On 12 May 2011, the International Accounting Standards Board (IASB) issued IFRS 13 Fair Value Measurement that is intended to replace the fair value measurement guidance contained under various standards with a single authoritative pronouncement on fair value measurement.
In this article we focus on the guidance provided under IFRS 13 in relation to the definition of fair value, the framework for measuring the fair value and certain disclosure requirements, giving our perspectives on the requirements that are modified and that are expected to have an impact on the preparers and users of IFRS financial statements.
IFRS 13 provides elaborate guidance on how to measure the fair value when required or permitted under IFRS. It neither introduces new requirements to measure assets or liabilities at fair value, nor does it eliminate the exceptions to fair value measurements on the grounds of practicality in line with guidance contained under certain standards.
Scope of IFRS 13
The IFRS 13 guidance shall be applied to items of assets, liabilities and equity that are permitted or required to be measured at fair value. However, the guidance contained therein does not apply to the measurement and disclosure requirements in certain cases, such as:
- share-based payment transactions within the scope of IFRS 2 Share-based Payment;
- leasing transactions within the scope of IAS 17 Leases; and
- measurements that have some similarities to fair value but are not fair value, such as net realisable value in IAS 2 Inventories or value in use in IAS 36 Impairment of Assets.
Further, the fair value measurement guidance also does not apply to the disclosure requirements in certain cases, such as:
- plan assets measured at fair value in accordance with IAS 19 Employee Benefits;
- retirement benefit plan investments measured at fair value in accordance with IAS 26 Accounting and Reporting by Retirement Benefit Plans; and
- assets for which recoverable amount is fair value less costs of disposal in accordance with IAS 36.
Measurement principles
Definition of fair value
IFRS 13 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Measurement of asset or liability
A fair value measurement of an asset or liability considers the characteristics of that asset or liability (e.g., the condition and location of the asset and restrictions, if any, on its sale or use), if market participants would consider those characteristics when determining the price of the asset or liability at the measurement date.
The transaction
A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under current market conditions. The hypothetical transaction is considered from the perspective of a market participant that holds the asset or owes the liability, i.e., it does not consider entityspecific factors that might influence an actual transaction. Therefore, the entity need not have the intention or ability to enter into a transaction on that date. An orderly transaction is 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 i.e. it is not a forced transaction, e.g., a forced liquidation or distress sale.
Principal or most advantageous market
The hypothetical transaction to sell the asset or transfer the liability is assumed to take place in the principal market. This is the market with the greatest volume and level of activity for the asset or liability.
In the absence of a principal market, the transaction is assumed to take place in the most advantageous market. This is the market that maximises the amount that would be received to sell the asset or minimises the amount that would be paid to transfer the liability, after considering transaction costs and transport costs. Because different entities may have access to different markets, the principal or most advantageous market for the same asset or liability may vary from one entity to another.
Market participants
Fair value measurement uses assumptions that market participants would use in pricing the asset or liability. Market participants are buyers and sellers in the principal (or most advantageous) market who are independent of each other, knowledgeable about the asset or liability, and willing and able to enter into a transaction for the asset or liability.
Price
Fair value is the price that would apply in a transaction between market participants whether it is observable in an active market or estimated using a valuation technique.
Transaction cost and transportation cost
Although transaction costs are taken into account in identifying the most advantageous market, the price used to measure the fair value of an asset or a liability is not adjusted for transaction costs. This is because they are not a characteristic of the asset or liability and are instead characteristic of a transaction. However, if location is a characteristic of an asset e.g., crude oil held in the Arctic Circle, then the price in the principal or most advantageous market is adjusted for the costs that would be incurred to transport the asset to that market, e.g., costs to transport the crude oil from Arctic Circle to the appropriate market.
Application to non-financial assets — highest and best use and valuation premise
A fair value measurement considers a market participant’s ability to generate economic benefit by using the asset or by selling it to another market participant who will use the asset in its highest and best use. Highest and best use refers to the use of an asset that would maximise the value of the asset, considering uses of the asset that are physically possible, legally permissible and financially feasible. Highest and best use is determined from the perspective of market participants, even if the reporting entity intends a different use. However, an entity need not perform an exhaustive search for other potential uses if there is no evidence to suggest that the current use of an asset is not its highest and best use. The concept of highest and best use is relevant only to the valuation of non-financial assets and does not apply to the valuation of financial assets or liabilities.
Liabilities and equity instruments
The fair value of a liability or an entity’s own equity instrument is measured using quoted prices for the transfer of identical instruments. When such prices are not available, an entity measures fair value from the perspective of a market participant holding the identical item as an asset. If quoted prices in an active market for the corresponding asset are also not available, then other observable inputs are used, such as prices in an inactive market for the asset. Otherwise, an entity uses another valuation technique(s), such as a present value measurement or the pricing of a similar liability or instrument. IFRS 13 retains the principle in IAS 39 that the fair value of a financial liability with a demand feature is not less than the present value of the amount payable on demand.
Fair value at initial recognition
The price paid in a transaction to acquire an asset or received to assume a liability, often referred to as the ‘entry price’, may or may not equal the fair value of that asset or liability based on an exit price. If an IFRS requires or permits an entity to measure an asset or liability initially at fair value and the transaction price differs from fair value, then the entity recognises the resulting gain or loss in profit or loss unless the specific IFRS requires otherwise. Therefore, the recognition of a ‘day one’ gain or loss when the transaction price differs from the fair value will be determined by the particular standard that prescribes the accounting for the asset or liability.
Valuation techniques
The objective of using a valuation technique is to determine the price at which an orderly transaction would take place between market participants at the measurement date. An entity uses valuation techniques that are appropriate in the circumstances and for which sufficient data are available, maximising the use of relevant observable inputs and minimising the use of unobservable inputs. IFRS 13 identifies three valuation approaches: income, market and cost.
Fair value hierarchy
IFRS 13 establishes a fair value hierarchy based on the inputs to valuation technique used to measure fair value to increase consistency and comparability. The inputs are categorised into three levels, with the highest priority given to unadjusted quoted price in active markets for identical assets or liabilities and lowest priority given to unobservable inputs.
The level into which a fair value measurement is classified in its entirety is determined by reference to the observability and significance of the inputs used in the valuation model. The valuation technique often incorporate both observable and unobservable inputs, however the fair value measurement is classified in its entirety into either level 2 or level 3, based on the lowest level input that is significant to the fair value measurement.
The availability of relevant inputs and their relative subjectivity might affect the selection of appropriate valuation techniques. However, the fair value hierarchy prioritises the inputs to valuation techniques, not the valuation techniques used to measure fair value. For example, a fair value measurement developed using a present value technique might be categorised within level 2 or level 3, depending on the inputs that are significant to the entire measurement and the level of the fair value hierarchy within which those inputs are categorised.
Level 1 Inputs
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. A quoted price in an active market provides the most reliable evidence of fair value and shall be used without adjustment to measure fair value.
An active market is a market in which transactions for the asset or liability takes place with sufficient frequency and volume for pricing information to be provided on an ongoing basis.
Level 2 Inputs
The determination of whether a fair value measurement is categorised into level 2 or level 3 depends on whether the inputs used in the valuation techniques are observable or unobservable and their significance to the fair value measurement.
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.
Observable inputs are inputs that are developed using market data, such as publicly available information about actual events or transactions, and that reflect the assumptions that market participants would use when pricing the asset or liability.
Level 3 Inputs
Level 3 inputs are unobservable inputs for the asset or liability. 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.
Inputs into valuation techniques
When selecting the inputs into a valuation technique, an entity selects inputs that are consistent with the characteristics that market participants would take into account in a transaction. A premium or discount, such as a control premium or a discount for lack of control, may be appropriate if it would be considered by market participants in pricing the asset or liability based on the unit of account.
Using quoted prices provided by third parties
IFRS 13 does not preclude the use of quoted prices provided by third parties, such as brokers or pricing services, provided that the prices are developed in accordance with IFRS 13.
Markets that are not active and transactions that are not orderly
IFRS 13 describes factors that may indicate that a market has seen a decrease in the volume or level of activity. An entity evaluates the significance and relevance of factors to determine whether, based on the evidence available, there has been a significant decrease in the volume or level of activity; however, the standard stresses that even if a market is not active, it is not appropriate to conclude that all transactions in that market are not orderly, i.e., are forced or distress sales.
Quoted prices derived from a market that is not active may not be determinative of fair value. In such circumstances, further analysis of the transactions or quoted prices is needed, and a significant adjustment to the transaction or quoted prices may be necessary to measure fair value.
Disclosures
The objective of the disclosures is to provide information that enables financial statement users to assess the methods and inputs used to develop fair value measurements and, for recurring fair value measurements that use significant unobservable inputs (level 3), the effect of the measurements on profit or loss or other comprehensive income.
To meet this objective, an entity provides certain minimum disclosures for each class of assets and liabilities. For non-financial assets and non-financial liabilities that are measured at or based on fair value in the statement of financial position, IFRS 13 requires fair value disclosures that are similar to existing fair value disclosures for financial assets and financial liabilities in IFRS 7. This disclosure is also required for non-recurring fair value measurements (e.g., an asset held for sale). The requirement to disclose a fair value hierarchy and information on valuation techniques is also extended to assets and liabilities which are not measured at fair value in the statement of financial position, but for which fair value is disclosed pursuant to another standard.
In addition, a description of the valuation processes used by the entity for level 3 measurements is required to be disclosed. This includes, for example, how an entity decides its valuation policies and procedures and analyses changes in fair value measurements from period to period. An entity should disclose a narrative description of the sensitivity of level 3 measurements to changes in unobservable inputs, including the effect of any interrelationships between unobservable inputs, as well as quantitative information on significant unobservable inputs used in measuring fair value.
Effective date and transition
An entity should apply IFRS 13 prospectively for annual periods beginning on or after 1 January 2013. Earlier application is permitted with disclosure of that fact.
The disclosure requirements of IFRS 13 need not be applied in comparative information for periods before initial application.
Summary
Overall, the implementation of IFRS 13 will require significant judgment while preparing the entity’s financial statements. The standard is neither mandatorily effective until periods beginning on or after 1st January 2013, nor does it require retrospective application. As such, the comparative disclosures and measurements are not required in line with IFRS 13 in the first period of application.
At this moment, it is unclear by when the corresponding changes will be introduced under the Ind AS framework. However, it is advisable for Indian companies to evaluate the impact of this new standard, as it is inevitable that Ind AS will ultimately incorporate the changes due to the new standard.
