Fair Value Measurement

By: Feras AlghamdiShawneen KellyAustin TullosMeredith Whitaker

Contents:

• IFRS 13 overview.• The definition of fair value.• IFRS & GAAP differences.• Application of fair value.• Fair Value Hierarchy.• Measuring issues.• Disclosure.• Question.

IFRS 13 overview• “Fair Value Measurement”.

• Issued in May 2011 and applies to annual periods beginning on or

after 1 January 2013.

• IFRS 13 applies when another IFRS requires or permits fair value

measurements.

• The main objectives of IFRS 13 are:

• To define fair value.

• To establish a framework for measuring fair value

• To require disclosures about fair value measurement

The definition of fair value• Prior to the introduction of IFRS 13 many standards defined fair value

as:

“the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction”

• The NEW definition of fair value in IFRS 13 is as follows:

“...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.”

• Why change the definition?•The new definition requires the use of an exit price.•To provide clarity to the term “settling”.•To establish that fair value occurs at the measurement date.

Elements of the Definition• Exit Price:

“...The price that would be received to sell an asset or paid to transfer a liability”

• Exit price could be based on:

• The perspective of the entity that holds the asset or owes the liability.

• Expectations about future cash flows that will be generated by the asset/liability subsequent to the sale/transfer date.

• Orderly transactions:

“ 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”

Elements of the Definition• Key Issues:

• Refers to transactions made under normal market conditions.

• Excludes sales made under liquidation or “fire sale” conditions.

• Excludes non-arms length sales.

• Market participants need to meet these criteria:

• Must be independent from each other.

• Must be knowledgeable about the asset or liability.

• Must have the ability to enter into the transaction.

• Must not be forced or compelled.

IFRS 13 and ASC 820

• IFRS 13 and ASC 820 were a joint project between the IASB and FASB

• The goal was to provide converged guidance on fair value measurements

• While convergence was close there were a few differences

• Went into effect 1 January 2013

IFRS and GAAP differences

Application to Non-Financial Assets

• IFRS 13 applies to:• Non-financial assets• Liabilities and an entity’s own equity instruments

• Four step process in making a FV measurement:

1. Determine the asset or liability that is to be measured2. Determine the valuation premise that is appropriate3. Determine the principal or most advantageous market4. Determine the appropriate valuation technique

Step 1: Determine the Asset/Liability that is the Subject of Measurement

• Involves considering characteristics that market participants would take into account when pricing an asset or liability

• Relevant questions to consider include:• What is the location of the asset?• What is the condition of the asset?• Are there any restrictions on sale or use of the

asset?• Is the asset or liability a stand-alone asset or is it a

group of assets?

Step 2: Determine the Valuation Premise that is Appropriate

• Fair value is measured by considering the highest and best use of an asset:

“...the use of a non-financial asset by market participants that would maximize the value of the asset or the group of assets and liabilities (eg a business) within which the asset would be used.”

• These uses must be physically possible, legally permissible and financially feasible.

• The highest and best use is from the perspective of the market participant, not the holder

Step 2: continued…

• In combination valuation premise:

• FV is determined under this premise where market participants would obtain maximum benefit principally through using the asset in combination with other assets and liabilities as a group

• The asset will be sold as an individual asset, not as a group, but the asset will be used by the market participant in conjunction with other assets

• Stand-alone valuation premise

• FV is determined under this premise where market participants would obtain maximum benefit principally through using the asset on a stand-alone basis

Step 3: Determine the Principal or Most Advantageous Market

• FV measurement assumes that the transaction takes place in the principal market or in the absence of a principal market, the most advantageous market

• Principal market: the market with the greatest volume and level of activity

• Most advantageous market: the market that would maximize the amount received/paid after deducting transaction and transport costs

Step 4: Determine the Appropriate Valuation Technique

• The objective of the valuation technique selected is to estimate the price at which an orderly transaction would take place between market participants under current market conditions

• Three possible valuation techniques exist:

• The market approach

• The cost approach

• The income approach

• Judgement is required to select the most appropriate technique for the situation

• Market approach- is a method of determining the appraisal value of an asset (or asset group) based on the selling price of similar items.

• Cost approach- is a way of estimating the cost someone should pay to build/ have built a similar item. – common in new real estate construction land + construction cost.

• Income approach- where the value is appraised based on the income it produces.

• Market value = Net operating Income

Step 4: continued…Inputs:

• When applying a technique, the use of observable inputs needs to be maximized and unobservable inputs minimized

• Observable inputs are developed using market data, such as publicly available information

• Unobservable inputs are those where market data is not available and are developed using the best information available

• To achieve consistency and comparability IFRS 13 provides a hierarchy of inputs.

Fair Value Hierarchy

• There are 3 levels of the fair value hierarchy.

• Hierarchy was established by the IASB to increase consistency and comparability in the fair value measures.

• As the level increases, fair value measurements become more subjective.

Fair Value Hierarchy

• Level 1 Inputs:

“...quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date.”

• A market is not active if there are few recent transactions or price quotes vary substantially over time

• Level 1 inputs must be for identical items – for buildings, items may be similar, but will not be identical

• Example: A closing share price in the Financial Times

Fair Value Hierarchy• Level 2 Inputs:

“...inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.”

• Included within this definition are:

• Quoted prices for similar assets in active markets

• Quoted prices for identical items in inactive markets

• Inputs other than quoted prices that are observable

• Inputs that are derived from or corroborated by observable market data

9/29/15

Fair Value Hierarchy

• Level 3 Inputs:

“...unobservable inputs for the asset or liability.”

• Most subjective level which requires the most judgment

• Level 3 inputs would be used include when valuing:

• Cash generating units – hard to determine stand alone use of asset when in a unit

• Trademarks – internally valuated

• Accounts receivable – collectability assessment

Application to Liabilities

• Prior to IFRS 13, the measurement was based on the amount required to settle the present obligation

• In IFRS 13, fair value is the amount paid to transfer a liability

• Fair value measurement assumes that the liability is transferred to another market participant at the measurement date

• The IASB argues that the fair value of a liability from the perspective of market participants who owe the liability is the same regardless of whether it is settled or transferred

Application to Liabilities

• Financial Liabilities:

• There is often an observable market and a quoted price may be obtained to measure the FV of the liability

• Measurement will depend on whether or not a corresponding asset is held by another entity

Corresponding Asset:

• Measurement should be in the following order:

•The quoted price of the asset in an active market•The quoted price for the asset in an inactive market•A valuation under a technique such as the income or market approach

Application to liabilities

Non Corresponding Asset:

•Measurement must be done by applying a valuation technique from the perspective of a market participant that owes the liability

•A present value technique could be applied

Application to Liabilities

Non performance risk:

•The fair value of a liability will reflect the effect of non-performance risk

“...the risk that an entity will not fulfill an obligation. Non-performance risk includes, but may not be limited to, the entity’s own credit risk”

Application to Liabilities

• Measurement of equity instruments may be needed where an entity undertakes a business combination and issues its own equity instruments in exchange for a business

• The principles in relation to liabilities also apply to equity instruments

• The company must measure the fair value of the equity instrument from the perspective of a market participant who holds the instrument as an asset

Application to Equity Instruments

Inputs based on bid and ask prices:

•Some inputs are based on market prices that include: • Bid prices - the price a dealer is willing to pay • Ask prices - the price a dealer is willing to sell

•The price within a bid - ask spread that is most representative of fair value should be used or

• A mid-market price may be used as a practical expedient

Issues in Measuring Financial Instruments

Offsetting positions

•Entities may hold both financial assets and financial liabilities and as such is exposed to both market risk and credit risk.

•Where these assets and liabilities are managed as a group, IFRS 13 allows an entity to measure the net financial asset or net financial liability

•This exception may be only be applied where an entity manages the group of financial assets and liabilities on a net exposure basis as a part of its documented risk management strategy.

Issues in Measuring Financial Instruments

• IFRS 13 requires an entity to disclose information that enables users to assess both of the following:

• The valuation techniques and inputs used to develop measurements of assets & liabilities measured at fair value

• When using significant unobservable inputs (Level 3), the effect of the measurements on profit or loss or other comprehensive income for the period

Disclosure

• How reliable are the FV numbers?

• Does past experience warn us against the extensive use of FV?

• Are the FV measures not based on directly observable market prices costly to determine?

• Should measures based on unobservable inputs be called FV?

Questions About FV Measurement

Thank you …