Initial measurement financial instruments

Initial measurement Financial instruments

IFRS 9 requires an entity to recognise a financial asset or liability on its balance sheet only when it becomes a party to the contractual provisions of the instrument.

Under IFRS 9 the requirements, on initial recognition, are that financial assets and financial liabilities are measured at (IFRS 9.5.1.1):

IFRS 9 classes	Fair value	Fair value plus eligible transaction costs
Amortised cost		√
Fair value through other comprehensive income		√
Fair value though profit or loss	√

IFRS 9 retained the guidance from IAS 39 that – the best evidence of fair value at initial recognition is normally the transaction price – i.e. the fair value of the consideration given or received for the financial instrument. (IFRS 9.5.1.1A, IFRS 9.B5.1.2A)

However, if this is not the case, any difference is accounted for in accordance with the substance of the transaction. If there is a difference between the entity’s estimate of fair value at initial recognition and the transaction price, then:

• if the estimate of fair value uses only data from observable markets, then the difference is recognised in profit or loss; or
• in all other cases, the difference is deferred as an adjustment to the carrying amount of the financial instrument.

The ‘which’ and ‘how’ of fair value measurement

In terms of where to start in the determination of fair value, it is useful to consider three broad steps that should be taken before delving into the details that inevitably will follow. These steps are important in illustrating the relationship between the primary IFRS that dictates when fair value measurement is required and IFRS 13 which is the “how” IFRS.

Step 1:	Identify the balance or transaction (group of balances or transactions) ‘which’ must (may) be measured or disclosed at fair value and when such measurement (disclosure) is necessary.
Step 2:	Consult IFRS 13 for guidance on how to determine fair value upon initial recognition (see below).
Step 3:	Consult the ‘when’ IFRS to determine if the subsequent measurement of the account balance is at fair value and/or if fair value disclosures are required.

Trade receivables

IFRS 9 requires trade receivables that do not have a significant financing component to be initially recognised at their transaction price (as defined in IFRS 15 – i.e. the amount of consideration to which the entity expects to be entitled), rather than at fair value. (IFRS 9.5.1.3, IFRS 15.60-65)

Whether a trade receivable has a ‘significant financing component’ is determined in accordance with the guidance in IFRS 15 on assessing whether a contract contains a significant financing component. IFRS 15 states that a contract contains a significant financing component if the timing of payments agreed to by the parties provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer. IFRS 15 includes the following examples of factors to consider when assessing whether a contract contains a significant financing component: (IFRS 15.60-62)

• the difference, if any, between the amount of promised consideration and the cash selling price of the promised goods or services; and
• the combined effect of both:
  • the expected length of time between the entity transferring the promised goods or services to the customer and when the customer pays for those goods or services; and
  • the prevailing interest rates in the relevant market.

Food for thought – Measuring trade receivables on initial recognition

Trade receivables without a significant financing component (IFRS 13.BC138A) In many cases, the measurement on initial recognition for trade receivables without a significant financing component based on the transaction price guidance in IFRS 15 is unlikely to be significantly different from that currently applied under IAS 39. This is because the IASB has indicated that an entity can measure short-term receivables and payables with no stated interest rate at their invoiced amounts without discounting when the effect of not discounting is immaterial. Trade receivables with a significant financing component (IFRS 15.108) IFRS 9 does not exempt a trade receivable with a significant financing component from being measured at fair value on initial recognition. Therefore, differences may arise between the initial amount of revenue recognised in accordance with IFRS 15 – which is measured at the transaction price as defined in IFRS 15 – and the fair value of the trade receivable recognised at the date of initial recognition. Any difference between the measurement of the receivable in accordance with IFRS 9 and the corresponding amount of revenue recognised is presented as an expense. Impact of the practical expedient in IFRS 15 (IFRS 15.63, IFRS 9.BC235) As a practical expedient, IFRS 15 does not require an entity to adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract inception, that the period between the entity transferring a promised good or service to the customer and the customer paying for that good or service is one year or less (see Simplified approach for trade and lease receivable and contract assets). IFRS 9 does not state that a trade receivable with a significant financing component to which this practical expedient is applied may be initially measured at an amount equal to the undiscounted amount of consideration recognised as revenue under IFRS 15 (in the same way as a trade receivable without a significant financing component) rather than at fair value.

Measurement of fair value

– Definition of fair value (IFRS 13)

Fair Value: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Price The price is determined at measurement date under current market conditions (i.e. an exit price). This is regardless of whether that price is directly observable or estimated using another valuation technique.	Asset or liability Fair value considers specific characteristics: Asset condition and location Any restrictions on the sale.	Transaction Is assumed to takes place either in: The principal market (i.e. market with the greatest volume and level of activity), or in the absence of a principal market The most advantageous market (i.e. the market that maximizes /minimizes the amount received/ paid, after transaction and transport costs).	Market participants Fair value of an asset or liability is measured using the assumptions that market participants would use when pricing the asset or liability (assuming they act in their own economic best interest) Market participants do not need to be identified.

Food for thought – Market

If there is a principal market, the price in that market must be used, either directly or as an input into a valuation technique. IFRS 13 does not permit the use of a price in the most advantageous market if a principal market price is available! This said, it is not necessary to perform an exhaustive search of all possible markets to identify the principal market (or, in the absence of a principal market, the most advantageous market). However, all information that is reasonably available should be considered and the basis for all conclusions should be documented. There is a presumption in the standard that the market in which the entity normally transacts to sell the asset or transfer the liability is the principal or most advantageous market unless there is evidence to the contrary. Where your entity transacts in various markets (such as when assets are sold on multiple commodity and/or equity exchanges), the entity should document which particular market price is used and what process was followed to determine the appropriate market to use for determining fair value.

Food for thought – Market participant assumptions

A fair value measurement under IFRS 13 requires an entity to consider the assumptions a market participant, acting in their economic best interest, would use when pricing the asset or a liability. Market participants are defined as having the following characteristics: Independent of each other (i.e. unrelated parties). Knowledgeable and using all available information. Able of entering into the transaction. Willing to enter into the transaction (i.e. not a forced transaction). In addition, consider these considerations The key concept here is that the standard requires your entity to put itself in the place of a market participant and exclude any entity-specific factors that might impact the price that your entity is willing to accept in the sale of an asset or be paid in the transfer of a liability. So, for example, relevant characteristics of an asset might include or relate to: The condition and location of the asset; and Restrictions, if any, on the sale or use of the asset. Here, you would need to consider the extent to which a market participant would take the above characteristics into account when pricing the asset or liability at the measurement date. The extent to which restrictions on the sale or use of the asset should be reflected in fair value are very much contingent on where the source of the restriction comes from and whether or not the restriction is separable from the asset. Depending on the particular item that is the subject of the fair value measurement, the analysis of determining exactly what a market participant would consider may, in some cases, prove to be challenging. As such, in more challenging cases, we would recommend consultation with your auditors and advisors.

Fair value of offsetting market risk or counterparty credit risk for groups of financial assets and financial liabilities

An entity that holds a group of financial assets and financial liabilities is exposed to:

• Market risks
• (Credit risk of each of the counterparties.

If these are managed on either a market risk or a credit risk net exposure basis:

• The entity is permitted to apply an exception (‘offsetting exemption’) to IFRS 13 for measuring fair value. Fair value would be based on the price:
  • Received to sell a net long position (i.e. an asset) for a particular risk exposure, or
  • To transfer a net short position (i.e. a liability) for a particular risk exposure in an orderly transaction between market participants.

Fair value of this ‘offset group’ of financial assets and financial liabilities is made consistently with how market participants would price the net risk exposure.

– Offsetting exemption

This exemption can only be used if the entity does all the following:

• Manages the offset group on the basis of net exposure to a particular market risk (or risks) or to the credit risk of a particular counterparty in accordance with the entity’s documented risk management or investment strategy.
• Provides information on that basis about the offset group to the entity’s key management personnel, as defined in IAS 24 Related Party Disclosures.
• Is required (or has elected) to measure the offset group at fair value in the statement of financial position at the end of each reporting period.

The exception does not relate to presentation.

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors must be applied when using the offsetting exception.

– Fair value of offset groups with…

Exposure to market risk

Exposure to counterparty credit risk

When using the offsetting exception: – Apply the price within the bid-ask spread that is most representative of fair value in the circumstances to the entity’s net exposure to those market risks – Ensure that the market risk (or risks) within the offset group are substantially the same: Any basis risk resulting from the market risk parameters not being identical are taken into account in the fair value measurement of the financial assets / liabilities within the offset group Similarly, the duration of the entity’s exposure to a particular market risk (or risks) arising from the financial assets and financial liabilities of the offset group must be substantially the same.

When using the offsetting exception: – Include the effect of the entity’s net exposure to the credit risk of that counter party’s net exposure to the credit risk of the entity in the fair value measurement when market participants would take into account any existing arrangements that mitigate credit risk exposure in the event of default. Fair value is required to reflect market participants’ expectations about the likelihood that such an arrangement would be legally enforceable in the event of default.

Fair value of financial assets and liabilities

– Fair value at initial recognition

The transaction price is the price paid / received to acquire an asset or to assume a liability (i.e. entry price).

In contrast, fair value is the price that would be received to sell the asset or paid to transfer the liability (i.e. exit price).

However, in many cases the transaction price will equal the fair value – however it is still necessary to take into account factors specific to the transaction and to the asset or liability.

For example, the transaction price might not represent the fair value of an asset or a liability at initial recognition if any of the following conditions exist: The transaction is between related parties, although the price in a related party transaction may be used as an input into a fair value measurement if the entity has evidence that the transaction was entered into at market terms. The transaction takes place under constraints or the seller is forced to accept the price in the transaction. For example, that might be the case if the seller is experiencing financial difficulty. The unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value. For example, that might be the case if the asset or liability measured at fair value is only one of the elements in the transaction (e.g. in a business combination), the transaction includes unstated rights and privileges that are measured separately in accordance with another IFRS, or the transaction price includes transaction costs. The market in which the transaction takes place is different from the principal market (or most advantageous market). For example, those markets might be different if the entity is a dealer that enters into transactions with customers in the retail market, but the principal (or most advantageous) market for the exit transaction is with other dealers in the dealer market.

Fair value hierarchy

IFRS 13 includes a fair value hierarchy that categorises the inputs to valuation techniques used to measure fair value into three (input) levels:

• Level 1: Observable inputs are quoted (unadjusted) prices, that are determined using market data, such as publicly available information about actual identical events or transactions, and that reflect the assumptions that market participants would use when pricing the asset or liability in active markets. An entity shall not make adjustments to quoted prices, only under specific circumstances, for example when a quoted price does not represent the fair value (i.e. when a significant event takes place between the measurement date and market closing date).

• Level 2: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Adjustments to Level 2 inputs will vary depending on factors specific to the asset or liability.

  Level 2 inputs include the following:

1. 1. quoted prices for similar assets or liabilities in active markets.
   2. quoted prices for identical or similar assets or liabilities in markets that are not active.
   3. inputs other than quoted prices that are observable for the asset or liability, for example:
      1. interest rates and yield curves observable at commonly quoted intervals;
      2. implied volatilities; and
      3. credit spreads.
   4. market-corroborated inputs.

• Level 3: Unobservable inputs are inputs for which market data are not available and that are developed using the best information available about the assumptions that market participants would use when pricing the asset or liability. An entity shall use Level 3 inputs to measure fair value only when relevant observable inputs are not available.

The level of an accounting/reporting item values at fair value is based on its lowest input level (i.e. many times valuation techniques use level 1, level 2 and level 3 inputs, as a result of which the complete accounting/reporting item is considered to be valued at Level 3).

Recurring and non-recurring fair value measurements

IFRS 13 requires specific disclosures based on whether fair value measurement is recurring or non-recurring.

Recurring fair value measurements and Non-recurring fair value measurements are not defined in IFRS 13.

However, in general:

• Recurring fair value measurements: Fair value measurement is required at reporting date by other IFRSs (e.g. investment property, biological assets etc.)
• Non-recurring fair value measurements: Fair value measurement is triggered by particular events/circumstances (e.g. assets held for sale under IFRS 5 etc.).

Disclosure requirement	Recurring fair value measurements	Non-recurring fair value measurements	Items not valued at fair value requiring disclosure of fair value
Fair value at reporting date	Ѵ	Ѵ
Reasons for fair value measurement		Ѵ
Fair value hierarchy level i.e. Level 1, 2, or 3	Ѵ	Ѵ	Ѵ
Transfers between Level 1 and 2 (including reasons for the transfer and the entity’s policy for transfer)	Ѵ
Valuation technique, inputs, changes, reasons for change etc. – Level 2 and 3	Ѵ	Ѵ	Ѵ
Level 3 valuation processes /policies	Ѵ	Ѵ
Level 3 unobservable inputs	Ѵ	Ѵ
Level 3 reconciliation of total gains or losses in P&L and OCI, purchases, sales issues, settlements, and transfers	Ѵ
Level 3 unrealised gains /losses recognised in P&L	Ѵ
Level 3 sensitivity to changes in unobservable inputs (Qualitative for non-financial instruments, quantitative for financial instruments)	Ѵ
Reasons if highest and best use (non-financial assets) differs from current use	Ѵ	Ѵ	Ѵ
Items not valued at fair value requiring disclosure of fair value refers to items that are measured and included in the Financial position on a basis other than fair value, but where disclosure is required of the fair value of these financial assets and financial liabilities.

Unit of account

The determination of the unit of account must be established prior to determining fair value and is defined as the level at which an asset or a liability is aggregated or disaggregated in an IFRS for recognition purposes.

The unit of account is determined under the IFRS applicable to the asset or liability (or group of assets and liabilities) that requires fair value measurement.

Food for thought – Unit of account

The item for which fair value is determined may be a single asset or liability such as a derivative instrument or a share in a publicly traded entity or it may be a group of assets (i.e. a portfolio of receivables), group of liabilities (i.e. a portfolio of deposits) or group of assets and liabilities (e.g. a cash-generating unit, a business or an asset group which is held for sale). IFRS 13 does not generally provide specific guidance on the determination of the unit of the account – rather it directs preparers to other IFRSs to make this determination. IFRS 13 does specifically address one area relating to the unit of account in the form of guidance for financial assets and financial liabilities with offsetting positions. Here IFRS 13 includes a “portfolio exception” allowing a specified level of grouping when a portfolio of financial assets and financial liabilities are managed together with offsetting markets risks or counterparty credit risk. This exception is subject to your entity meeting certain eligibility criteria. (IFRS 13.48-52).

Valuation techniques

An entity shall use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs.

Changes in the valuation technique or its application are accounted for as a change in accounting estimate in accordance with IAS 8.

Inputs to valuation techniques

• IFRS 13 is clear that the valuation technique your entity uses must maximize the use of relevant observable inputs and minimize the use of unobservable inputs. For example, if a quoted price is available for a specific asset, this price must be used instead of an entity-specific assumption about the price.
• If an asset/liability measured at fair value has both a bid and ask price, the price within the bid-ask spread that is most representative of fair value is used – regardless of where the input is categorised within the fair value hierarchy.
• Further, there is a direct correlation between the level of disclosures required and the level of unobservable inputs – the more the degree of unobservable data used in your valuation technique, the more the degree of disclosure that you must include in your financial statements.
• A change in a valuation technique can be made but only if the change results in a measurement that is equally or more representative of fair value. Any such change, where justified, is considered to be a change in estimate (IFRS 13.66).

IFRS 13 requires entities to apply valuation techniques consistent with any of the following three methods:

• Market approach – uses prices and other relevant information generated by market transactions involving identical or comparable (i.e. similar) assets, liabilities or a group of assets and liabilities, such as a business
• 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).
• Income approach – converts future amounts (e.g. cash flows or income and expenses) to a single current (i.e. discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts.

Valuation techniques should be applied consistently from one period to the next.

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.

Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments

Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments Initial measurement financial instruments