Fair value measurement and pandemics under IFRS 13

Fair value measurement and pandemics

The context

The virus has significantly impacted the world economy. Many countries have imposed travel bans on millions of people and more people in more locations are subject to quarantine measures. Businesses are dealing with lost revenue and disrupted supply chains. While some countries have started to ease the lockdown, the relaxation has been gradual and, as a result of the disruption to businesses, millions of workers have lost their jobs. The pandemic has also resulted in significant volatility in the financial and commodities markets worldwide. Various governments have announced measures to provide both financial and non-financial assistance to the disrupted industry sectors and the affected business organisations.

The issues discussed are by no means exhaustive and their applicability depends on the facts and circumstances of each entity.

Fair value measurement and pandemics

The objective of fair value measurement is to estimate the price at which an orderly transaction to sell an asset or to transfer a liability would take place between market participants at the measurement date under current market conditions (i.e., to estimate an exit price). The impact on fair value measurement (FVM) arising from the coronavirus pandemic and the ensuing economic and market disruptions varies across countries, markets and industries.

Uncertainty is likely to continue, even as some jurisdictions begin to ease the restrictions and open up their economies. Fair value measurement and pandemicsWhen valuations are subject to significant measurement uncertainty due to the current environment and there is a wider range of possible estimates of FVM, the entity is required to apply judgement to determine the point within that range that is most representative of FVM in the circumstances.

Below are certain key FVM considerations within IFRS 13 Fair Value Measurement that can help entities navigate challenges in the context of volatile and uncertain markets.

The definition of fair value contemplates an orderly transaction, which is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities and it is not a forced transaction (e.g., a forced liquidation or distress sale).

While volatility in the financial markets may suggest that the prices are aberrations and do not reflect fair value, it would not be appropriate for an entity to disregard market prices at the measurement date, unless those prices are from transactions that are not orderly.

Evidence of whether a transaction is orderly must be evaluated when deciding the weight that is placed on the transaction price when estimating FVM or market risk premiums. If the observed price is based on a transaction that is determined to be forced or disorderly, little, if any, weight should be placed on it compared with other indications of value.

The determination of whether a transaction is orderly is made at the individual transaction level and requires the use of judgement based on the available evidence from all relevant factors. While market factors such as an imbalance in supply and demand and liquidity constraints can affect the prices at which transactions occur in a given market, such an imbalance does not automatically indicate that the parties to a transaction were not knowledgeable and willing market participants or that a transaction was not orderly.

The entity’s conclusion that it would not sell its own asset (or transfer its own liability) at prices currently observed in the market does not mean these transactions should be presumed to be distressed. IFRS 13 makes clear that fair value is a market-based measurement, not an entity-specific measurement, and notes that the reporting entity’s intention to hold an asset or liability in a market downturn is not relevant.

Food for thought – Market downturn from pandemics

IFRS 13 makes clear that fair value is a market-based measurement, not an entity-specific measurement, and notes that the reporting entity’s intention to hold an asset or liability in a market downturn is not relevant.

An active market is one in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. The level of activity of a market is determined based on the weight of available evidence, such as the number of transactions taking place, widening bid-ask spreads and significant increases in implied liquidity risk premiums.

IFRS 13 is clear that, while observable prices from inactive markets may not be representative of fair value in all cases, Fair value measurement and pandemicsthis data should not be ignored. Additional analysis is required in these instances to assess the relevance of observed transactions or quoted prices in these markets, including analysis to determine whether the transaction is orderly (as discussed above) and factors specific to the asset or liability being measured, as well as facts and circumstances surrounding the price (e.g., size of the transaction, proximity of the transaction to the measurement date and significant developments of the subject and market conditions between these dates).

If the quoted price is based on a transaction that is determined to be orderly, this data point should be considered in the estimation of fair value, albeit adjustments to observable prices (which could be significant) may be necessary or the weight placed on that price in the FVM changed.

A significant decrease in volume or activity in a market can also influence which valuation technique(s) are used, how those techniques are applied and whether inputs are observable at the measurement date. For example, the application of the market approach can prove more challenging and the use of additional valuation techniques may be warranted.

Such additional valuation techniques may need the use of unobservable inputs and would need to be calibrated to the initial transaction price (if determined to represent fair value) to ensure that the valuation technique reflects market conditions. These can also impact the categorisation of the FVM within the fair value hierarchy and changes thereto (e.g., transfer from Level 2 to Level 3 if unobservable inputs are significant to the FVM) that will drive the nature and extent of disclosures required by IFRS 13.

In addition, a significant decrease in the volume of transactions does not automatically imply that a market is no longer active. Despite a decrease from recent (or historical) levels of activity, transactions for an asset or liability in that market may still occur with sufficient frequency and volume to provide pricing information on an ongoing basis, such as an equity security traded on a public exchange.

Where there is an active market for an identical asset or a liability at the measurement date, entities are required to use the quoted price at the measurement date in that market (i.e., Level 1 input) as the basis of FVM without adjustment. This is required even where higher volatilities are experienced in an active market near to the measurement date.

Food for thought – Volume of transactions

Even if there is significant decrease in the volume of transactions, a market may still be active and relevant prices or inputs observed from orderly transactions in that market must still be considered.

IFRS 13’s fair value hierarchy requires valuation techniques to maximise the use of observable inputs from orderly transactions and minimise the use of unobservable inputs. Consequently, even if the market for an asset has become less liquid due to the current environment, relevant prices or inputs observed from orderly transactions in these markets must still be considered.

It would be inappropriate for an entity to default solely to a model’s value based on unobservable inputs such as income approach that uses only an entity’s own inputs (a Level 3 measurement), when Level 2 (observable) information, such as recent transacted prices, is available. Judgement is required in assessing the relevance of observable market data and whether they reflect orderly transactions, particularly in situations where there has been a significant decrease in market activity for an asset or liability.

Resume

IFRS 13 provides relevant guidance on FVM of assets and liabilities in markets that have experienced significant volatilities or reduction in volume or activity, which are particularly relevant in this current environment. The application of this guidance to arrive at a reasonable estimate of FVM requires significant management judgement and hinges on the robustness of the entity’s FVM determination and review processes.

In certain cases, the changes to the existing valuation techniques and valuation adjustments required in response to the current market conditions may warrant assistance from external valuation specialists who possess the necessary expertise, experience and market knowledge.

Providing transparency over the techniques, key assumptions and inputs used in determining fair value, including the sensitivities by providing disclosures required by IFRS 13, is an integral part of FVM and is key to enhancing the usefulness of financial reporting in this unprecedented time.

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.

Fair value measurement and pandemics

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