Fair value measurement

Fair value is defined as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’, also referred to as the willing buyer-willing seller principle. It is important to note that fair value is a market-based measurement and not an entity-specific measurement.

In principle, this is the same as market value. Although actual transactions are usually regarded as taking place at fair value, IASB envisages situations in which they would not be – where a party to the transaction sells at a price lower than it could have done or buys at a price higher than it could have done.

The concept of fair value as an exchange value presents some difficulties. It creates a tension, for example, with the principle that ideally fair value is a theoretical value distinct from either buying or selling prices, actual market prices will never quite match it. The more active the market, however, the less significant this point becomes. For example, in valuing traded securities in accounts it is usual to take the mid-market price as fair value. While this is neither a buying price nor a selling price, it is a value clearly based on and very closely related to market prices.

IFRS 13 (paras 27-30) also states: ‘A fair value measurement of a non-financial asset takes into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use …….. The highest and best use of a non-financial asset takes into account the use of the asset that is physically possible, legally permissible and financially feasible, … Highest and best use is determined from the perspective of market participants, even if the entity intends a different use …..

This approach has similarities to recoverable amount as it appears in recoverable historical cost and value to the business (or recoverable replacement cost). The position adopted in IFRS 13 Fair value measurement is that it is an exit value: sale value for assets and settlement value for liabilities.

For many of the assets and liabilities in companies’ accounts in the precise form and condition in which they exist at the balance sheet date, there are no active markets, so sale and settlement values are difficult to establish. For this reason, IFRS 3 Business Combinations, prescribes a number of alternative measurements that can be taken as fair value. These include:

  • estimated value,
  • present value,
  • selling price less the costs of disposal, plus a reasonable profit allowance,
  • selling price less the sum of costs to complete and costs of disposal, plus a reasonable profit allowance,
  • current replacement cost,
  • depreciated replacement cost,
  • calculation by reference to an active market,
  • the amount that a third party would charge.

‘Calculation by reference to an active market’ can cover a wide range of different forms of calculation. Some of them may be models – such as the Black-Scholes option pricing model – in which prices from active markets provide one or more of the components in a possibly complex formula. This approach, the mark-to-marking model, is common in the financial services sector. The credibility of such model-based valuations is higher where market participants use the same model to determine the prices they will offer or demand in actual transactions.

To increase the consistency and comparability in fair value measurements and related disclosures, IFRS 13 (paras 72-90) established a fair value hierarchy that categorises the inputs to valuation techniques into three levels:

  • Level 1: Quoted (unadjusted) market prices in active markets for identical assets or liabilities,
  • Level 2: Valuation techniques for which the lowest level input that is significant to the fair value measurement is directly or indirectly observable,
  • Level 3: Valuation techniques for which the lowest level input that is significant to the fair value measurement is unobservable.

Fair value implies the recognition of assets and liabilities that are unrecognised under historical cost. If an asset or a liability has a fair value, this in itself is an argument for its recognition. Fair value also implies recognition of gains as they arise rather than as they are realised. This avoids the problem, which arises under historical cost, of asset disposals being timed so as to smooth reported earnings. Fair value income is the increase in the fair value of a business’s net assets during the accounting period.

Why we like fair value measurement?

Where fair values are taken from active markets, they are verifiable and objective.

Why we object fair value measurement?

Where fair values are not taken from active markets, they are estimates, made with more or less subjectivity, of what they would have been if there had been active markets.

In practice, this problem has often been overcome by using forms of fair value measurement – present value, depreciated replacement cost and so on. To the extent that these proxies are used, they carry the advantages and disadvantages of the particular measurement basis concerned. In terms of IFRS 13’s approach, fair value measurements become more subjective the more they depend on inputs from lower levels in the fair value hierarchy.

Why is fair value measurement relevant?

Information prepared on a fair value basis might be more relevant for some purposes than information prepared on other bases. For example, where fair value shows current market prices, it may be of interest to various users.

  • Investors and lenders will be able to see what could be realised (gross) on disposal of the business’s separable assets. This is also a measure of the opportunity cost of holding the assets. This information may be particularly relevant where assets – investments and properties, for example – could be disposed of separately without affecting the underlying business.
  • Where assets generate cash flows separately from the rest of the business, their fair value determined in an active market should provide the best available indication of the value of the probable risk-adjusted future cash flows from those assets. This information may be of interest to investors and creditors.

The investment analysts representatives have argued that:

  • ‘Fair value information is the only information relevant for financial decision-making’;
  • ‘The clearest measures of a company’s wealth-generating or wealth-consuming patterns are changes in the fair values of its assets and obligations’; and
  • ‘Investors who rely on fair values for decision-making must expend considerable effort trying to restate to fair value all decision-relevant financial statement items that are measured at historical cost’. It would help them if the items were stated at fair value in the first place.

What do we hold against fair value measurement?

Except in certain areas of financial services, little use seems to be made of fair value for management purposes. This could be because fair value measurements are made on the basis of a rejected alternative. They show the values that would have been realised had all assets been sold and all liabilities settled at the balance sheet date.

IFRS 9 The Business Model Test
IFRS 9 The Business Model Test

However, the fact that an asset or a liability appears in the balance sheet indicates that the option to sell or settle it at that date was rejected. Why, therefore, would values that reflect a rejected alternative either be the most relevant to disclose or provide the most appropriate basis for measuring performance? This is an argument against the relevance of opportunity costs in measuring a business’s income and financial position. The argument is perhaps less strong where an asset is held for sale. In such cases, the option to sell has been rejected only temporarily.

There is also the objection that assets sold jointly (as business units) usually achieve higher values than assets sold separately. For users interested in market values, therefore, fair values for separable assets seem unlikely to be very relevant. The higher values that could be obtained from sales of business units would be more relevant (unless the business units will have to be broken up). This criticism is met to some extent by the in-use approach in IFRS 13.

Fair value is also likely to be volatile, and could therefore be regarded as misleading, where it is based on probable disposal values for fixed assets – as opposed to, e.g, depreciated replacement cost.

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