the fair value option’s use.

The required documentation of the entity’s strategy need not be on an item-by-item basis, nor at the level of detail required for hedge accounting. Documentation may be on a portfolio or group basis as long as it clearly identifies the items for which the fair value option is to be used. If the documentation relies on other pre-existing documents, reference should be made to those documents and there should be clear demonstration that the entity manages and evaluates the relevant financial assets or financial liabilities on a FV basis.

The documentation also needs to be sufficient to demonstrate that using the fair value option is consistent with the entity’s risk management or investment strategy. In many cases, the entity’s existing documentation, as approved by key management personnel, should be sufficient for this purpose. For example, if the performance management system for a group—as approved by key management personnel—clearly demonstrates that its performance is evaluated on a total return basis, no further documentation is required to demonstrate compliance with the above requirements (IFRS 9 B4.1.36). 11 Best fair value measurements under IFRS 13

11 Best fair value measurements under IFRS 13