Case Studies: Fair Value Measurement - World...

Case Studies:

Fair Value

Measurement

Executive IFRS Workshop for

Regulators

Diplomatic Academy of Vienna, 4 June 2013

KPMG International Standards Group

© 2013 KPMG IFRG Limited, a UK registered company limited by guarantee.

All rights reserved. Internal use only. Case Study: Fair Value Measurement 1

Case study 1: Restriction on sale of financial asset

Restriction on sale of equity instrument (financial asset)

Quoted price in active market for shares that is not subject to

restriction is available

■ Fact pattern:

– Entity A enters into a borrowing arrangement.

– In accordance with the arrangement, an equity security that A holds as

an investment is pledged as a collateral.

– A is restricted from selling the security pledged during the period the

borrowing is outstanding.

Question:

Should the restriction be considered when measuring the fair value of the

security?



Case study 1 solution: Restriction on sale of financial asset

Is the restriction a characteristic of the financial asset (IFRS 13.11)?

■ transferability

■ imposed on holder by regulations

■ part of contractual terms of financial asset

■ attached to financial asset through purchase contract or other commitment?

Solution:

The restriction is entity-specific and should not be considered in measuring

the fair value of the security

Adjustment for restriction required

Yes

Adjustment for restriction prohibited

No

Level 1 input for financial asset without

restriction is not level 1 input for financial

asset with restriction

Holder of restricted financial asset

considered to have access to principal

market at measurement date



Case study 2: Day 1 gain

Bank B enters into an interest rate swap (IRS) contract with a corporate

client for no initial cash consideration.

B has access to the wholesale market which is the principal market for this

instrument.

B estimates the fair value of the IRS in the wholesale market at the

transaction date using a valuation technique. The fair value using the

valuation technique is CU 10 (an asset).

Scenario 1:

■ All the inputs used in the valuation technique are observable

Scenario 2:

■ The valuation technique uses inputs that are not observable

Question:

What is the fair value of the IRS? Should Bank B recognise a “day 1” gain?



Case study 2 solution: Day 1 gain (1/2)

Transaction is between related parties

Transaction is forced

Unit of account represented by the transaction is

different from unit of account used for measuring

fair value

The market in which transaction takes place is

different from the market in which the entity

would sell the asset or transfer the liability

May indicate that

transaction price and

fair value are different

(IFRS 13.B4).

IFRS 13 does not

prescribe rules for

recognition of gains

or losses at initial

recognition – look to

IFRS that

permits/requires the

fair value

measurement (e.g.

IAS 39/IFRS 9)



Case study 2 solution: Day 1 gain (2/2)

Scenario 1:

■ The fair value is CU 10 (based on the valuation technique)

■ Bank B recognises day 1 gain of CU 10

Scenario 2:

■ The fair value is CU 10 (based on the valuation technique)

■ Bank B does not recognise a day 1 gain (the carrying amount of the IRS

on initial recognition is adjusted to defer the difference between the fair

value measurement and the transaction price)

Fair value represents the price in the principal market. However, under

IAS 39/IFRS 9, if the fair value at initial recognition differs from the

transaction price but is not evidenced by a valuation technique that

uses only data from observable markets, any “day 1” gain is deferred

(IAS 39.AG76, IFRS 9.B5.1.2A)



Case study 3: Low interest loan

■ Entity G makes an interest-free loan of CU 100 to a related party at

1/1/X3

■ The loan is repayable after 3 years at CU 100

■ Entity G estimates that the annual interest rate that the related party

would have been required to pay to an unrelated party (e.g. a bank) for a

loan with similar terms is 5%. However, this estimate is not based solely

on observable market data.

Question:

What is the fair value of loan at 1/1/X3? Should G recognise a “day 1” loss?



Case study 3 solution: Low interest loan

The fair value/transaction price of the loan is CU 86 (100/1.05³). G

expenses the remainder of 14.

Fair value at initial recognition usually = transaction price = fair value of

consideration given. But if part of the consideration relates to something

other than the financial instrument, measure the FV of the financial

instrument.

The fair value of a loan that carries no interest can be measured as the

present value of all future cash flow receipts discounted using the prevailing

market rate of interest for a similar instrument with a similar credit rating.

Any additional amount lent is an expense or a reduction in income unless it

qualifies for recognition as some other type of asset (IAS 39.AG64).



Case study 4: Principal and most advantageous markets

Entity D owns an asset. It has access to two different active markets

to sell the asset

Scenario 1:

■ Market A is the principal market as it is the market with the greatest

volume and level of activity for the asset

Scenario 2:

■ There is no principal market

Market A Market B

Price 99 96

Transaction costs 6 2

Net amount received 93 94

Question:

What is the fair value of the asset in each scenario?



Case study 4 solution: Principal and most advantageous

markets

Scenario 1:

■ The fair value is 99 (the price in market A which is the principal market)

Scenario 2:

■ The most advantageous market is market B

■ The fair value is 96 (the price in market B)

In measuring fair value, the price is not adjusted for transaction costs

(IFRS 13.25). However, transaction costs are taken into account in

determining the most advantageous market (IFRS 13.A)



Case study 5: The most representative price within a bid-

ask spread

Entity L holds 2 securities; X and Y which have bid and ask prices as follow:

Question:

Can L use mid-market prices for measuring the fair values of the securities?

Security Bid Price Ask price Mid-market

price

X 99.9 100.1 100

Y 90 110 100



Case study 5 solution: The most representative price within

a bid-ask spread

■ The entity uses the price within the bid-ask spread that is most

representative of fair value in the circumstances (IFRS 13.70).

■ IFRS 13 does not preclude the use of mid-market pricing or other pricing

conventions that are used by market participants as a practical expedient

for fair value measurement within a bid-ask spread (IFRS 13.71).

For security X, the mid-market price of 100 may be used as it seems to

provide a reasonable approximation of the exit price

For security Y, due to the wide bid-ask spread, the mid-market price of

100 may not provide a reasonable approximation of the exit price and

therefore would not be used



Case study 6: Premiums and discounts

■ Entity M holds:

– 5% of the shares of entity Z; and

– 80% of the shares of entity W which give M control over W.

■ Z and W shares do not have a quoted price. Fair values for these shares

are initially estimated using multiples for comparable public companies.

Questions:

1. Should the fair value of Z shares be adjusted for the effect of lack of

liquidity?

2. Should the fair value of the investment in W be adjusted to include a

control premium?



Case study 6 solution: Premiums and discounts

■ The fair value of Z shares should be adjusted for the effect of lack of

liquidity if market participants would take this into account when

measuring the fair value (IFRS 13.69)

– May be required if initial estimate of fair value is based on

comparables for public companies (ie. quoted/liquid shares).

■ The fair value of W should be adjusted for a control premium if:

– it is not inconsistent with the asset’s unit of account (IFRS 13.14, 69);

and

– market participants would include such a premium when measuring

the fair value (IFRS 13.69).

The issue of how to determine the unit of account

is currently under discussion by the IASB



Case study 7: Large holding

Fact pattern:

■ Entity B holds 8% (i.e. 1.5 million shares) of the share capital in Entity Q.

■ Daily trading volume is 1% of outstanding shares.

■ The quoted price for one share in Q is CU 10 at the measurement date.

■ B assumes that it would be able to sell its 8% stake in one transaction for

CU 13.5 million at the measurement date.

Question:

What is the fair value of B’s 8% interest in Q at the measurement date if Q’s

shares are traded in an active market?



Case study 7 solution: Large holding

■ Unit of valuation and unit of account is individual share in

accordance with IFRS 13.14 and IAS 39/IFRS 9.

■ If Level 1 input available, it should be used for FV measurement (IFRS

13.69, 77, 80): 1.5 million shares × CU 10 = CU 15 million.

■ Discount of CU 1.5 million is a blockage factor that is:

– a characteristic of the entity’s holding;

– inconsistent with the unit of account;

– not a characteristic of the individual share; and

– conceptually similar to transaction costs.

The FV of A’s 8% interest in Q is CU 15 million CU

15 million

Follow up question:

Would the answer be different if the market for Q’s shares was not active?



Case study 8: Fair value measurement of a portfolio of

assets and liabilities

■ Bank C has a long position of 100 individual financial assets and a short

position of 95 individual financial liabilities in a particular market risk.

■ The financial instruments within the portfolio are identical.

■ Bid price is CU 99; mid price is CU 100; ask price is CU 101.

■ C uses bid prices to measure asset positions and ask prices to measure

liability positions.

■ The individual financial instruments are not categorised within level 1 of

the fair value hierarchy.

■ Assume there is no discount/premium that results from the size of the net

risk exposure.

Question:

What is the sum of the fair values of the assets and liabilities assuming:

A. Bank C applies the portfolio exception; or

B. Bank C does not apply the portfolio exception.



Case study 8 solution: Fair value measurement of a

portfolio of assets and liabilities (1/2)

If C applies the portfolio exception, the sum of the fair values is CU

495 and can be measured as follows:

Quantity held Price Fair value

Financial assets

95 100 9,500

5 99 495

Financial

liabilities

(95) 100 (9,500)

Net long position 5 99 495



Case study 8 solution: Fair value measurement of a

portfolio of assets and liabilities (2/2)

Without the application of the portfolio exception, the sum of the fair

values is CU 305 and is measured as follows:

Quantity held Price Fair value

Financial assets 100 99 9,900

Financial

liabilities

(95) 101 (9,595)

Net long position 5 305



Case study 9: Adjustment for DVA

■ Entity H entered into an interest rate swap (IRS) contract with a bank in

2011.

■ Under IAS 39, H has not adjusted the fair value of the IRS for its own

credit risk (DVA adjustment).

■ H applies IFRS 13 from 1 January 2013.

■ The value of the IRS on 1 January 2013, excluding DVA, is CU 100 (an

asset)

■ H believes that an adjustment to the fair value for its own credit risk is not

required under IFRS 13 because:

– it would be misleading since H intends to settle the IRS with the bank; and

– the IRS is currently classified as an asset, so the effect of H’s own credit risk is not

relevant for the valuation.

Question:

Should the fair value of the IRS be adjusted for H’s own credit risk?



Case study 9 solution: Adjustment for DVA

■ Under IFRS 13, the fair value of a liability reflects the effect of ‘non

performance risk’ which includes an entity’s own credit risk (IFRS 13.42).

■ Since fair value under IFRS 13 is an ‘exit price’, H’s intention to settle

should not affect the measurement (IFRS 13.9).

■ The effect of the entity’s own credit risk may be relevant for measuring

the fair value of an instrument that might change from being an asset to a

liability (even when the current position of the instrument is an asset) –

since a market participant may consider this risk and the potential credit

exposure to H that might arise when determining the price of the asset.

[Similarly, counterparty credit risk may be relevant to measuring a liability

that might change to being an asset.]

H’s own credit risk should be considered when measuring the fair

value of the IRS if market participants would do so when valuing the

instrument



Case study 10: Decrease in volume or level of activity (1/2)

■ Entity C holds 4% of the share capital in Entity F.

■ Quoted price on stock exchange is CU 200 at measurement date

(31/12/20X2).

■ During Q2-20X2, trading was suspended for 8 weeks and during 20X2

the government took several steps to support the market.

■ Due to financial and political instability, the share price and trading

activity have declined sharply since Q2-20X2, with historical lows in Q4-

20X2.

■ Trading volume on measurement date is similar to the average quarterly

trading volume.



Case study 10: Decrease in volume or level of activity (2/2)

Question:

Is C allowed to use a price, other than the quoted price, to measure the FV

of a share in F at the measurement date?



Case study 10 solution: Decrease in volume or level of

activity

■ Is market active (i.e. is the quoted price a Level 1 input (IFRS 13.76))?

■ In an active market, transactions for the asset or liability take place with

sufficient frequency and volume to provide pricing

information on an ongoing basis (IFRS 13.A).

■ There may be a significant decrease in volume or

level of activity for the shares in F (IFRS 13.B37).

■ Significant decrease in volume or level of activity ≠ inactive market

■ Based on fact pattern presented sufficient evidence to consider the

market active.

■ Even if market is inactive, quoted price may still

represent best evidence of FV as the transactions can still be orderly

(IFRS 13.B43).



Case study 11: Not using the transaction price when

measuring fair value (1/2)

■ Entity K holds a debt security for which there has been a significant

decrease in the level of activity in the market such that there were only a

few transactions in recent months.

■ K concludes that the market for the security is no longer an active

market.

■ The last transaction in the market took place at 23/12/X3 at a price of CU

60. The debt security’s principal amount is CU 100.

■ K states that:

– due to the lack of activity and the illiquidity of the market, the price in

the market does not represent fair value;

– the current low market price results from irrational trends caused by

wider economic concerns that are not specific to the security;

– it will hold the security until the market price increases or until maturity.



Case study 11: Not using the transaction price when

measuring fair value (2/2)

■ Accordingly, K values the security at 31/12/X3 at CU 90 using an income

approach that is based on its analysis of expected cash flows and what it

considers a reasonable rate of return of 6%.

Question:

Can K ignore the last transaction price of CU 60 and use its own valuation

technique when measuring the fair value of the security?



Case study 11 solution: Not using the transaction price

when measuring fair value (1/2)

FV represents price of an orderly transaction. It is not appropriate to

conclude that all transactions in the market are not orderly – need to

evaluate the circumstances of transactions (IFRS 13.B44):

■ if evidence indicates orderly – take transaction price into account

■ if insufficient evidence – also take into account but less weight

■ if evidence indicates not orderly – little, if any, weight



Case study 11 solution: Not using the transaction price

when measuring fair value (2/2)

FV should reflect market participants’ (not K’s) assumptions about expected

cash flows and discount rates, including the risk premium a market

participant would demand. Therefore, K’s intention to hold the asset is not

relevant (IFRS 13.22).

Multiple valuation techniques may be appropriate – but weighting should

reflect objective of determining the point that is most representative of

current market conditions (IFRS 13.63).

Need to consider time between last transaction and measurement date

(IFRS 13.B44(b)).

Based on the information presented, K cannot ignore the transaction

price of CU 60. Also, K’s alternative valuation technique is not

calibrated to a market participant perspective.

Questions and feedback

Please send your feedback on today’s

session to:

Chris Spall

Seconded Partner in KPMG’s

International Standards Group

[email protected]

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate

and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon

such information without appropriate professional advice after a thorough examination of the particular situation.

KPMG International Standards Group is part of KPMG IFRG Limited.

© 2013 KPMG IFRG Limited, a UK registered company limited by guarantee. All rights reserved.

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