Market-corroborated inputs

Market-corroborated inputs are inputs to fair value calculation models that are derived principally from or corroborated by observable market data by correlation or other means (level 2 inputs see below).

By correlation or other means implies the inputs are directly or indirectly based on executable market prices, modified mathematically to pertain to the target security.Estimating market rate of return when volume or activity is slight

IFRS 13 (paras 72-90) established a fair value hierarchy that categorises the inputs to valuation techniques into three levels:

Level 1: Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. An active market for the asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available.

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. If the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability. Level 2 inputs include the following:

  • Quoted prices for similar assets or liabilities in active markets.
  • Quoted prices for identical or similar assets or liabilities in markets that are not active, that is, markets in which there are few transactions for the asset or liability, the prices are not current, or price quotations vary substantially either over time or among market makers (for example, some brokered markets), or in which little information is released publicly (for example, a principal-to-principal market). Market-corroborated inputs
  • Inputs other than quoted prices that are observable for the asset or liability (for example, interest rates and yield curves observable at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates).
  • Inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs).

Level 3: Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs shall be used to measure fair value to the extent that 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.

However, the fair value measurement objective remains the same, that is, an exit price from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs shall reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability (including assumptions about risk).

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NOTE

The inclusion of market-corroborated inputs is significant because it expands the scope of Level 2 inputs beyond those directly observable for the asset or liability. Inputs determined through mathematical or statistical techniques, such as correlation or regression, may be categorised as Level 2 if the inputs into, and/(or) the results from, these techniques can be corroborated with observable market data.

IFRS 13 does not provide any detailed guidance regarding the application of statistical techniques, such as regression or correlation, when attempting to corroborate inputs to observable market data (Level 2) inputs. However, the lack of any specific guidance or ‘bright lines’ for evaluating the validity of a statistical inference by the IASB should not be construed to imply that the mere use of a statistical analysis (such as linear regression) would be deemed valid and appropriate to support Level 2 classification (or a fair value measurement for that matter).

Any statistical analysis that is relied on for financial reporting purposes should be evaluated for its predictive validity. That is, the statistical technique should support the hypothesis that the observable input has predictive value with respect to the unobservable input. MMarket-corroborated inputsarket-corroborated inputs

In the below example, for the three-year option on exchange-traded shares, the implied volatility derived through extrapolation has been categorised as a Level 2 input because the input was corroborated (through correlation) to an implied volatility based on an observable option price of a comparable entity.

In this example, the determination of an appropriate proxy (i.e., a comparable entity) is a critical component in supporting that the implied volatility of the actual option being measured is a market-corroborated input.

In practice, identifying an appropriate benchmark or proxy requires judgement that should appropriately incorporate both qualitative and quantitative factors.

For example, when valuing equity-based instruments (e.g., equity options), an entity should consider the industry, nature of the business, size, leverage and other factors that would qualitatively support the expectation that the benchmarks are sufficiently comparable with the subject entity.

Qualitative considerations may differ depending on the type of input being analysed or the type of instrument being measured (e.g., a foreign exchange option versus an equity option). Market-corroborated inputs

In addition to the qualitative considerations discussed above, quantitative measures are used to validate a statistical analysis. For example, if a regression analysis is used as a means of corroborating non-observable market data, the results of the analysis can be assessed based on statistical measures. Market-corroborated inputs

Example – Highest and best use vs intended use

An entity acquires a research and development (R&D) project in a business combination. The entity does not intend to complete the project. If completed, the project would compete with one of its own projects (to provide the next generation of the entity’s commercialised technology). Instead, the entity intends to hold (i.e., lock up) the project to prevent its competitors from obtaining access to the technology. In doing so, the project is expected to provide defensive value, principally by improving the prospects for the entity’s own competing technology. To measure the fair value of the project at initial recognition, the highest and best use of the project would be determined on the basis of its use by market participants. For example:

  1. The highest and best use of the R&D project would be to continue development if market participants would continue to develop the project and that use would maximise the value of the group of assets or of assets and liabilities in which the project would be used (i.e., the asset would be used in combination with other assets or with other assets and liabilities). That might be the case if market participants do not have similar technology, either in development or commercialised. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project, assuming that the R&D would be used with its complementary assets and the associated liabilities and that those assets and liabilities would be available to market participants.
  2. The highest and best use of the R&D project would be to cease development if, for competitive reasons, market participants would lock up the project and that use would maximise the value of the group of assets or assets and liabilities in which the project would be used. That might be the case if market participants have technology in a more advanced stage of development that would compete with the project if completed and the project would be expected to improve the prospects for their own competing technology if locked up. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project, assuming that the R&D would be used (i.e., locked up) with its complementary assets and the associated liabilities and that those assets and liabilities would be available to market participants.
  3. The highest and best use of the R&D project would be to cease development if market participants would discontinue its development. That may be the case if the project is not expected to provide a market rate of return if completed and would not otherwise provide defensive value if locked up. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project on its own (which might be zero).

If the highest and best use in this example was (a), then that is the value that the entity must ascribe to the R&D project, even though its intended use is to lock up the project.

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The fair value of the in-process research and development project in the above example above depends on whether market participants would use the asset offensively, defensively or abandon it (as illustrated by points (a), (b) and (c) in the example, respectively). If there are multiple types of market participants who would use the asset differently, these alternative scenarios must be considered before concluding on the asset’s highest and best use. Market-corroborated inputs

The place of market-corroborated inputs in the fair value framework:

IFRS 13 fair value is exit price

Market-corroborated inputs

Market-corroborated inputs

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