IFRS 13 The best Fair value fundamentals discusses the key concepts in the fair value standards, including the definition of fair value, inputs to fair value measurements, and the fair value hierarchy. It also addresses certain issues associated with the application of these concepts.
1 Definition of fair value
Under the fair value standard, fair value is based on the exit price (the price that would be received to sell an asset or paid to transfer a liability), not the transaction price or entry price (the price that was paid for the asset or that was received to assume the liability). Conceptually, entry and exit prices are different.
The exit price concept is based on current expectations about the sale or transfer price from the perspective of market participants. In accordance with the fair value standards, a fair value measurement should reflect all of the assumptions that market participants would use in pricing an asset or liability.
- Unit of account IFRS 13 The best Fair value fundamentals
- Principal or most advantageous market IFRS 13 The best Fair value fundamentals
- Market participants IFRS 13 The best Fair value fundamentals
- Price IFRS 13 The best Fair value fundamentals
- Application to non-financial assets IFRS 13 The best Fair value fundamentals
- Application to liabilities and instruments classified in shareholders’ equity
- Application to financial assets and financial liabilities with offsetting positions in market risks or counterparty credit risk
1.1 Unit of account
As described in the fair value standard (IFRS 13 11 – 14), a fair value measurement relates to a particular asset or liability. Thus, the measurement should incorporate the asset or liability’s specific characteristics, such as condition, location, and restrictions, if any, on sale or use, if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. IFRS 13 The best Fair value fundamentals
In some cases, the fair value measurement will be applied to a standalone asset or liability (e.g., a financial instrument or a non-financial asset) or a group of related assets and/or liabilities, such as a business, or a cash-generating unit (CGU). How the fair value measurement applies to an asset or a liability depends on the unit of account.
The unit of account is determined based on the level at which the asset or liability is aggregated or disaggregated in accordance with IFRS applicable to the particular asset or liability being measured. IFRS 13 The best Fair value fundamentals
The fair value standards address how to measure fair value and not what is being measured. Accordingly, the fair value standards do not change the unit of account prescribed by other standards. As a result, differences between IFRS and US GAAP with respect to the determination of the unit of account may result in differences in fair value measurements.
The fair value standards emphasize the unit of account (as defined in other guidance), generally requiring that the fair value of financial instruments be measured based on the level of the unit of account, rather than at an aggregated or disaggregated level. In some cases, the unit of account may not be clear.
There are few instances in which the unit of account is explicitly defined. Often, it is inferred from the recognition or measurement guidance in the applicable standard and/or from industry practice. For example, under US GAAP, it is clear that the unit of account for evaluating goodwill impairment is the reporting unit.
On the other hand, under US GAAP the guidance on accounting for securities by investment companies is not explicit as to the unit of account. Also, there are times when the unit of account varies depending on whether one is considering recognition, initial measurement, or subsequent measurement, including impairments.
A prominent example of when the application of unit of account has been problematic relates to the fair value of investments in listed subsidiaries and associates (referred to as the “P x Q” issue). The problem specifically is whether the unit of account is the investment as a whole or each share. IFRS 13 The best Fair value fundamentals
Some believe that the unit of account for associates, joint ventures, and subsidiaries is the investment as a whole, and others believe that the fair value of a listed investment quoted in an active market is the product of the share price at the date of measurement and the number of shares held (P × Q).
After completing post-implementation review of IFRS 13, the IASB decided not to perform any further work regarding the unit of account, because the costs of such work would exceed its benefits. Entities reporting under IFRS can use either P × Q for valuing their shareholdings in investments in associates, joint ventures, or subsidiaries, or an appropriate model that takes into consideration any premiums or discounts arising, for example, for existence or lack of control, respectively.
Entities should disclose clearly in the financial statements the fair value model that they have used. Significant implied premiums or discounts are likely to be scrutinized by regulators.
1.2 Determination of the principal or most advantageous market
The fair value standards (IFRS 13 16 – 21) discuss the concepts of principal market and most advantageous market. In accordance with these concepts, the transaction to be fair valued should take place either in: IFRS 13 The best Fair value fundamentals
- The principal market, that is the market with the greatest volume and level of activity for the asset or liability, or
- In the absence of a principal market, the most advantageous market. The most advantageous market is the market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability, after taking into account transaction costs and transportation costs. However, although transaction costs are taken into account when determining which market is the most advantageous, the price used to measure the asset’s fair value is not adjusted for those costs (although it is adjusted for transportation costs). IFRS 13 The best Fair value fundamentals
The principal market is the market with the greatest volume and level of activity for the asset or liability, not necessarily the market with the greatest volume of activity for the particular reporting entity. This concept emphasizes the importance of considering the market participant’s perspective. IFRS 13 The best Fair value fundamentals
If there is a principal market for the asset or liability, the fair value standards state that fair value should be based on the price in that market, even if the price in a different market is potentially more advantageous at the measurement date. It is only in the absence of the principal market that the most advantageous market should be used.
To determine the principal market, the reporting entity needs to evaluate the level of activity in various markets. However, the entity does not have to undertake an exhaustive search of all possible markets in order to identify the principal or most advantageous market; it should take into account all information that is readily available.
In the absence of evidence to the contrary, the market in which an entity normally transacts is presumed to be the principal market, or the most advantageous market in the absence of a principal market.
In many cases, a reporting entity may regularly buy and sell a particular asset and may have clearly identified exit markets. For example, a company engaged in trading natural gas may buy and sell financial gas commodity contracts on the New York Mercantile Exchange and in bilateral markets.
In determining the principal market, the company would need to evaluate the level of activity in various markets. The reporting entity’s principal market will be the market in which the gas commodity contracts have the greatest activity, even if the prices in other markets are more advantageous or if the reporting entity itself has greater trading volume in another market.
The following example illustrates the framework for identifying the principal or most advantageous market.
In a territory, there are two available markets for soy beans:
Producers intend to sell all of the production they can in the export market and, when they do not have any further authorization to export, will sell the remaining production in the domestic market.
What is the principal market?
Although the most advantageous market is the export market in that it gives the higher benefits to the producers, the domestic market is the principal market as it can handle all of the volume that producers have to sell.
Determination of the principal market
Assume a company in the business of refining oil into gasoline enters into a contract to purchase a quantity of crude oil and the contract qualifies as a derivative instrument under IFRS 9 Financial Instruments.
No. Commonly the gasoline market is not considered an appropriate principal market in this case.
The unit of account for the crude oil contract is established by IFRS 9 as the entire contract for the crude oil. The price of gasoline would not provide an appropriate valuation, because the price considers the process of converting crude oil to gasoline.
In this example, the potential markets for the crude oil contract are based on the wholesale markets in which the crude oil can be sold.
1.3 Market determination – other considerations
IFRS 13 Appendix A
Orderly transaction: A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale).
Even where there is no observable market to provide pricing information about the sale of an asset or the transfer of a liability at the measurement date, a fair value measurement shall assume that a transaction takes place at that date, considered from the perspective of a market participant that holds the asset or owes the liability. That assumed transaction establishes a basis for estimating the price to sell the asset or to transfer the liability.
The definition emphasizes the use of market participant assumptions in the determination of fair value. In addition, the concept of an orderly transaction excludes a distressed sale or a forced liquidation as an input in the determination of fair value. For example, assume the normal lead time for sale of an operating asset is approximately three months, which allows for marketing and sufficient due diligence by market participants.
However, if a company needed to raise cash quickly due to a liquidity crisis, it may agree to a distressed sale of certain operating assets at lower-than-market prices. These transactions would not be representative of the fair value for the related assets. In a forced liquidation, the transaction price may not equal the fair value of the asset or liability at initial recognition (see further discussion in Fair value at initial recognition, below).
Reporting entities have the responsibility to determine the principal market, and in the absence of a principal market, the most advantageous market. This allows for differences in markets used among entities with different activities, even those that are party to the same transaction.
For example, the fair value standards (IFRS 13 IE24 – IE26) describe a dealer that enters into an interest rate swap with a retail customer. From the perspective of the dealer, the principal market for the swap is the dealer market; however, the principal market for the retail customer is the retail market because the customer does not have access to the dealer market.
In addition, different operating units within a reporting entity may have access to different markets and each separate unit should individually consider the principal market, and in the absence of a principal market, the most advantageous market.
Therefore, the same reporting entity could have different fair value measurements for identical or similar assets or liabilities, depending on the operating units holding the assets or liabilities and differences in the markets to which they have access and the differences in assumptions of the market participants in those markets. For example, a reporting entity’s operating units located in Asia, Europe, and the US may each hold investments in the same debt and equity securities.
The fair value measurements reported by the operating units may differ at times due to differences in the markets to which they have access and the level of activity for the asset in each market.
The fair value standards require that each reporting unit consider the facts and circumstances appropriate to its valuation of the asset or liability being valued and follow the framework of the fair value standards, independent of other reporting units that may be valuing an identical or similar asset or liability.
1.4 Secondary markets
Secondary markets exist when investors trade among themselves, rather than investing directly through the issuer of a financial instrument in the primary market. In secondary markets, sometimes called “aftermarket,” the issuer of the instrument is typically not involved in the transaction, as the instrument has already been issued.
The New York Stock Exchange is a type of liquid secondary market for stocks of publicly traded companies. Secondary markets also exist for private equity investments, where both current funded private equity investments as well as any remaining unfunded commitments are traded. However, this type of secondary market tends to be less liquid than those of publicly traded instruments.
Therefore, similar to any other asset or liability, when determining the fair value measurement of an instrument traded in a secondary market with limited activity, it is necessary to consider all available trade data in developing market participant assumptions, including from thinly traded secondary markets.
1.5 Market participants
The fair value standards emphasize that a fair value measurement should be based on the assumptions of market participants; it is not an entity-specific measurement. Market participants are buyers and sellers in the principal (or the most advantageous) market for the asset or liability. They are interested in and could benefit from ownership of a specific asset or liability.
IFRS 13 23 Excerpt:
[Reporting entities should consider factors specific to:]
The reporting entity is not required to identify specific market participants, but instead to develop a profile of potential market participants. The determination of potential market participants is a critical step in the overall determination of fair value due to the emphasis on the use of market participant assumptions. In some cases, the identification of market participants may be straightforward, as there may be general knowledge of the types of entities that transact in a particular market.
However, in certain other cases, a reporting entity may need to make assumptions about the type of market participant that may be interested in a particular asset or liability. The determination of the appropriate market and market participants may have a significant effect on the fair value measurement.
In some cases, a reporting entity may have more than one potential exit market and many market participants in each exit market. The fair value standards state that the reporting entity need not undertake an exhaustive search of possible markets to identify the principal market, or in the absence of the principal market, the most advantageous market, but it should consider information that is reasonably available.
Therefore, the reporting entity can use the price in the market in which it normally enters into transactions, unless there is evidence to the contrary. Consistent with this guidance, a reporting entity should use information that is reasonably available to it when developing its profile of market participants.
1.6 No observable markets or no access to markets
There may be situations when there is no observable market for an asset or liability, or a reporting entity may not have access to any markets. For example, there may be no specific market for the sale of an intangible asset. In such cases, the reporting entity should identify potential market participants (e.g., strategic or financial buyers).
Another example is an existing market for buying and selling internet domain names. Although it may not be a principal or most advantageous market for a reporting entity, if the reporting entity has no principal market, the market may provide data for the valuation of domain names.
A reporting entity should determine the characteristics of a market participant to which it would hypothetically sell the asset if it were seeking to do so. Once the market participant characteristics have been determined, the reporting entity would identify the assumptions that those market participants would consider when pricing the asset.
The reporting entity should construct a hypothetical or “most likely” market for the asset based on its own assumptions about what market participants would consider in negotiating a sale of the asset or transfer of the liability.
If there are no apparent exit markets or if the reporting entity does not have access to any known or observable markets, activity in inaccessible known markets may be considered in developing the inputs that would be used in a hypothetical market.
However, the information from the inaccessible market may need adjustment for any differences in the characteristics of the asset or liability being measured and the price observed within a market. That is, the need to adjust the inputs applies even when the inputs are observable.
Some common characteristics that may prevent an entity from accessing a particular price within a market are:
- A reporting entity’s need to transform the asset or liability in some way to match the asset or liability in the observable market
- Restrictions that may be unique to the reporting entity’s asset or liability that are not embedded in the asset or liability in the observable market
- Marketability or liquidity differences between the asset or liability in the observable market relative to the reporting entity’s asset or liability
1.7 Changing market participants
The applicable market participants may change over time; therefore, a reporting entity should reconsider potential market participants each time a fair value measurement is performed. For example, financial buyers may have been identified as market participants in a previous fair value measurement because they were active in a specific market, such as the purchase of a retail business.
However, if strategic buyers become active in acquiring the assets or liabilities being measured, they may become appropriate market participants to consider in the fair value measurement as it becomes more likely that they would transact in the current market.
1.8 The price
The standards provide guidance on the price as it relates to fair value.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (that is, an exit price) regardless of whether that price is directly observable or estimated using another valuation technique.
1.9 Transaction costs
IFRS 13 Appendix A
Transaction costs: The costs to sell an asset or transfer a liability in the principal (or most advantageous) market for the asset or liability that are directly attributable to the disposal of the asset or the transfer of the liability and meet both of the following criteria:
The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. Transaction costs shall be accounted for in accordance with other IFRS-standards.
While transaction costs are not included in the fair value of the asset or liability under the fair value standards, these amounts are included when assessing the net transaction proceeds to determine the most advantageous market, as illustrated in the below example.
1.10 Transportation costs
If location is a characteristic of the asset or liability being measured (e.g., in the case of a physical commodity), the fair value measurement should incorporate transportation costs. The cost of transporting a physical asset from its current location to the market should be considered in the computation of fair value that is based on the price in that market.
For example, assume a company intends to sell corn by using a corn futures contract on the Chicago Board of Trade. The contract calls for physical delivery to the Chicago Switching Yard; therefore, because the location of the corn is an attribute of the contract, the company should deduct the cost of physically transporting the corn to the sale location in the calculation of fair value.
FV Company has an asset that is sold in two different markets, Market A and Market B, with similar volumes of activities, but with different prices. FV Company enters into transactions in both markets and can access the price in those markets for the asset at the measurement date. There is no principal market for the asset.
Information from both markets is presented as follows.
How should FV Company measure the fair value of the asset?
As a principal market for the asset does not exist, FV Company should measure the fair value of the asset using the price in the most advantageous market. The most advantageous market is the market that maximizes the amount that would be received to sell the asset, after taking into account transaction costs and transport costs (that is, the net amount that would be received in the respective markets).
FV Company would receive greater net proceeds in Market B ($22) than in Market A ($21). So the fair value of the asset should be measured using the price in that market ($25), less transport costs ($2), resulting in a fair value measurement of $23.
If either Market A or Market B had been the principal market for the asset (that is, the market with the greatest volume and level of activity for the asset), FV Company would measure the asset’s fair value using the price that would be received in that market, after taking into account transport costs.
1.11 Inputs based on bid and ask prices
Bid-ask price quoting is common within markets for certain securities and commodities. In these markets, deal ers stand ready to buy at the bid price and sell at the ask price. If an input is based on bid and ask prices, the fair value measurement should represent the price within the bid-ask spread at which market participants would transact on the measurement date.
A reporting entity may establish a policy to use bid prices for long positions (assets) and ask prices for short positions (liabilities). Alternatively, the fair value standards allow for the use of mid-market pricing (i.e., the midpoint between the bid and the ask prices) or other pricing convention that is used by market participants within the bid-ask spread as a practical expedient for fair value.
Many reporting entities use the mid-market convention because it simplifies some of the necessary calculations and allows the use of the same quotes and prices when calculating the fair value of both assets and liabilities.
However, use of the mid-market convention as a practical expedient may result in a measurement that is less precise than use of the price at which the reporting entity expects to trade. When electing mid-market pricing, a reporting entity does not need to evaluate mid-market pricing against expectations of where it actually would trade within the bid-ask range.
There are times when use of bid-ask pricing is appropriate, and times when reporting entities should consider using valuation techniques. Use of bid-ask pricing and therefore, the mid-market practical expedient, is presumed appropriate for inputs within a bid-ask spread that fall within Level 1 of the fair value hierarchy (i.e., unadjusted observable quoted prices for identical assets or liabilities).
Beyond that, judgment is required.
Generally, the less observable the input, the less probable it is subject to a bid-ask spread and, therefore, the less likely that use of bids, asks, or a mid-market convention would be appropriate.
For example, it may not be appropriate to apply bid-ask pricing or a mid-market convention when the bid-ask spread is wide. A wide bid-ask spread could indicate the inclusion of a pricing element other thantransaction costs (e.g., a liquidity reserve).
Once established, a reporting entity should apply its convention consistently.
The following question discusses whether a reporting entity can change its use of the mid-market practical expedient pricing convention.
Can a reporting entity change its use of a mid-market practical expedient pricing convention?
While there may be circumstances when reporting entities may need to reconsider their use of the mid-market practical expedient, we generally believe that it should be applied consistently.
The following example illustrates recording a gain or loss at the inception of a contract as a result of the use of a mid-market pricing convention.
Recording a gain or loss at the inception of a contract as a result of the use of a mid-market pricing convention
FV Company enters into a six-month forward contract for the purchase of natural gas at an actively traded location (its principal market for that type of transaction) and the contract is accounted for at fair value under IFRS 9.
The bid-ask spread is $1 (bid: $99; ask: $100). Use of the midpoint ($99.50) convention will result in a $0.50 loss at initial recognition assuming FV Company purchased at the ask price and recorded the contract using the mid-price convention.
Is it appropriate to record a loss at inception on the forward contract?
Yes. Because the contract is actively traded and was entered into in FV Company’s principal market, the transaction price would be expected to be the same as the exit price. For Level 1 inputs, it is expected that differences between the mid-market pricing and the transaction prices would be due to transaction costs and should be minimal. Thus, use of the mid-market pricing results in recognition of an initial loss.
How should a reporting entity account for transaction costs in a bid-ask spread?
While conceptual and/or economic arguments can be made that transaction costs represent a component of the bid-ask spread, we do not believe a reporting entity needs to bifurcate the bid-ask spread to identify and account separately for transaction costs, which are typically not included in fair value measurements. In other words, the unadjusted bid, ask, or mid-prices, depending on the reporting entity’s convention, are considered fair value.
1.12 Application to non-financial assets – the valuation premise and highest and best use
1.12.1 Highest and best use of non-financial assets
The highest and best use of a non-financial asset or group of non-financial assets and non-financial liabilities is the use by market participants that maximizes the value of the non-financial asset(s). As such, the determination of highest and best use impacts the fair value measurement.
The concept refers to both (1) the different ways of utilizing the individual asset (e.g., as a factory or residential site), the highest and best use, and (2) the valuation premise, whether the maximum value is on a standalone basis or in combination with other assets.
For example, a reporting entity may intend to operate a property as a bowling alley, while market participants would pay a higher price to use the asset as a parking lot and zoning requirements allow for this change in use. In this case, the fair value of the property should be based on its highest and best use (in the principal or most advantageous market) as a parking lot.
1.12.2 Interaction of unit of account and valuation premise for non-financial assets
IFRS 13 Appendix A
The unit of account represents what is being valued, based upon other relevant US GAAP or IFRS for the asset or liability being measured, while the valuation premise determines whether the maximum value of the non-financial asset is on a standalone basis or in combination with other assets.
The unit of account determines what is being measured for purposes of recognition in the financial statements by reference to the level at which the asset or liability is aggregated or disaggregated when applying other applicable US GAAP or IFRS. A reporting entity should go through the fair value framework to establish the principal, most advantageous, or hypothetical market based on the unit of account being valued.
Whether the valuation premise is in combination with other assets and liabilities or standalone is determined from the perspective of market participants. That is, a unit of account may be grouped with other units of account to achieve the highest and best use.
In considering potential markets, a reporting entity may need to consider different groupings of non-financial assets to determine which grouping provides the highest value from the perspective of a market participant. However, a unit of account may not be included in more than one group in the final determination of fair value.
The valuation premise may also be on a disaggregated basis. Disaggregation is the process of determining the fair value of a unit of account based on the individual sale of the components of the group. This is applicable if a unit of account can be sold in components that would maximize the overall value of the unit of account from the perspective of market participants. As with asset groupings, the reporting unit must have access to the market into which components of a unit of account would be sold.
That is the case even when that fair value measurement assumes that the highest and best use of the asset is to use it in combination with other assets or with other assets and liabilities because a fair value measurement assumes that the market participant already holds the complementary assets and associated liabilities.
The guidance indicates that the unit of account for non-financial assets may differ from the unit of measurement. If the highest and best use of an asset is that it should be combined with other assets, the fair value is determined for the asset in combination with those other assets. This may require the value of the group to be allocated to the components in a systematic and rational manner.
When applying the concepts of both aggregation and disaggregation, the valuation should be allocated to the individual components such that the ultimate valuation relates solely to the unit of account.
A business is an example of assets and liabilities used in combination. Separate assets often work together or complement each other. Liabilities associated with the complementary assets can include liabilities that fund working capital. However, liabilities used to fund assets other than those within the group of assets cannot be included in the valuation.
1.13 Application to liabilities
Under the fair value standards, the fair value of a liability is based on the price to transfer the obligation to a market participant at the measurement date, assuming the liability will live on in its current form.
Even though most liabilities restrict their transfer, fair value should not be adjusted for such restrictions to the liability. However, in the absence of an observable market for the transfer of a liability, the fair value standards require that preparers consider the value of the corresponding asset held by a market participant, if applicable, when measuring the liability’s fair value.
The Basis for Conclusions of IFRS 13 noted this concept.
IFRS 13 BC 88
…in the boards’ view, the fair value of a liability equals the fair value of a properly-defined corresponding asset (that is, an asset whose features mirror those of the liability), assuming an exit from both positions in the same market.
The Boards believe that fair value from the viewpoint of investors and issuers should be the same in an efficient market, otherwise arbitrage would result. They considered whether these different viewpoints could result in different fair values because the asset is liquid but the liability is not.
The asset holder could easily sell the asset to another party, whereas the liability will be more difficult to transfer to another party. The Boards decided that there was no conceptual reason why a different fair value should result, given that both parties are measuring the same instrument with identical contractual terms in the same market.
IFRS 13 45 states that there should be no separate inputs or adjustments to existing inputs for restrictions on transfer of liabilities in the measurement of fair value. IFRS 13 BC100 indicates that the Boards had two reasons for this guidance.
First, restrictions on the transfer of a liability relate to the performance of the obligation whereas restrictions on the transfer of an asset relate to its marketability. Second, nearly all liabilities include a restriction on transfer, whereas most assets do not. As a result, the effect of a restriction on transfer of a liability would theoretically be the same for all liabilities. This differs from the treatment of assets with restrictions (see restricted assets).
The fair value of the liability may not be the same as the fair value of the corresponding asset in certain circumstances, such as when the pricing includes a bid-ask spread. In such cases, the liability should be valued based on the price within the bid-ask spread that is most representative of fair value for the liability, which may not necessarily be the same as the price within the bid-ask spread that is most representative of fair value for the corresponding asset.
IFRS 13 37 addresses the situation in which a quoted price for the transfer of an identical or similar liability or instrument classified in a reporting entity’s shareholder’s equity is not available and the identical item is not held by another party as an asset. In that case, the reporting entity should measure fair value using a valuation technique from the perspective of a market participant that owes the liability or has issued the claim on equity.
1.14 Non-performance risk
The fair value of a liability reflects the effect of non-performance risk. Non-performance risk includes, but may not be limited to, a reporting entity’s own credit risk. Non-performance risk is assumed to be the same before and after the transfer of the liability.
This concept assumes that the liability would be transferred to a credit-equivalent entity. However, transfers of liabilities are rare. In practice, most liabilities are settled with the holder or may be extinguished through execution of an offsetting contract. Therefore, measuring the transfer value of a liability has proven to be a challenge when settlement has historically been the primary means for exit and there is no market for the corresponding asset.
The fair value standards also provide guidance on the income approach for the measurement of certain liabilities at fair value. IFRS 13 B31 indicates that the compensation that a market participant would require for taking on the obligation includes the return that the market participant would require for (1) undertaking the activity and (2) assuming the risk associated with the obligation.
The return for undertaking the activity represents the value of fulfilling the obligation, for example, by using resources that could be used for another purpose. The return for assuming the risk represents the value associated with the risk that cash outflows may ultimately differ from expectations.
1.15 Difference between financial and non-financial liabilities
A performance obligation may be contractual or non-contractual, which affects the risk that the obligation is satisfied. These differences affect the variability and magnitude of risks and uncertainties that can influence the settlement or satisfaction of the obligation and its fair value. Therefore, it is important to be aware of these differences when measuring the fair value of performance obligations.
The value of a liability measured at fair value is the price that would be paid to transfer the liability to a third party. The amount that would be required to pay a third party (of equivalent credit or non-performance risk) to assume a liability may differ from the amount that a reporting entity would be required to pay its counterparty to extinguish the liability.
For example, a financial institution transferee may be willing to assume non-demand-deposit liabilities for less than the principal amount due to the depositors because of the relatively low funding cost of such liabilities. However, in other instances, an additional risk premium above the expected payout may be required because of uncertainty about the ultimate amount of the liability (e.g., asbestos liabilities or performance guaranties).
The risk premium paid to a third party may differ from the settlement amount the direct counterparty would be willing to accept to extinguish the liability. In addition, the party assuming a liability may have to incur certain costs to manage the liability or may require a profit margin.
These factors may cause the transfer amount to differ from the settlement amount. In measuring liabilities at fair value, the reporting entity must assume that the liability is transferred to a credit equivalent entity and that it continues after the transfer (i.e., it is not settled).
Accordingly, it follows that the hypothetical transaction used for valuation is based on a transfer to a credit equivalent entity that is in need of funding and willing to take on the terms of the obligation.
In application, there may be significant differences between settlement value and transfer value. Among the differences is the impact of credit risk, which is often not considered in the settlement of a liability, as demonstrated in the following example.
Transfer value compared to settlement value
A debt obligation is held by a bank with a face value of $100,000 and a market value of $95,000. The interest rate is at market; however, there is a $5,000 discount due to market concerns about the risk of non-performance.
What is the presumed settlement value and transfer value of the note?
Absent exceptional circumstances, the counterparty (Counterparty A) would be required to pay the full face value of the note to settle the obligation, as the bank may not be willing to discount the note by the credit risk adjustment. Therefore, the settlement value would be equal to the face amount of the note.
To calculate the transfer value, Counterparty A must construct a hypothetical transaction in which another party (Counterparty B) with a similar credit profile is seeking financing on terms that are substantially the same as the note. Counterparty B could choose to enter into a new note agreement with the bank or receive the existing note from Counterparty A in a transfer transaction.
In this hypothetical transaction, Counterparty B should be indifferent to obtaining financing through a new bank note or assumption of the existing note in transfer for a payment of $95,000.
The bank should also be indifferent to Counterparty B’s choice, as both counterparties have similar credit profiles.
Therefore, the transfer value would be $95,000, $5,000 less than the settlement amount.
Under the fair value standard, reporting entities should adopt an approach to valuing liabilities that incorporates the transfer concept. There is no exemption from or practical expedient for this requirement.
The principles in the fair value standards are also applied to “own issued equity instruments” and instruments classified in shareholders’ equity. An example of this is when equity interests are issued as consideration in a business combination.
The guidance specifies that even when there is no observable market to provide pricing information about the transfer of an entity’s own equity instrument, the entity should measure the fair value of its own equity instruments from the perspective of a market participant who holds the instrument as an asset.
Similar to the application to liabilities, when equity instruments are not held by other parties as assets in an observable market, an entity should use a valuation technique using market participant assumptions.
1.17 Financial assets and liabilities with offsetting risks
The fair value standards include an exception to the general valuation principles when an entity manages its market risk(s) and/or counterparty credit risk exposure within a group (portfolio) of financial instruments, on a net basis. This exception includes portfolios of derivatives that meet the definition of a financial instrument that are managed on a net basis.
The “portfolio exception” allows for the fair value of those financial assets and financial liabilities to be measured based on the net positions of the portfolios (i.e., the price that would be received to sell a net long position or transfer a net short position for a particular market or credit risk exposure), rather than the individual values of financial instruments within the portfolio.
Therefore, size is an attribute of the portfolio being valued, and a premium or discount based on size is appropriate if incorporated by market participants. This represents an exception to how financial assets and financial liabilities are measured under the fair value standards, which requires each unit of account within a portfolio to be measured on its own (that is, on a gross basis).
2 Fair value at initial recognition
Certain accounting standards require or permit an asset or a liability to be initially recognized at fair value. The fair value standards state that in many cases the transaction price equals fair value, such as when on the transaction date the transaction to buy an asset takes place in the market in which the asset would be sold. In determining whether a transaction price represents the fair value at initial recognition, a reporting entity should take into account factors specific to the transaction and to the asset or the liability. As discussed in IFRS 13 B4, a transaction price may not represent fair value in certain situations:
- a related party transaction;
- a transaction under duress or a forced transaction;
- the unit of account for the transaction price does not represent the unit of account for the asset or liability being measured; or
- the market for the transaction is different from the market for the asset or liability being measured.
A Day 1 gain or loss on a financial instrument (i.e., upon initial recognition of the instrument) is recognized only when the fair value of that instrument is evidenced by a quoted price in an active market for an identical asset or liability (i.e.,. a Level 1 input) or based on a valuation technique that uses only data from observable markets.
3 Valuation approaches, techniques, and methods
The fair value standards describe three main approaches to measuring the fair value of assets and liabilities: the market approach, the income approach, and the cost approach. The fair value standard also provides examples of valuation techniques that are consistent with each valuation approach. In practice, valuation professionals often refer to valuation methods. Commonly, valuation techniques and methods are synonymous. The terms are used interchangeably here.
International Valuation Standards
In addition to the guidance in US GAAP and IFRS, the International Valuation Standards (IVS) 2017 edition, finalized in January 2017, includes:
- a general framework for the selection of valuation approaches and methods
- a description of the circumstances when each of the three approaches should be afforded significant weight in a valuation
- key factors that valuation professionals need to consider in the application of the most commonly used valuation methods
General standards include: scope of work, investigations and compliance, reporting, bases of value, and valuation approaches and methods. The bases of value standard includes a requirement that valuation professionals select a basis of value appropriate to the purpose of the valuation (and follow all applicable guidance related to that basis of value). For example, in performing a valuation for financial reporting purposes, “fair value” as defined by the FASB or IASB must be used.
property interests, development property, and financial instruments.
3.1 Market approach
The market approach is often used as the primary valuation approach for financial assets and liabilities when observable inputs of identical or comparable instruments are available. The fair value standard defines the market approach.
The market approach uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business.
For example, valuation techniques consistent with the market approach often use market multiples derived from a set of comparables. Multiples might be in ranges with a different multiple for each comparable. The selection of the appropriate multiple within a range requires judgment, considering qualitative and quantitative factors specific to the measurement.
The market approach is also used commonly for real estate when comparable transactions and prices are available, and can be used to value a business or elements of equity (e.g., NCI). The market approach may also be used as a secondary approach to evaluate and support the conclusions derived using an income approach.
Matrix pricing is a valuation technique within the market approach. It is a mathematical technique that may be used to value debt securities by relying on the securities’ relationship to other benchmark quoted prices and is commonly used to price bonds, most notably corporate and municipal bonds.
3.2 Cost approach
The cost approach reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost).
This approach assumes that a market participant buyer would not pay more for an asset than the amount for which it could replace the service capacity of that asset. Obsolescence includes “physical deterioration, functional (technological) obsolescence, and economic (external) obsolescence.”
Therefore, in using a replacement cost approach, a reporting entity would need to consider the impact of product improvements.
The cost approach is typically used to value assets that can be easily replaced, such as property, plant, and equipment.
3.3 Income approach
The income approach is applied using the valuation technique of a discounted cash flow (DCF) analysis, which requires (1) estimating future cash flows for a certain discrete projection period; (2) estimating the terminal value, if appropriate; and (3) discounting those amounts to present value at a rate of return that considers the relative risk of the cash flows and the time value of money.
Terminal value represents the present value at the end of the discrete projection period of all subsequent cash flows to the end of the life of the asset or into perpetuity if the asset has an indefinite life.
The income approach converts future amounts (for example, cash flows or income and expenses) to a single current (that is, discounted) amount. When the income approach is used, the fair value measurement reflects current market expectations about those future amounts.
Income approaches are used to measure the value of liabilities, intangible assets, businesses (e.g., for purposes of computing an internal rate of return, or to measure the fair value of an NCI or previously held equity interest when the price is not observable), and financial instruments when those assets are not traded in an active market.
The fair value standard (IFRS 13 B12) discusses the use of present value techniques in the determination of fair value. Those techniques include the “discount rate adjustment” technique and the “expected cash flow (expected present value)” technique.
The fair value standards neither prescribe the use of one single specific present value technique nor limit the use of specific present value techniques to measure fair value, instead indicating that a reporting entity should use the appropriate technique based on facts and circumstances specific to the asset or liability being measured and the market in which they are transacted, and with all valuation techniques, maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs.
In practice, adjusting the expected cash flows to reflect systematic risk is often difficult. In most instances, therefore, for non-financial assets, the discount rate that is applied to cash flows incorporates systematic or non-diversifiable risk, which is often represented by a weighted-average cost of capital that would be required by a marketplace participant.
However, adjustments made to the discount rate tend to underweight risk. Additionally, the discount rate is a single point estimate, while expected cash flows are weighted by different probabilities of occurrence in the future. IFRS 13 The best Fair value fundamentals
3.4 Application of valuation techniques
These are the common valuation techniques within each of the valuation approaches. IFRS 13 The best Fair value fundamentals
Replacement cost method
Reproduction cost method
IFRS 13 The best Fair value fundamentals
IFRS 13 The best Fair value fundamentals
IFRS 13 The best Fair value fundamentals
IFRS 13 The best Fair value fundamentals
Market pricing based on recent transactions
IFRS 13 The best Fair value fundamentals
IFRS 13 The best Fair value fundamentals
IFRS 13 The best Fair value fundamentals
IFRS 13 The best Fair value fundamentals
Relief from royalty method
Price premium method
Multi-period excess earnings method (MEEM)
Incremental cash flow method
Contingent claims/real option models
Discounted cash flow method
In some cases, one valuation technique may provide the best indication of fair value (e.g., the use of the market approach in the valuation of an actively traded equity security); however, in other circumstances, multiple valuation techniques may be appropriate (e.g., in valuing a reporting unit or cash-generating unit for purposes of step 1 of a goodwill impairment test).
The application of each technique may indicate different estimates of fair value. These estimates may not be equally representative of the fair value due to the assumptions made in the valuation or the quality of inputs used. IFRS 13 The best Fair value fundamentals
Using multiple valuation techniques can act as a check on these assumptions and inputs. The reporting entity should carefully evaluate the inputs and assumptions used if the range of values is wide. Fair value should be based on the most representative point within the range considering the specific circumstances. IFRS 13 The best Fair value fundamentals
If the transaction price is fair value at initial recognition and a valuation technique that uses unobservable inputs will be used to measure fair value in subsequent periods, the valuation technique shall be calibrated so that at initial recognition the result of the valuation technique equals the transaction price.
Calibration ensures that the valuation technique reflects current market conditions, and it helps a reporting entity to determine whether an adjustment to the valuation technique is necessary (for example, there might be a characteristic of the asset or liability that is not captured by the valuation technique).
After initial recognition, when measuring fair value using a valuation technique or techniques that use unobservable inputs, a reporting entity shall ensure that those valuation techniques reflect observable market data (for example, the price for a similar asset or liability) at the measurement date.
As discussed in IFRS 13 65 – 66, reporting entities should consistently apply the valuation techniques used to measure fair value for a particular type of asset or liability. However, it is appropriate to change a valuation technique or an adjustment that is applied to a valuation technique if the change will result in a measurement that better represents fair value; for instance, a change in a particular technique’s weighting when multiple valuation techniques are used may be appropriate based on changes in facts and circumstances.
A change in valuation technique may also be warranted as new markets develop, new information becomes available, information previously used is no longer available, valuation techniques improve, or market conditions change. Revised valuations resulting from a change in the valuation technique or its application are accounted for as a change in accounting estimate, with the change impacting the current and future periods, if applicable. IFRS 13 The best Fair value fundamentals
Application of the income approach to foreign currencies
When a discounted cash flow analysis is done in a currency that differs from the currency used in the cash flow projections, the cash flows should be translated using one of the following two methods: IFRS 13 The best Fair value fundamentals
- Discount the cash flows in the reporting currency using a discount rate appropriate for that currency. Convert the present value of the cash flows at the spot rate on the measurement date.
- Use a currency exchange forward curve, if available, to translate the reporting currency projections and discount them using a discount rate appropriate for the foreign currency.
4 Inputs to fair value measurement and hierarchy
- Level 1: observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets
- Level 2: inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or indirectly
- Level 3: unobservable inputs (e.g., a reporting entity’s or other entity’s own data) IFRS 13 The best Fair value fundamentals
The fair value standards define a principal market as the market with the greatest volume and level of activity for the asset or liability. It further states that market participants are buyers and sellers in this market that are independent of each other, knowledgeable, and willing and able to enter into a transaction for the asset or liability.
The determination of the reporting entity’s principal market is made from the perspective of the reporting entity; the availability of pricing inputs is not part of that assessment. For example, if the reporting entity is a retail customer and does not have access to the wholesale market, the reporting entity’s principal market is the retail market and quoted prices in the wholesale market will not qualify as fair value for that reporting entity. IFRS 13 The best Fair value fundamentals
If a price for the exact unit of account (i.e., a Level 1 input) is not available in the principal market, then the reporting entity will have to use a valuation technique with one or more inputs from the same or other markets to derive fair value. The availability of pricing inputs from other markets may impact the choice of valuation technique.
For example, if Level 1 inputs are available in another market (i.e., a market approach), that approach may provide more objective evidence of fair value than an income approach using Level 2 inputs from the principal market. However, in either case, the resulting fair value measurement would not be considered a Level 1 input.
By distinguishing between inputs that are observable in the marketplace, and therefore more objective, and those that are unobservable and therefore more subjective, the hierarchy is designed to indicate the relative subjectivity and reliability of the fair value measurements. IFRS 13 The best Fair value fundamentals
Disclosure is required by level; as the objectivity of the inputs decrease, disclosure increases. Certain required disclosures are applicable only to those fair value assets and liabilities characterized as Level 3. IFRS 13 The best Fair value fundamentals
The following figure sketches the steps to differentiate Level 2 and Level 3 in the fair value hierarchy of a fair value measurement. Level 1 fair value measurements have been excluded from the framework as they have a Level 1 price for the entire unit of account. IFRS 13 The best Fair value fundamentals
Fair value hierarchy framework (for Levels 2 and 3)
Steps 1 through 4 are explained below. See Fair value disclosures for the required disclosures.
4.1 Step 1: determine all inputs to valuation techniques
Inputs broadly refer to the information that market participants use to make pricing decisions, including assumptions about risk. Inputs may include price information, revenue growth, changes in profitability, volatility factors, specific and broad credit data, liquidity statistics, and all other factors that have more than an insignificant effect on the fair value measurement.
Reporting entities should use observable inputs when available.
4.2 Step 2: determine which inputs are significant
In some cases, a valuation technique used to measure fair value may include inputs from multiple levels of the fair value hierarchy. IFRS 13 73 indicates that the asset or liability is categorized in its entirety on the lowest level of a significant input. IFRS 13 The best Fair value fundamentals
One significant unobservable input results in the entire asset or liability being classified in Level 3. Therefore, the reporting entity needs to identify all significant inputs when determining the appropriate classification within the hierarchy. IFRS 13 The best Fair value fundamentals
Assessing the significance of a particular input to the fair value measurement requires judgment, and should consider factors specific to the asset or liability. There are no bright lines for determining significance. A reporting entity should develop and consistently apply a policy for assessing significance.
In assessing the significance of unobservable inputs to an asset or liability’s fair value, a reporting entity should (1) consider the sensitivity of the asset or liability’s overall value to changes in the input and (2) assess the likelihood of variability in the input over the life of the asset or liability.
An input could be unobservable and have little impact on the valuation at initial recognition, but the same input could have a significant remeasurement impact if markets and related assumptions change.
Additionally, we believe reporting entities should perform the significance assessment on an individual input level and an aggregate input level, considering aggregation of inputs when more than one item of unobservable data (or more than one parameter) is used to measure the fair value of an asset or liability.
IFRS 13 B35(b) provides an example of an interest rate swap with a ten-year life that has an observable yield curve for nine years. In that example, provided that the extrapolation of the yield curve to the tenth year is not significant to the fair value measurement of the swap in its entirety, the fair value measurement is considered Level 2. IFRS 13 The best Fair value fundamentals
Had the reporting entity judged the final year of the instrument to be a significant input, it would have been a Level 3 measurement.
4.3 Step 3: determine if significant inputs are observable
- Prices or quotes from exchanges or listed markets (e.g., New York Mercantile Exchange, Chicago Board of Trade, London Stock Exchange, Tokyo Stock Exchange, or New York Stock Exchange and Euronext) in which there is sufficient activity IFRS 13 The best Fair value fundamentals
- Proxy observable market data that is proven to be highly correlated and has a logical, economic relationship with the instrument being valued (e.g., electricity prices in two different locations or “zones” that are highly correlated) IFRS 13 The best Fair value fundamentals
- Other direct and indirect market inputs that are observable in the marketplace IFRS 13 The best Fair value fundamentals
The following list of characteristics, if present, would provide evidence that an input is derived from observable market data. However, inputs need not have all of the following characteristics for it to qualify as observable market data. IFRS 13 The best Fair value fundamentals
Supported by market transactions IFRS 13 The best Fair value fundamentals
Although data need not be traced directly to a “live” or “perfectly offsetting” transaction, there should be strong evidence that (1) the data sources draw their information from actual market transactions between other market participants or (2) the information is used by market participants to price actual market transactions. The reporting entity will normally need to perform a degree of review and/or verification of the data supporting the quote. IFRS 13 The best Fair value fundamentals
Not proprietary IFRS 13 The best Fair value fundamentals
Observable data incorporated into an input of a valuation technique comes from sources other than within the reporting entity that is making the determination. In addition, the data should be distributed broadly, and not limited in its distribution to only the entity making the determination or to a small group of users. The data should be available to and regularly used by participants in the relevant market/product sector as a basis for pricing transactions or verifying such prices. Even an internally developed assumption may be an observable input if it can be corroborated to an external source. IFRS 13 The best Fair value fundamentals
Readily available IFRS 13 The best Fair value fundamentals
Market participants should be able to obtain access to the data, although the supplier of the information could impose a reasonable fee for access.
Regularly distributed IFRS 13 The best Fair value fundamentals
The term “regular distribution” means that the data is made available in a manner that is timely enough to allow the data to be meaningful in pricing decisions. Further, there should be procedures in place to verify that changes between intervals have not occurred that would render the data meaningless. In addition, the distributed information should indicate its effective date to ensure that data received is not stale. IFRS 13 The best Fair value fundamentals
Transparent IFRS 13 The best Fair value fundamentals
The people/sources providing and/or distributing the data and their role in a particular product/market should be transparent and known to be reliable. In addition, it needs to be clear to the people who provide the data that market participants use this information to price/verify transactions. IFRS 13 The best Fair value fundamentals
Verifiable IFRS 13 The best Fair value fundamentals
The data should be verifiable. Further, there should be evidence that users are, in fact, regularly verifying the data. For example, people who are independent of a particular reporting entity should be able to contact the third-party data provider directly in order to verify the data that is obtained and used. It also should be possible for people to verify the data by comparing it with data that is obtained from other reliable sources. IFRS 13 The best Fair value fundamentals
Reliable IFRS 13 The best Fair value fundamentals
The data should reflect actual market parameters and be subject to certain levels of periodic testing and monitoring. These controls should exist at the entity providing the data, and at the entity using the data. Reporting entities should test and review the reliability of a source’s data on an ongoing basis before actually using that source as a basis for determining or disclosing a fair value measurement and its level within the fair value hierarchy. IFRS 13 The best Fair value fundamentals
Based on consensus IFRS 13 The best Fair value fundamentals
The data or inputs that are provided by multiple sources should be comparable within a reasonably narrow range before a reporting entity can regard the information as demonstrating a market consensus. If particular sources produce price outliers, the reporting entity should understand them and how they impact the data. Due diligence should be performed to confirm that the consensus was derived from different sources. IFRS 13 The best Fair value fundamentals
Provided by sources actively involved in the relevant market IFRS 13 The best Fair value fundamentals
The data should originate from a source that is an active participant with respect to the relevant product and within the relevant market. Further, the reporting entity that is using the data should periodically demonstrate that the source of the data provides reliable information on a consistent basis. Although there are instances in which market forces could help ensure that a data source provides reliable information, such assurance may need to be supplemented with other evidence, such as the results of back-testing applied to verify the consistency and reliability of a particular source’s data. IFRS 13 The best Fair value fundamentals
4.3.1 Assessing market activity to determine if inputs are observable
The level of activity in the asset or liability’s principal market will contribute to the determination of whether an input is observable or unobservable. Level 1 and Level 2 measurements are based on observable inputs while Level 3 measurements are unobservable. IFRS 13 The best Fair value fundamentals
The fair value standards define an active market as one in which transactions for the asset or liability being measured take place with sufficient frequency and volume to provide pricing information on an ongoing basis. An observable input that may otherwise be a Level 1 input will be rendered Level 2 if the information relates to a market that is not active.
To determine the level of the inputs within the hierarchy, the reporting entity should consider recent activity supporting the quote and trading volume trends. For example, in assessing market inputs, consider a security for which aggregate broker data is published on occasion, and for which trading does not occur on a regular basis. In this case, the price is quoted only occasionally and the security is not regularly traded. Consequently, the quote is no longer a Level 1 input, and would be Level 2 or 3. IFRS 13 The best Fair value fundamentals
Although observability could have an indirect relationship with liquidity, only the observability of significant inputs serves to distinguish between Levels 2 and 3. Liquidity is not a differentiating factor. IFRS 13 The best Fair value fundamentals
For example, a reporting entity may be able to sell a structured security in one day; however, for valuation purposes, they are only able to obtain indicative broker quotes that cannot be corroborated by market observable inputs. IFRS 13 The best Fair value fundamentals
Additionally, there can be a wide spectrum of liquidity associated with instruments in Levels 2 and 3. IFRS 13 The best Fair value fundamentals
For example, a residential mortgage-backed security is likely significantly more liquid than an abandoned warehouse and land in tertiary markets, while both may accurately be determined to be Level 3 valuations. IFRS 13 The best Fair value fundamentals
In addition, a US dollar fixed-for-floating interest rate swap is likely to be determined to be a Level 2 instrument by most market participants based upon the observability of the market inputs used to value it. IFRS 13 The best Fair value fundamentals
However, it is not easy and likely time consuming, to novate an interest rate swap to another party. By definition, this derivative is less “liquid” than many fixed income securities that are determined to be Level 3. This is another example of why Level 2 versus Level 3 is not a representation of liquidity.
IFRS 13 B34 provides examples of markets in which inputs might be observable for some assets and liabilities. Reporting entities should consider the specific facts and circumstances of each input in each market in assessing whether an input in a particular market is observable. IFRS 13 The best Fair value fundamentals
Examples of markets in which inputs might be observable for some assets and liabilities (for example, financial instruments) include exchange markets, dealer markets, brokered markets, and principal-to-principal markets. [Emphasis added.]
The following, based on information in the ASC 820 Glossary and IFRS 13.B34, provides additional clarification on each market: IFRS 13 The best Fair value fundamentals
Exchange market IFRS 13 The best Fair value fundamentals
In an active exchange market (e.g., NYSE, London Stock Exchange), closing prices are both readily available and representative of fair value.
Dealer market IFRS 13 The best Fair value fundamentals
In a dealer market, dealers stand ready to trade at an executable bid or ask price for their own account, thereby providing market liquidity by using their capital to hold an inventory of the items for which they make a market. Over-the-counter markets are dealer markets. Assets and liabilities, other than securities, also exist in dealer markets, such as financial instruments, commodities, and physical assets. IFRS 13 The best Fair value fundamentals
Brokered market IFRS 13 The best Fair value fundamentals
In a brokered market, brokers attempt to match buyers with sellers; they may not stand ready to trade. Instead, they typically provide indicative valuations for their own account, and do not use their own capital to hold an inventory of the items for which they make a market. IFRS 13 The best Fair value fundamentals
For a broker quote to be observable, a reporting entity may not need transparency into the market data used to develop the quote, but would need knowledge of how the quote is created and whether the broker stands ready to execute. Broker quotes can be derived from models or based on market observable transactions.
In many cases, transparency into the specific technique used is not available. However, a reporting entity may be able to determine the implied inputs used (e.g., discount rate/yield). From this analysis, a reporting entity may be able to connect such implied inputs to market observable information (e.g., trade information).
Principal-to-principal transactions (both originations and resales) are negotiated independently, with no intermediary. Often, very little information about these transactions is publicly available, and as such, the markets are generally not considered observable IFRS 13 The best Fair value fundamentals
4.3.2 Pricing services, broker quotes, and dealer quotes
Ultimately, it is management’s responsibility to determine the appropriateness of its fair value measurements and their classification in the fair value hierarchy, including measurements for which pricing services (such as Bloomberg, Interactive Data Corporation, Thomson Reuters, Markit, Standard and Poor’s), broker pricing information, and similar sources are used.
IFRS 13 B45 indicates that the use of quoted prices provided by third parties, such as pricing services or brokers, is permitted if the reporting entity has determined that the quoted prices provided by those parties are developed in accordance with the fair value standard. IFRS 13 The best Fair value fundamentals
Therefore, reporting entities that use pricing services need to understand how the pricing information is developed and obtain sufficient information to determine where instruments fall within the fair value hierarchy. IFRS 13 The best Fair value fundamentals
For example, a pricing service could provide quoted prices for an actively traded equity security which, if corroborated by the reporting entity, would be considered Level 1 inputs. The same pricing service may also provide a corporate bond price based on matrix pricing, which may constitute a Level 2 or Level 3 input, depending on the information used in the model.
The information provided by these sources could result in a financial instrument falling into any level in the fair value hierarchy, depending on the inputs and methods used for a particular financial instrument. IFRS 13 The best Fair value fundamentals
Dealer quotes are observable only if the dealer stands ready and willing to transact at that price. Brokers, on the other hand, report what they see in the market but usually are not ready and willing to transact at that price. In order for broker quotes to be observable, they need to be corroborated by other market events or data.
A broker quote may be a Level 2 input if observable market information exists for comparable assets and/or the dealer is willing and able to transact in the security at that price. In many cases, a single broker quote may be indicative of a Level 3 measure if there are no comparables and the quote is provided with no commitment to actually transact at that price.
A reporting entity should have some higher-level (i.e., observable) data to support classification of an input as Level 2. A broker quote for which the broker does not stand ready to transact cannot be corroborated with an internal model populated with Level 3 information to support a Level 2 classification. IFRS 13 The best Fair value fundamentals
Multiple indicative broker quotes or vendor prices based on Level 3 inputs do not raise the categorization of that instrument to Level 2. However, there may be other instances in which pricing information can be corroborated by market evidence, resulting in a Level 2 input. IFRS 13 The best Fair value fundamentals
In some cases, reporting entities may rely on pricing services or published prices that represent a consensus reporting of multiple brokers or “evaluated prices.” It may not be clear if the reporting entity can transact at the prices provided or if observable market data was used to develop the indicative price. IFRS 13 The best Fair value fundamentals
To support an assertion that a broker quote or information obtained from a pricing service represents a Level 2 input, the reporting entity should perform further review procedures to understand how the price was developed, including understanding the nature and observability of the inputs used to determine that price. As market activity often ebbs and flows, pricing techniques often do as well. Because of this, reporting entities should perform review procedures on an ongoing basis for financial reporting purposes versus at a singular point in time. Additional corroboration could include the following: IFRS 13 The best Fair value fundamentals
- Use of liquidity or transparency information and metrics provided by the vendor which may include the liquidity score and depth of the quotes informing the price
- Review of vendor valuation methodology documentation IFRS 13 The best Fair value fundamentals
- Discussions with pricing services, dealers, or other companies to obtain additional prices of identical or similar assets to corroborate the price
- Back-testing of prices to determine historical accuracy against actual transactions. While this analysis provides more evidence on the accuracy/reliability of historical prices provided, it may also provide an initial indication of whether pricing uses observable data inputs. It is likely that additional corroboration would be necessary to determine the use of observable market data.
- Comparisons to other external or internal valuation model outputs and their corroboration with observable market data
The level of investigation necessary is highly dependent on the facts and circumstances, such as the type and complexity of the asset or liability being measured, and its observability and the level of activity in the marketplace. Generally, the more specialized the asset or liability being measured and the less actively traded it is, the more review procedures will be necessary to corroborate the price to support classification as a Level 2 input. IFRS 13 The best Fair value fundamentals
When performing additional procedures, reporting entities should clearly document the assessment and conclusion. Without additional supporting information, we believe prices obtained from a single or multiple broker sources or a pricing service are indicative values or proxy quotes that generally represent Level 3 inputs.
In another example, a reporting entity may obtain a price from a broker or pricing service for a municipal security. The reporting entity may be fully aware of the depth and activity of the security’s trading in the marketplace based on its historical trading experience. In addition, the pricing methodology for the security may be common and well-understood (e.g., matrix pricing) and the reporting entity may be able to perform less due diligence. IFRS 13 The best Fair value fundamentals
However, this conclusion may not be appropriate for a reporting entity that obtains a price from a broker or pricing service for a collateralized debt obligation that is not frequently traded and may not be as easily subject to common, well-understood pricing methodologies (e.g., matrix pricing), for example. Therefore, the reporting entity may need to perform more due diligence.
4.3.3 Valuation models
Reporting entities commonly use proprietary models to calculate certain fair value measurements (e.g., some long-term derivative contracts, impairments of financial instruments, and illiquid investments such as real estate). However, they determine the level within the fair value hierarchy based on the inputs to the valuation, not on the methodology or complexity of the model.
The use of a valuation model does not automatically result in a Level 3 fair value measurement. A standard valuation model that uses all observable inputs may result in a measurement classified as Level 2. For example, consider the measurement of a financial asset that is not actively traded. The reporting entity performs the valuation using a proprietary model incorporating inputs provided by brokers. IFRS 13 The best Fair value fundamentals
While the financial asset is not actively traded, the entity assumes the broker providing the inputs is standing ready to transact at the quoted price and/or the reporting entity obtains sufficient corroborating data. Provided the model does not include management assumptions used to make adjustments to the data, it may be reasonable to conclude that the inputs are observable, and thus the measurement would be classified as Level 2. IFRS 13 The best Fair value fundamentals
However, if adjustments or interpolations are made to Level 2 inputs in an otherwise standard model, the measurement may fall into Level 3, depending on whether the adjusted inputs are significant to the measurement. Further, if a reporting entity uses a valuation model that is proprietary and relies on significant unobservable inputs, the resulting fair value measurement will be categorized as Level 3. IFRS 13 The best Fair value fundamentals
For example, when Level 2 inputs are not available and the reporting entity is required to develop a forward price curve because the duration of the contract exceeds the length of time that observable inputs are available, or is otherwise required to make adjustments to observable data, the valuation is relying on Level 3 inputs and would be classified as a Level 3 fair value measurement if those inputs are significant to the overall fair value measurement. IFRS 13 The best Fair value fundamentals
4.4 Step 4: determine level in the hierarchy of the significant input (or all significant inputs)
Quoted prices for identical assets or liabilities in active markets (unadjusted) IFRS 13 The best Fair value fundamentals
Quoted prices for similar items in active markets IFRS 13 The best Fair value fundamentals
Liabilities traded as assets in inactive markets IFRS 13 The best Fair value fundamentals
A common misconception is that securities that are “less risky” should be categorized in Level 1. For instance, many might perceive US Treasury securities as essentially risk-free, and, therefore, should be considered Level 1 in the fair value hierarchy. However, certain Treasury securities are more appropriately categorized in Level 2 because they do not trade in an active market.
4.4.1 Level 1 inputs
Level 1 inputs are quoted prices (unadjusted) for identical assets or liabilities in active markets. A quoted price for an identical asset or liability in an active market (e.g., an equity security traded on a major exchange) provides the most reliable fair value measurement and, if available, should be used to measure fair value in that particular market.
- Listed equity securities traded in active, deep markets (e.g., NYSE, NASDAQ) IFRS 13 The best Fair value fundamentals
- London Metal Exchange futures contract prices IFRS 13 The best Fair value fundamentals
- On-the-run Treasury bills, notes, and bonds (on-the-run Treasury bonds and notes are the most recently issued of a given maturity. They are the most frequently traded, and therefore, the most liquid) IFRS 13 The best Fair value fundamentals
- Exchange-traded futures and options IFRS 13 The best Fair value fundamentals
- Open-ended mutual funds with published daily NAV at which investors can freely subscribe to or redeem from the fund. These are investments that do not use NAV as a practical expedient and, therefore, are still required to be leveled in the fair value hierarchy — unlike funds that use NAV as a practical expedient.
- Closed-ended registered mutual funds (e.g., exchange-traded funds) traded on active markets (the exchange price may represent a Level 1 input)
- Many government-backed to-be-announced securities (TBAs) IFRS 13 The best Fair value fundamentals
4.4.2 Cleared transactions
Each day, the clearinghouse provides a “value mark” that dictates the amount owed by/to the counterparty. Because this value mark is not a value at which a reporting entity could open or close the trade at that particular point in time, the value mark is not a Level 1 fair value input. IFRS 13 The best Fair value fundamentals
Can a single price source or quote be considered a Level 1 valuation? IFRS 13 The best Fair value fundamentals
Maybe. Absent the source being transactions on an exchange, in general, a single source would not be a Level 1 input since a single market maker would almost, by definition, suggest an inactive market. However, in some rare cases, a single market maker dominates the market for a particular security such that trading in that security is active but all trades flow through that market maker. In those limited circumstances, a reporting entity may be able to support a determination that the input is Level 1. IFRS 13 The best Fair value fundamentals
Other than in this fact pattern, the reporting entity should determine if the single broker quote represents a Level 2 or Level 3 input. See key considerations in making this assessment in Step 3: determine if significant inputs are observable. IFRS 13 The best Fair value fundamentals
Commonly the unit of account for interests in mutual or alternative fund investments is the interest in the fund itself, rather than the individual assets and liabilities held by the fund. Thus, the reporting entity should assess the categorization within the fair value hierarchy based on the investment in the fund itself and not the securities within the fund.
An investor cannot simply “look through” an interest in an alternative investment to the underlying assets and liabilities to estimate fair value or to determine the classification of the fair value measurement in the fair value hierarchy. Rather, the reporting entity should consider the inputs used to establish fair value of the fund and whether they were observable or unobservable.
The investment could be classified as Level 1 if the fair value measurement of the interest in the fund (not the underlying investments) was based on observable inputs that reflect quoted prices (unadjusted) for identical assets in active markets (i.e., the fund is exchange-traded). IFRS 13 The best Fair value fundamentals
4.4.3 Large number of similar assets and liabilities
IFRS 13 79(a) provides a practical expedient for the fair value measurement of a large number of similar assets or liabilities (e.g., debt securities) for which quoted prices in active markets are available, but not readily accessible. IFRS 13 The best Fair value fundamentals
In accordance with this guidance, a reporting entity may measure fair value by using an alternative pricing method (e.g., matrix pricing) instead of obtaining quoted prices for each individual security, provided that the reporting entity demonstrates that the method replicates actual prices. IFRS 13 The best Fair value fundamentals
4.4.4 Post-market close events
As discussed in IFRS 13 79(b), in some situations, significant events (e.g., principal-to-principal transactions, brokered trades, or announcements) may occur after the close of a market but before the end of the measurement date. When that is the case, a quoted market price may not be representative of fair value on the measurement date.
Reporting entities should establish and consistently apply a policy for identifying and incorporating events that may affect fair value measurements. In addition, if a reporting entity adjusts the quoted price, the resulting measurement will not be classified in Level 1, but will be a lower-level measurement. IFRS 13 The best Fair value fundamentals
In general, the measurement date, as specified in each accounting standard requiring or permitting fair value measurements, is the “effective” valuation date. Accordingly, a valuation should reflect only facts and circumstances that exist on the specified measurement date (these include events occurring before the measurement date or that were reasonably foreseeable on that date) so that the valuation is appropriate for a transaction that would occur on that date. IFRS 13 The best Fair value fundamentals
4.4.5 Level 2 inputs
The categorization of an asset/liability as Level 1 requires that it is traded in an active market. If an instrument is not traded in an active market, it may fall to Level 2. Level 2 inputs are inputs that are observable, either directly or indirectly, but do not qualify as Level 1. IFRS 13 The best Fair value fundamentals
- A dealer quote for a non-liquid security, provided the dealer is standing ready and able to transact
- Posted or published clearing prices, if corroborated with market transactions
- Vendor or broker provided indicative prices, if due diligence by the reporting entity indicates such prices were developed using observable market data IFRS 13 The best Fair value fundamentals
Examples of instruments that are typically Level 2 measurements include: IFRS 13 The best Fair value fundamentals
- Most US public debt IFRS 13 The best Fair value fundamentals
- Short-term cash instruments IFRS 13 The best Fair value fundamentals
- Certain derivative products IFRS 13 The best Fair value fundamentals
- Off-the-run Treasury bills, bonds and notes (off-the-run Treasury bills, bonds, and notes are those that were issued before the most recent issue and are still outstanding)
- Mortgage-backed securities when valued by adjusting the quoted prices of TBAs) IFRS 13 The best Fair value fundamentals
4.4.6 Adjustments to Level 2 inputs
Adjustments to Level 2 inputs should include factors such as the condition and/or location of the asset/liability on the measurement date. An adjustment that is significant to the fair value measurement may place the measurement in Level 3 in the fair value hierarchy. IFRS 13 The best Fair value fundamentals
4.4.7 Extrapolating and interpolating data
IFRS 13 82 indicates that a Level 2 input needs to be observable for substantially the full term of an asset or liability that has a contractual term. However, certain inputs derived through extrapolation or interpolation may be corroborated by observable market data (e.g., interpolating three-year yields using observable one- and five-year interest rate yields) and would be considered a Level 2 input. IFRS 13 The best Fair value fundamentals
For example, assume that the interest rate yield curve for index A has historically been correlated to the interest rate yield curve for index B, and market participants believe the indexes will continue to be correlated. Also, assume that the interest rate yield curve for index A is observable for three years, but the interest rate yield curve for index B is only observable for two years.
A reporting entity could extrapolate the third year of the interest rate yield curve for index B based on years one and two and the correlation of the third year of interest rate yield curve for index A. In this example, the interest rate yield for index B for year three would be considered a Level 2 input. IFRS 13 The best Fair value fundamentals
However, extrapolating short-term data to measure longer-term inputs may require assumptions and judgments that cannot be corroborated by observable market data and, therefore, represent a Level 3 input. Then, the reporting entity would need to evaluate the significance of the input to determine if the resulting fair value measurement in its entirety is a Level 3 measurement.
Assume there are quoted forward prices available for 30-day and 60-day FX contracts, and the reporting entity is valuing a 50-day contract. If the price can be derived through simple interpolation, the resulting measurement is a Level 2 valuation. IFRS 13 The best Fair value fundamentals
However, if the contract length is three years, FX rates are only quoted for the next two years, and there is no other observable market information to corroborate the rates in the third year, the input for year 3 would be a Level 3 input. If it is considered a significant input, the resulting fair value measurement would be Level 3.
4.4.8 Level 3 inputs
Reporting entities may use unobservable inputs to measure fair value if relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. These unobservable inputs are considered Level 3.
Even when Level 3 inputs are used, the fair value measurement objective remains the same—that is, to reflect an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs should reflect the assumptions that market participants would use when pricing the asset or liability (including assumptions about risk). IFRS 13 The best Fair value fundamentals
Level 3 inputs may include information derived through extrapolation or interpolation that cannot be directly corroborated by observable market data. In developing Level 3 inputs, a reporting entity need not undertake exhaustive efforts to obtain information about market participant assumptions; however, it should take into account all information that is reasonably available. Therefore, if a reporting entity uses its own data to develop Level 3 inputs, it should adjust that data if information is reasonably available that indicates market participants would use different assumptions. IFRS 13 The best Fair value fundamentals
- Inputs obtained from broker quotes that are indicative (i.e., not firm and able to be transacted upon) or not corroborated with market transactions
- Management assumptions that cannot be corroborated with observable market data IFRS 13 The best Fair value fundamentals
- Vendor-provided prices, not corroborated by market transactions IFRS 13 The best Fair value fundamentals
Examples of instruments that are typically Level 3 measurements include: IFRS 13 The best Fair value fundamentals
- Complex instruments, such as longer-dated interest rate and currency swaps and structured derivatives IFRS 13 The best Fair value fundamentals
- Fixed income asset-backed securities, depending on the specific asset owned (i.e., the specific tranche), the nature of the valuation model used, and whether the inputs are observable
- Impairment testing of goodwill or indefinite-lived intangible assets IFRS 13 The best Fair value fundamentals
- Contingent consideration IFRS 13 The best Fair value fundamentals
4.5 Step 5: Assess disclosure required by the fair value standard
The disclosure requirements of the fair value standard can be divided into two areas: those explaining (1) the fair value of the entire asset or liability, and (2) the significant input(s) to the fair value measurement. IFRS 13 The best Fair value fundamentals
4.6 Step 6: Reassess
The categorization of a particular instrument in the fair value hierarchy may change over time. As markets evolve, certain ones may become more or less liquid, inputs may become more or less observable, and therefore, the level in the fair value hierarchy could change. Therefore, it is important to evaluate the continued appropriateness of the levels in which fair value measurements are categorized at each reporting date. IFRS 13 The best Fair value fundamentals
5 Fair value measurements and inactive markets
The fair value standards provide additional factors to consider in measuring fair value when there has been a significant decrease in market activity for an asset or a liability and quoted prices are associated with transactions that are not orderly. For those measurements, pricing inputs for referenced transactions may be less relevant.
A reporting entity should determine if a pricing input for an inactive security was “orderly” and representative of fair value by assessing if it has the information to determine that the transaction is not forced or distressed. If it cannot make that determination, the input needs to be considered; however, the input may be less relevant to the measurement than other transactions which are known to be orderly.
5.1 Evaluating whether there has been a significant decrease in volume or level of activity
IFRS 13 B37 provide a list of factors to consider in determining whether there has been a significant decrease in the volume or level of activity in relation to normal market activity.
The factors that an entity should evaluate include (but are not limited to): IFRS 13 The best Fair value fundamentals
- There is a significant decline in the activity of, or there is an absence of a market for new issues (that is, a primary market) for that asset or liability or similar assets or liabilities
- There are few recent transactions IFRS 13 The best Fair value fundamentals
- Price quotations are not developed using current information IFRS 13 The best Fair value fundamentals
- Price quotations vary substantially either over time or among market makers (for example, some brokered markets)
- Indices that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability
- There is a significant increase in implied liquidity risk premiums, yields, or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the reporting entity’s estimate of expected cash flows, taking into account all available market data about credit and other nonperformance risk for the asset or liability
- There is a wide bid-ask spread or significant increases in the bid-ask spread IFRS 13 The best Fair value fundamentals
- Little information is publicly available (for example, a principal-to-principal market) IFRS 13 The best Fair value fundamentals
If a reporting entity concludes that there has been a significant decrease in the volume or level of activity in the market for an asset or liability, the reporting entity should perform further analysis of the transactions or quoted prices observed in that market. IFRS 13 The best Fair value fundamentals
A significant decrease in activity on its own is not indicative that the market is not orderly. Further analysis is required because the transactions or quoted prices may not be determinative of fair value and significant adjustments may be necessary when using the information in estimating fair value.
5.2 Adjusting observable inputs
The fair value standards do not prescribe a methodology for making significant adjustments to transactions or quoted prices when estimating fair value. Instead of applying a prescriptive approach, reporting entities should weight indications of fair value. IFRS 13 The best Fair value fundamentals
If there has been a significant decrease in the volume and level of activity for the asset or liability, it may be appropriate for the reporting entity to change its valuation technique or to apply multiple valuation techniques. For example, a reporting entity may use indications of fair value developed from both a market approach and a present value technique in its estimate of fair value.
When using multiple indications of fair value, the reporting entity should consider the reasonableness of the range of fair value indications. The objective is to determine the point within that range that is most representative of fair value under current market conditions. IFRS 13 The best Fair value fundamentals
One approach to selecting a point within a range of indications of fair value would be to weight the multiple indications. Reporting entities are required to consider the reasonableness of the range, as noted in IFRS 13 B40. A wide range of fair value measurements might indicate that further analysis is required in order to achieve the fair value measurement objective.
Importantly, the fair value measurement objective remains the same regardless of the valuation techniques used, even when circumstances indicate that there has been a significant decrease in the volume and level of activity for the asset or liability. IFRS 13 The best Fair value fundamentals
When there has been a significant decrease in the volume or level of activity for the asset or liability, a reporting entity will need to perform additional work to evaluate observable inputs, such as quoted prices or broker quotes, to determine whether observable inputs reflect orderly transactions or whether a valuation technique reflects market participant assumptions.
A reporting entity must consider price quotes when markets are not active, including those obtained from pricing services and broker quotes, provided it determines that those prices reflect orderly transactions. Further, a reporting entity is not precluded from concluding that the inputs are Level 2 in the fair value hierarchy even though a market is not active.
The reporting entity’s intention to hold an asset is not relevant in estimating fair value at the measurement date. Rather, the fair value measurement should be based on a hypothetical transaction to sell the asset or transfer the liability at the measurement date, considered from the perspective of willing market participants.
Reporting entities may make adjustments to observed prices to address the decrease in activity. It may be challenging to develop appropriate inputs to be used in the valuation techniques and to reconcile fair value measures when a significant difference exists between the use of a valuation technique and an observable price.
5.3 Identifying transactions that are not orderly
IFRS 13 B43 state that even when an entity determines that there has been a significant decrease in the volume and level of activity for an asset or liability in relation to normal market activity for the asset or liability (or similar assets or liabilities), it is not appropriate to conclude that all transactions in the market for the asset or liability are not orderly. Rather, a determination as to whether a transaction is orderly, and thus a relevant input into the valuation requires analysis. See ‘Evaluating whether there has been a significant decrease in volume or level of activity‘ above.
The fair value standards provide a list of circumstances that may indicate that a transaction is not orderly, including (but not limited to):
- There was not adequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such an asset or liability. IFRS 13 The best Fair value fundamentals
- There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant.
- The seller is in or near bankruptcy or receivership (i.e., distressed) or the seller was required to sell to meet regulatory or legal requirements (i.e., if the seller was forced). Though, not all requirements to divest result in a forced sale, as many requirements to divest are made in circumstances which allow sufficient time and marketing effort to result in an orderly disposal.
- The transaction price is an outlier when compared with other recent transactions for the same (or a similar) asset or liability.
Although the fair value standards provide a list of factors to consider that may indicate a transaction is not orderly, we believe there is an implicit rebuttable presumption that observable transactions between unrelated parties are orderly. In our experience, such transactions are considered to be orderly in almost all instances. Therefore, the evidence necessary to conclude an observable transaction between unrelated parties is not orderly should be incontrovertible. IFRS 13 The best Fair value fundamentals
5.4 Evaluating observable transaction prices
The determination of whether a transaction is (or is not) orderly is more difficult if there has been a significant decrease in the volume and level of activity for the asset or liability. However, the fair value standards provide guidance once the determination has been made. Specifically, IFRS 13.B44 provide guidance to be considered in evaluating observable transaction prices under different circumstances: IFRS 13 The best Fair value fundamentals
- Transaction is not orderly—If the evidence indicates the transaction is not orderly, a reporting entity is required to place little, if any, weight (compared with other indications of fair value) on that observable transaction price when estimating fair value. IFRS 13 The best Fair value fundamentals
- Transaction is orderly—If the evidence indicates the transaction is orderly, a reporting entity is required to consider that transaction price when estimating fair value. The amount of weight placed on that transaction price (when compared with other indications of fair value) will depend on the facts and circumstances of the transactions and the nature and quality of other available inputs. IFRS 13 The best Fair value fundamentals
If a reporting entity does not have sufficient information to conclude whether an observed transaction is orderly (or is not orderly), it is required to consider that transaction price when estimating fair value or implied market risk premiums. In those circumstances, that transaction price may not be determinative (i.e., the sole or primary basis) for estimating fair value. There may be circumstances in which less weight should be placed on transactions in which a reporting entity has insufficient information to conclude whether the transaction is orderly when compared with other transactions that are known to be orderly. IFRS 13 The best Fair value fundamentals
6 Premiums and discounts
The fair value standards include restrictions on the application of premiums and discounts related to the size of a position of financial instruments held when measuring fair value. The fair value standards distinguish between premiums or discounts related to the size of the reporting entity’s holding (such as a blockage factor for an equity investment classified as available for sale), which are prohibited unless using the portfolio exception, as opposed to those related to a characteristic of the asset or liability (for example, a control premium on a subsidiary), which is permitted under certain circumstances. IFRS 13 The best Fair value fundamentals
6.1 Level 1 measurements
The fair value standards state that there should be no adjustment to Level 1 inputs. In accordance with IFRS 13 80, the fair value of a position for an investment in a financial instrument in an active market should be calculated as the product of the quoted price for the individual instrument times the quantity held (commonly referred to as “P x Q”). Refer to FV 4.5 for further detail on the fair value hierarchy. IFRS 13 The best Fair value fundamentals
In all cases, if there is a quoted price in an active market (that is, a Level 1 input) for an asset or liability, a reporting entity shall use that quoted price without adjustment when measuring fair value…
6.2 Blockage factors
A blockage factor is a discount applied to reflect the inability to trade a block of the security because the market for the security, although an active one, cannot absorb the entire block at one time without adversely affecting the quoted market price. When measuring the fair value of a financial instrument that trades in an active market, the fair value standards prohibit the use of a blockage factor. IFRS 13 The best Fair value fundamentals
However, when using the portfolio exception, because the unit of measurement is the net position of the portfolio, size is an attribute of the portfolio being valued, and consequently, a premium or discount based on size is appropriate if incorporated by market participants. IFRS 13 The best Fair value fundamentals
6.3 Control premiums
A control premium is an amount a buyer is willing to pay over the current market price of a publicly traded company to acquire a controlling interest in that company. IFRS 13 69 indicates that control premiums are also not permitted as adjustments to Level 1 measurements. IFRS 13 The best Fair value fundamentals
6.4 Level 2 and Level 3 measurements
Certain premiums or discounts are permitted for instruments that are not classified as Level 1. When determining whether it is appropriate to include a premium or discount in a Level 2 or Level 3 fair value measurement, reporting entities should consider the following: IFRS 13 The best Fair value fundamentals
- Market participant assumptions IFRS 13 The best Fair value fundamentals
- The unit of account as defined by other guidance for the asset or liability being measured
- The unit of measurement IFRS 13 The best Fair value fundamentals
- Whether the premium or discount is related to the size of the entity’s holding of the asset or liability or reflective of a characteristic of the asset or liability itself
- Whether the impact of the premium or discount is already contemplated in the valuation IFRS 13 The best Fair value fundamentals
While the determination of fair value, including the application of premiums and discounts, is rooted in market participant assumptions, such application cannot contradict the unit of account prescribed in other guidance for the asset or liability being measured. IFRS 13 The best Fair value fundamentals
6.5 Restricted assets
If a reporting entity holds an asset that has restrictions on its sale or transferability (i.e., a restricted asset), the fair value measurement should be adjusted to reflect the discount, if any, a market participant would require as a result of the restriction. The impact of a restriction on the sale or use of an asset depends on whether the restriction is part of the instrument itself, and therefore, would be considered by market participants in pricing the asset. IFRS 13 The best Fair value fundamentals
Example 8: Restriction on the sale of an equity instrument of IFRS 13 (IFRS 13 IE28) illustrates a situation in which a reporting entity holds an equity instrument (a financial asset) for which sale is legally or contractually restricted for a specified period. For example, such a restriction could limit sale to only qualifying investors.
The restriction is a characteristic of the instrument and, therefore, would be transferred to market participants. In that case, the fair value of the instrument would be measured on the basis of the quoted price for an otherwise identical unrestricted equity instrument of the same issuer that trades in a public market, adjusted to reflect the effect of the restriction. The adjustment would reflect the amount market participants would demand because of the risk relating to the inability to access a public market for the instrument for the specified period. The adjustment will vary depending on all of the following: IFRS 13 The best Fair value fundamentals
- the nature and duration of the restriction; IFRS 13 The best Fair value fundamentals
- the extent to which buyers are limited by the restriction (for example, there might be a large number of qualifying investors); and
- qualitative and quantitative factors specific to both the instrument and the issuer. IFRS 13 The best Fair value fundamentals
Also, Example 9: Restrictions on the use of an asset of IFRS 13 (IFRS 13 IE29) illustrates the impact of a contractual restriction on the use of donated land to a not-for-profit organization. In those examples, the not-for-profit organization is perpetually restricted in its use of the property. However, it determines that the contractual restriction exists through an agreement (donor agreement) that is separate and distinct from the asset itself. The restriction would not legally be transferred to market participants if the land were to be sold as it is not part of the deed or legal description of the property. IFRS 13 The best Fair value fundamentals
Therefore, this asset restriction is specific to the not-for-profit organization and another owner could use the land for other purposes based on zoning where it is located. In this case, the restriction is not considered in the valuation of the land since the restriction is not an attribute of the asset itself and thus not a relevant input for market participants when determining the fair value of the land.
IFRS 13 The best Fair value fundamentals
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.
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.