In this issue: Fair value measurement of financial assets and financial liabilities. Welcome to the series

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1 IFRS FOR INVESTMENT FUNDS September 2012, Issue 5 Welcome to the series Our series of IFRS for Investment Funds publications addresses practical application issues that investment funds may encounter when applying IFRS. It discusses the key requirements and includes guidance and illustrative examples. This series considers accounting issues from currently effective IFRS as well as forthcoming requirements. For details of previous issues, see page 29. Further discussion and analysis about IFRS are included in our publication Insights into IFRS. In this issue: Fair value measurement of financial assets and financial liabilities Fair value measurement lies at the heart of accounting for investment funds ( funds ) that invest in financial instruments because they would commonly measure such investments at fair value for reporting purposes. Here we cover the following questions on the fair value measurement of financial assets and financial liabilities. 1. What is fair value? 2. How do you apply the fair value hierarchy? 3. Is the price quoted in an active market? 4. Bid, mid, ask or something else? 5. What if a transaction is not orderly? 6. What are the main considerations when applying a valuation technique? 7. What inputs into valuation techniques are commonly used by market participants? 8. What if fair value estimates are sourced from brokers or pricing services? 9. How do you determine the fair value of an investment in an open-ended investment fund? 10. How do you determine the fair value of a financial liability? 11. Are there instances when fair value cannot be reliably measured? 12. Is it possible to recognise a gain on initial recognition of a financial asset or financial liability? This issue does not cover fair value measurement of an entity s own equity instruments.

2 2 IFRS for Investment Funds Introduction Funds that invest in securities that are traded in an active market and whose prices are readily available will find the fair value measurement process relatively straightforward. Other funds that invest in instruments that, although not traded in an active market, are valued using observable inputs and well-established valuation models will need to put in place more involved processes to measure fair value. Arriving at fair value is likely to be most complex and involve most judgement for funds, such as private equity funds, that invest in securities whose valuation relies on significant unobservable inputs. In addition, fair value considerations for funds are not limited to their investments but extend to the units issued, which are often regarded as liabilities under IFRS. The current guidance on measuring the fair value of financial instruments is included in IAS 39 Financial Instruments: Recognition and Measurement. This guidance will be superseded by IFRS 13 Fair Value Measurement, which is effective for annual periods beginning on or after 1 January IFRS 13 replaces the fair value measurement guidance contained in individual IFRSs, including IAS 39, with a single framework for fair value measurement. The principal requirements of IFRS 13 relating to financial instruments are largely similar to those in IAS 39. However, some of the key definitions, such as the definition of fair value, have been changed, resulting in subtle differences that may potentially impact application of the standard. IFRS 13 expands and articulates in more detail the concepts and principles behind fair value, including introducing some new concepts such as the principal market. Each question in this publication deals with the relevant requirements of both IAS 39 (and, where applicable, its interactions with currently effective requirements of IFRS 7 Financial Instruments: Disclosures and IFRS 9 Financial Instruments) and IFRS 13 and explains any differences between the two standards in the area discussed. However, market practice in applying IFRS 13 may be further refined once the standard becomes effective and as potential new implementation issues are identified and considered.

3 IFRS for Investment Funds 3 1. What is fair value? Fair value is defined in IAS 39 as the amount for which an asset could be exchanged or a liability settled, between knowledgeable and willing parties in an arm s length transaction. The objective of determining fair value is to estimate the price at which an orderly transaction would take place between market participants at the measurement date. Fair value is a market-based measurement, rather than an entity-specific measurement. Fair value is measured using the assumptions that market participants would use when pricing the asset or liability. For example, the fact that a fund asserts that prices in orderly transactions are too low relative to its own expectations, and that accordingly it would be unwilling to sell at such prices, is not relevant. Generally, fair value is determined on an instrument-by-instrument basis. See Question 4 for a discussion of the open net position valuation for funds with assets and liabilities with offsetting market risks. Some funds use industry valuation guidance. In our view, although the valuation determined using these methods may be used as a starting point in determining fair value, adjustments may be required to determine an IFRS-compliant fair value. Valuations using these methods may result in a more conservative measure of value than current market-based fair value, which is the objective of fair value measurement under IFRS. IFRS 13 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. Therefore, fair value is an exit price. The amended definition no longer refers to an amount at which a liability could be settled see Question 10 for further discussion. Market participants are independent (not related parties under IAS 24 Related Party Disclosures), knowledgeable, able and willing to enter into a transaction, although the price in a related party transaction may be used as an input to a fair value measurement if the fund has evidence that the transaction was entered into on market terms. The exit transaction is assumed to take place either: in the principal market for that asset or liability; or in the absence of a principal market, in the most advantageous market for the asset or liability. See Question 3 for a discussion of the concepts of principal and most advantageous markets. Unit of account and unit of valuation IFRS 13 does not generally specify whether an individual asset or liability or a group of assets or liabilities is considered for fair value measurement. The unit of account is usually determined under the IFRS that requires or permits the fair value measurement. For example, the unit of account in IAS 39 or IFRS 9 is generally an individual financial instrument. Although it is not defined in IFRS, the term unit of valuation is used in this publication for convenience, to indicate the level at which an asset or a liability is aggregated or disaggregated for the purpose of measuring fair value. Generally, the unit of account and the unit of valuation are the same. However, there could be situations in which the unit of valuation is different. For example, IFRS 13 permits an entity to measure the fair value of a group of financial assets and liabilities on the basis of the net risk position in certain circumstances. In such cases, the unit of valuation for a particular risk exposure would be the net risk position (group of financial assets and financial liabilities), whereas the unit of account determined under IAS 39 or IFRS 9 would be an individual financial instrument.

4 4 IFRS for Investment Funds 2. How do you apply the fair value hierarchy? IAS 39 requires entities to maximise the use of market data in determining the fair value of a financial instrument. If a published price in an active market is available for a particular instrument, then that price is used. If no published price in an active market is available and so a fund estimates fair value using a valuation technique, then that technique has to maximise the use of observable inputs. However, although it prioritises the use of published prices in an active market and the use of other observable inputs, IAS 39 does not explicitly refer to a fair value hierarchy. The levels in the fair value hierarchy are included in IFRS 7, which requires disclosure of the fair value hierarchy for financial instruments measured at fair value in accordance with IAS 39. The flowchart below summarises the approach to determining the classification of fair value measurements under IFRS 7. Quoted price for an identical item in an active market available? Yes No Price requires adjustment? Level 1 No Yes Any significant unobservable inputs? No Level 2 Yes Level 3 Financial assets and financial liabilities are measured using quoted prices if a published price quotation in an active market is available for the instruments. Generally, quoted prices should not be adjusted when valuing large holdings. For example, a fund cannot depart from the quoted price in an active market solely because independent estimates indicate that it would obtain a higher or lower price by selling the holding as a block. See Question 3 for a discussion of how to determine whether a market in a financial instrument is active. When a financial instrument is not traded in an active market, its fair value is determined using a valuation technique. Such a measurement is Level 2 or Level 3 in the fair value hierarchy. Sometimes quoted prices are readily available from brokers or pricing services on enquiry, but the prices are not published. A fund may hold a large number of such investments; in this case, the fund may use a pricing service that does not rely exclusively on quoted prices for each identical instrument i.e. a matrix-pricing methodology as a practical expedient on costbenefit grounds. This is permitted only if the fund obtains evidence that provides reasonable assurance that the resulting value represents fair value. The evidence should support a conclusion that there would be no more than trivial differences between the prices used and the quoted prices that would be obtained from a relevant broker or dealer. If fair value is determined using a matrix-pricing methodology, then the fair value measurement would not be Level 1. This is despite the fact that the investment is regarded as quoted in an active market. See Question 8 for further discussion of the fair value sourced from pricing services or brokers. A fair value measurement is classified in its entirety into one of the levels of the fair value hierarchy based on the lowestlevel input that is significant to the fair value measurement. When multiple unobservable inputs are used, in our view the unobservable inputs should be considered individually and in total for the purposes of determining their significance. When factors such as volatility inputs are used, a fund could apply some form of comparability methodology e.g. a stress test on an option s volatility input or a with-and-without comparison to assist in determining significance.

5 IFRS for Investment Funds 5 Valuation techniques that are based on inputs that are observable result in Level 2 measurements. Valuation techniques that use inputs requiring significant adjustments based on unobservable inputs result in Level 3 measurements. Differentiating between Level 2 and Level 3 fair value measurements i.e. assessing whether inputs are observable and whether unobservable inputs are significant may require judgement and a careful analysis of the inputs used to measure fair value, including consideration of factors specific to the asset or liability. An input is observable if it can be observed as a market price or can be derived from an observed market price. In each case, it is not necessary for the market to be active. See Question 6 for further discussion of valuation techniques. Irrespective of the level in the fair value hierarchy used to measure the fair value of a financial instrument, the method chosen must maximise the use of relevant observable inputs and minimise the use of unobservable inputs. IFRS 13 Fair value hierarchy Guidance on the fair value hierarchy currently included in IFRS 7 has been incorporated into IFRS 13 (for measurement as well as disclosure). The guidance has been expanded considerably but is largely consistent with the general concepts currently in IAS 39. However, there are some changes. In its discussions about quoted prices in active markets, IAS 39 refers to prices in the most advantageous active market to which the entity has immediate access (see Question 3). In defining a Level 1 input, IFRS 13 states that the published price quotation is to be sourced from the entity s principal market or, in the absence of a principal market, from its most advantageous market. As under IAS 39 and as discussed earlier in this chapter, adjustments to Level 1 prices are not generally permitted under IFRS 13. However, as a practical expedient, a fund may measure the fair value of certain assets and liabilities using an alternative method (such as matrix pricing) that does not rely exclusively on quoted prices. This practical expedient is appropriate only when: the entity holds a large number of similar assets and liabilities that it measures at fair value; and a quoted price in an active market is available but not readily accessible for each instrument individually. The matrix-pricing method involves using a selection of data points (usually quoted prices) or yield curves to calculate prices for separate financial instruments that share characteristics similar to the data points. Matrix pricing using observable market-based data points will usually result in Level 2 fair value measurements. It appears that the use of such an alternative method as a practical expedient is also subject to the condition that it results in a price that is representative of fair value. We believe that application of a practical expedient is not appropriate if it would lead to a measurement that is not representative of an exit price at the measurement date. Specific guidance on blockage factors and discounts and premiums A fund selects inputs that are consistent with the characteristics of the asset or liability that market participants would take into account when determining the exit price of an asset or a liability. Sometimes it may be appropriate to make an adjustment to a preliminary value indication in respect of a control premium or a non-controlling interest discount in measuring fair value of an asset or a liability. A fund does not apply a premium or discount if: it is inconsistent with the item s unit of account; it reflects size as a characteristic of the entity s holding e.g. a blockage factor; the characteristic is already reflected in the preliminary value indication; or there is a quoted price in an active market for an identical asset or liability i.e. a Level 1 input.

6 6 IFRS for Investment Funds A fund may hold a large number of identical financial instruments where the market for the instruments does not have sufficient trading volume to absorb the quantity held without affecting the price. IFRS 13 provides specific guidance for such circumstances. It defines a blockage factor as a discount that adjusts the quoted price of an asset or a liability because the market s normal trading volume is not sufficient to absorb the quantity held by the fund. The standard clarifies that a blockage factor is not a characteristic of an asset or a liability but a characteristic of the size of the entity s holding, and it expressly prohibits application of a blockage factor. There is currently some uncertainty about the application of valuation adjustments under IFRS 13. This arises in part because: the IFRS that requires a fair value measurement may not be explicit in identifying the appropriate unit of account; and IFRS 13 is not explicit in identifying all circumstances in which the unit of account guidance in the IFRS giving rise to the fair value measurement is overridden by the unit of valuation guidance in IFRS 13. In particular, the interaction of IFRS 13 s and other IFRSs guidance on the unit of account may be inconsistent in certain cases with its requirement to use Level 1 prices without adjustment, when they are available.

7 IFRS for Investment Funds 7 3. Is the price quoted in an active market? Under IAS 39, a published price quotation in the most advantageous active market to which the fund has immediate access (a Level 1 fair value measurement) is the best indicator of the fair value of a financial asset or financial liability and, if one is available, is used. Therefore, determining whether the market is active is the first step in valuing a financial instrument. A financial instrument is regarded as being quoted in an active market if quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency and those prices represent actual and regularly occurring market transactions on an arm s length basis. In our view, whether transactions are taking place regularly is a matter of judgement and depends on the facts and circumstances of the market for the instrument. Quoted market prices may not be indicative of the fair value of an instrument if the activity in the market is infrequent, the market is not well-established, only small volumes are traded or bid-ask spreads are very wide. Determining whether a market is active involves judgement. In our view, characteristics of an inactive market (Level 2 or Level 3 fair value measurements) include the following. There is a significant decline in trading volume and level of trading activity. Available prices vary significantly over time or between market participants. Available prices are not current. A significant trading volume is between related parties. There are restrictions on trading. Example 1 Active market Fund of funds F holds units in an open-ended unlisted Fund B. Units in B are not traded on a stock exchange and can be bought from and sold to the fund only. This means that transactions cannot take place directly between investors. B calculates the price of the units only at a specific time each day to facilitate the purchase and sale of the units. Transactions take place only at that specific time each day at the price determined by B. Are units in B quoted in an active market? In our view, it is not necessary for there to be a large number of dealers or brokers for an active market to exist. As long as F is able to dispose of or acquire a reasonable quantity of a particular financial instrument at a price that is not discounted significantly or does not include a significant premium, then it may be concluded that the financial instrument is traded in an active market. In this example, whether units in B are quoted in an active market will depend on whether daily pricing is sufficient to meet the readily and regularly available criterion and whether the number and frequency of trades that occur in the units qualify as regularly occurring transactions. Daily pricing is likely to constitute evidence of regularly available prices. Judgement will then have to be applied to determine whether the number of trades occurring is sufficient to meet the regularly occurring transactions criterion. If it is concluded that actual transactions occur regularly then, notwithstanding that the units are being bought from and sold to the fund only, the units would be regarded as quoted in an active market. If for some reason the quoted price does not represent fair value at the measurement date e.g. because significant events occur after the close of the market but before the measurement date then the quoted price is adjusted to arrive at fair value and the fair value measurement is not a Level 1 measurement.

8 8 IFRS for Investment Funds Example 2 Adjusted quoted price Fund P invests in shares of Company C that are listed on a national stock exchange. On the last day of the reporting period, P obtains the closing price of the shares from the exchange. However, subsequent to the close of the market but still on the last day of the reporting period, C makes a public announcement that has an impact on the fair value of the shares as evidenced by prices for a small number of after-market transactions in depository receipts of the shares of C that are traded in another jurisdiction. Should P adjust the closing price from the exchange to reflect the after-market transactions? In this case, P uses the after-market prices to make appropriate adjustments to the closing price from the exchange to arrive at the fair value of the shares at the measurement date. The resulting fair value measurement is a Level 2 measurement because the exchange price has been adjusted for events occurring subsequent to the closing of the market and those subsequent events are observable. It is explicit in the concept of a Level 1 measurement that the instrument being valued is the same as other existing instruments of the same type. In some cases, instruments may be similar but not exactly the same. For example, over-the-counter derivative contracts are individual agreements between specific counterparties and therefore cannot be the subject of a Level 1 measurement because there is unlikely to be an active market for an identical instrument. In some cases, conditions attached to a financial instrument may not be reflected in the quoted price in an active market and in our view this may justify an adjustment to the quoted price to arrive at the instrument s fair value. For example, assume that an investor is contractually bound by lock-up provisions that prohibit or restrict the sale of the instrument for a specified period. In our view, it can be argued that these contractual lock-up provisions are characteristics of the instrument held by the investor and that this instrument is therefore not identical to the one with the quoted price. If the contractual lock-up provisions are considered characteristics of the instrument held by the investor, then we believe that it is appropriate to use a valuation model to make adjustments to the quoted price. IFRS 13 More detailed guidance As noted in Question 2, IFRS 13 provides more detailed guidance on applying the fair value hierarchy. The elements of this guidance with specific relevance to Level 1 measurement are highlighted below. Active market IFRS 13 amends the definition of an active market to a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis. We do not expect the amendment to represent a significant change and we expect that in practice it is likely to be interpreted in the same way as the current definition in IAS 39. Principal and most advantageous market IFRS 13 introduces the concepts of principal and most advantageous markets. It states that fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place in the principal market for the asset or liability i.e. the market with the greatest volume and level of activity. 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. In many cases, the principal market and the most advantageous market will be the same. A fund must be able to access the market in which the transaction is assumed to occur at the measurement date. The concepts of principal and most advantageous markets are considered from the perspective of the fund, allowing for differences between entities with different activities. For example, when a transaction takes place between an investment bank and a fund, the former may have access to wholesale and retail markets whereas the latter may have access only to retail markets.

9 IFRS for Investment Funds 9 IFRS 13 does not provide detailed guidance on: how an entity should identify the principal market; over what period it should analyse transactions in the asset or liability to determine what is the principal (or most advantageous) market; or how often it should update its analysis. It appears that a fund should update its analysis to the extent that events have occurred or activities have changed in a manner that could change its determination of the principal (or most advantageous) market for the asset or the liability. A fund is not required to undertake 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, it should take account of all information that is reasonably available. In the absence of evidence to the contrary, the principal (or most advantageous) market is presumed to be the market in which the fund normally enters into transactions to sell the asset or transfer the liability. Characteristics of the asset or liability being measured A fund should take into account characteristics of the asset or liability that market participants would take into account in a transaction for the asset or liability at the measurement date. In the case of a financial asset, these characteristics include, for example, restrictions, if there are any, on the sale or use of the asset. It is important to distinguish a characteristic of an asset or liability from a characteristic arising from an entity s holding of the asset or liability, which is an entity-specific characteristic. Factors used to evaluate whether a restriction on an asset is a characteristic of the asset or entity-specific may include whether the restriction is: transferred to a (potential) buyer; imposed on a holder by regulations; part of the contractual terms of the asset; or attached to the asset through a purchase contract or another commitment. For example, Fund D offers securities in a public offering and enters into an underwriting agreement with Company E. The underwriting agreement between D and E contains a lock-up provision that prohibits D and its founders, directors and executive officers from selling their securities for a period of 180 days. The lock-up provision may be based on a contract separate from the security (i.e. resulting from the underwriting agreement) and apply only to those parties that signed the contract (e.g. the issuing entity, D) and their affiliates. In that case, these restrictions may represent entity-specific restrictions that would not be considered in the fair value measurement of the securities. However, there may be situations in which a lock-up provision is determined to be a characteristic of the security and not entity-specific based on the specific terms and nature of the restriction. In that case, the restriction would be considered in the fair value measurement of the securities. Explicit requirement for a policy on adjustments to market price IFRS 13 explicitly requires entities to establish a policy for identifying events that might affect fair value measurement, including events that might indicate that a quoted price in an active market does not represent fair value at the measurement date.

10 10 IFRS for Investment Funds 4. Bid, mid, ask or something else? If a published price quotation in an active market is used to determine fair value, then a question arises over which price should be used: bid, mid, ask or something else? IAS 39 generally requires the use of bid prices for financial assets and ask prices for financial liabilities when they are available. However, it allows entities that have assets and liabilities with offsetting market risks to: use mid-market prices as a basis for establishing fair value for the offsetting risk positions; and apply the bid or ask price to the open net position as appropriate. Problems are often encountered by funds as they offer unit-linked investment products i.e. when the fund s obligation to unit holders is linked to the value of the fund s underlying investments. The units are often redeemable on demand and the fund is required by its prospectus to issue and redeem units to its investors at a unit price that reflects mid-market prices for its assets. For the purposes of the fund s financial statements, the investments held by the fund are valued at bid prices. The units issued are valued in accordance with the contractual agreement between it and the unit holders i.e. in this example, reflecting midmarket prices for its assets. This causes a presentation issue because a mismatch arises between: assets of the fund valued at bid prices; and unit liabilities valued on the basis of mid-market prices for the fund s assets. In our view, one solution may be to present the unit liability in a two-line format. The first line would be the amount of the net assets attributable to holders of redeemable shares measured at the redemption amounts determined in accordance with the prospectus, which reflects the actual redemption amount at which redeemable shares would be redeemed at the end of the reporting period. The next line would include an adjustment for the difference between this and the amount recognised in the statement of financial position. This reflects the fact that, for a fund with no equity, or with minimal equity, all, or almost all, recognised income and expenses should be attributed to unit holders, which also means that a dilution levy of that amount would be required if all units were redeemed. See our publication Illustrative financial statements: Investment funds for an illustration of this presentation. When current bid and ask prices are not available, a fund may use the price of the most recent transaction in the particular financial instrument, provided that there has been no significant change in economic circumstances since that transaction. Adjustments are made if significant changes have occurred since. IFRS 13 Bid and ask prices For assets measured at fair value that have a bid and an ask price, IFRS 13 requires the use of the price within the bid-ask spread that is most representative of fair value in the circumstances. The bid-ask spread includes transaction costs and may include other components. A price in the principal or most advantageous market is not adjusted for transaction costs. Therefore, an entity makes an assessment of what the bid-ask spread represents when determining the price that is most representative of fair value within the bid-ask spread. The use of bid prices for long positions and ask prices for short positions is permitted but not required.

11 IFRS for Investment Funds 11 The standard does not prohibit the use of mid-market prices or other pricing conventions generally used by market participants as a practical expedient for fair value measurements within a bid-ask spread. However, it appears that the use of mid-market prices is subject to the condition that a mid-market price provides a reasonable approximation of an exit price. We believe that using the practical expedient does not override the general fair value measurement guidance, and it should not be used if it leads to a measurement that is not representative of fair value. Therefore, a fund should not ignore available evidence that a mid-market price does not result in a price that is representative of fair value. For example, if the bid-ask spread is particularly wide, or if the applicable bid-ask spread has widened significantly for a specific asset or liability, then a mid-market price may not be representative of fair value. Financial assets and liabilities with offsetting positions in market risk(s) or credit risk IFRS 13 permits an exception to measure the fair value of a group of financial assets and liabilities that are within the scope of IAS 39 or IFRS 9 on the basis of net exposure to a particular market risk(s) and/or credit risk if certain conditions are met. The flowchart below summarises application of those conditions. Group managed on basis of net exposure to particular market risk or credit risk of a particular counterparty in accordance with documented risk management or investment strategy? Provide information to key management personnel on that basis? Measured at fair value in the statement of financial position on a recurring basis? Yes Yes Yes Measurement on a net basis permitted No No No Measure individual assets and liabilities; measurement on a net basis prohibited It appears that the application of the portfolio measurement exception changes the unit of valuation from the individual financial asset or financial liability to the net position for a particular risk exposure. We believe that the size of the net risk exposure is a characteristic to be considered when measuring the fair value of the net risk exposure. A fund that measures fair value on the basis of net exposure to a particular market risk(s): applies the price within the bid-ask spread that is most representative of fair value; and ensures that the nature and duration of the risk(s) to which the exception is applied are substantially the same. If the fund is permitted to use the exception for some or all of the portfolios that it holds, then it should choose an accounting policy, to be applied consistently, for a particular portfolio. However, a fund is not required to maintain a static portfolio. The above measurement exception for a group of financial instruments does not extend to the presentation of those instruments in the financial statements. Accordingly, if items in the portfolio are presented separately, then the bid-ask or credit adjustments that have been calculated for the portfolio as a whole have to be allocated to the individual assets and liabilities on a reasonable and consistent basis. See also 2.4A.200 in the 9 th Edition 2012/13 of our publication Insights into IFRS ( in the 8 th Edition 2011/12) for more discussion of the portfolio measurement exception.

12 12 IFRS for Investment Funds 5. What if a transaction is not orderly? Underlying the concept of fair value in IAS 39 is the presumption that the entity is a going concern and does not have an intention or a need to undertake a transaction on adverse terms. Therefore, fair value is not normally an amount that a fund would receive or pay in a forced transaction, involuntary liquidation or distress sale. Fair value is intended to represent the price in an orderly transaction (not forced) between market participants at the measurement date. In our view, an orderly transaction involves market participants that are willing to transact and allows for adequate exposure to the market. If a transaction is determined to be forced, then it is not used to measure fair value. Determining whether a transaction is forced requires analysis of the facts and circumstances and the use of judgement. In our view, it cannot be automatically assumed that all transactions in an inactive market or all transactions initiated during bankruptcy are forced. Further, we do not believe that an imbalance between supply and demand (e.g. fewer buyers than sellers) always results in a forced transaction. We believe that the indicators of a forced transaction may include: a legal requirement to transact e.g. a regulatory mandate; an immediate necessity to sell an asset with insufficient time for customary marketing; or a single potential buyer as a result of imposed legal or time restrictions. In our view, if a fund sells assets to market participants to meet regulatory requirements, the regulator does not establish the transaction price and the entity has a reasonable amount of time to market the asset, then the transaction provides evidence of fair value. IFRS 13 Transactions that are not orderly IFRS 13 introduces a definition of an orderly transaction: 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; it is not a forced transaction (eg a forced liquidation or distress sale). The standard provides guidance on circumstances that may indicate that a transaction is not orderly, which include the following. There was inadequate exposure to the market to allow usual and customary marketing activities. The seller marketed the asset or liability to a single market participant. The seller is in distress. The seller was forced to sell to meet regulatory or legal requirements. The transaction price is an outlier compared with other recent transactions in identical or similar items.

13 IFRS for Investment Funds 13 When the volume or level of activity has significantly decreased, the market is not active and prices are volatile, we expect the following matters to be of greater significance. If the evidence indicates that a transaction was not orderly, then the transaction price is given little, if any, weight in measuring fair value. If the evidence indicates that the transaction was orderly, then the transaction price is taken into account when measuring fair value. The amount of weight given to the transaction price will depend on factors such as transaction volume, comparability to the measured asset or liability, and proximity to the measurement date. If the fund does not possess sufficient information to conclude whether the transaction was orderly, then the transaction price is taken into account when measuring fair value, but with less weight placed on it compared with the transactions known to be orderly. Although a fund need not undertake exhaustive efforts to determine whether a transaction was orderly, it should not ignore information that is reasonably available. If an entity is party to a transaction, then it is presumed to have sufficient information to conclude whether the transaction was orderly.

14 14 IFRS for Investment Funds 6. What are the main considerations when applying a valuation technique? Determining fair value may be more complex for financial instruments that are not traded in an active market because the fair value of such instruments is determined using a valuation technique. The table below outlines the key requirements that a valuation technique has to meet to comply with IAS 39. Feature Objective of a valuation technique Principal characteristics Using observable data Incorporating credit risk Treatment of entity-specific factors Requirements The objective of a valuation technique is to establish what a transaction price would have been: on the measurement date; in an arm s length exchange; and motivated by normal business conditions. In our view, the valuation technique used should reflect current market conditions and appropriate risk adjustments that market participants would make for credit and liquidity risks on the measurement date. A valuation technique has the following principal characteristics. It: is commonly used by market participants; is consistent with accepted economic methodologies and techniques; uses inputs that market participants would usually consider; maximises the use of observable data; relies as little as possible on entity-specific factors; and is validated periodically against actual market transactions. Regardless of the level of trading activity in the market, a valuation technique has to take into account actual market transactions for identical or similar instruments that are not forced transactions. Such transactions cannot be ignored when measuring fair value using a valuation technique, although they might require significant adjustments based on unobservable data. Fair value reflects the credit quality of the financial instrument. For example, valuation techniques for derivative instruments reflect the credit risk of the counterparty and the credit risk of the reporting entity (own credit risk) as appropriate, including consideration of collateral and margining requirements, and the effect of master netting arrangements. See Question 10 for a discussion of the inclusion of credit risk in the valuation of financial liabilities. In our view, it is inappropriate to adjust the results of a model-based valuation for entity-specific factors e.g. uncertainty in estimated cash flows, liquidity or administration costs. We believe that such factors should be incorporated into a valuation model based on the amounts that market participants as a whole would consider in setting a price. Furthermore, it is not appropriate to adjust the result of a valuation technique to reflect model risk unless other market participants would make similar adjustments. Adjustments for known model weaknesses are more common for complex instruments. When a model requires adjustment for such a model weakness, in general, a fund would not expect the adjustment to persist over the longer term. This is because over time new techniques become available and therefore a model adjustment that corrects a known weakness should become unnecessary.

15 IFRS for Investment Funds 15 Feature A model providing a range of estimates as an output Requirements When the outcome of the valuation model is a range of estimates, the probabilities of the estimates within the range are determined and applied to arrive at a single estimate of fair value. In our view, if different models are used and each model gives a different outcome, then judgement should be used in determining which outcome is likely to be the most reliable. We do not believe that it is appropriate simply to average the outcomes of the various valuations. A fund selects a valuation technique that is commonly used by market participants to measure the fair value of the financial instrument concerned, if that technique has been demonstrated to provide reliable estimates of prices obtained in actual market transactions. Examples of valuation techniques include: discounted cash flow analyses; using recent market transactions for an identical instrument, adjusted for changes in market factors between the date of such recent transactions and the measurement date; current or recent market transactions in a similar financial instrument, adjusted for factors unique to the instrument being valued; and option pricing models. Applying a valuation technique may involve judgement, especially if one of the inputs into the valuation model is not observable. Example 3 Illiquid private equity (PE) investments PE Fund E has a non-controlling interest in Company C. The market for shares of C is not active. E estimated the fair value of the investment at 5.00 per share using a valuation model with Level 3 inputs. Fund F, another investor in C, estimated the fair value at 5.10 per share. What is the fair value of C s shares? Applying a valuation technique may involve judgement and so it is possible for different investors to arrive at different fair value estimates at the same measurement date, and for both estimates to meet the objective of fair value measurement in IAS 39. Different fair value estimates reflect the inherent uncertainty of estimating the fair value of instruments that do not have prices quoted in an active market. A single entity, however, has to ensure that it applies its judgement consistently (across time and by type of instrument) to measure the fair value of different instruments. Therefore, depending on the facts and circumstances, it might be possible for the fair value of C s shares to be determined to be 5.00 per share in E s financial statements and 5.10 in F s financial statements. IFRS 13 Valuation techniques IFRS 13 does not establish requirements for a specific valuation technique(s) to be used unless there is a quoted price in an active market for an identical asset or a liability that the entity can access at the measurement date. The standard refers to a valuation approach as a broad category of techniques, whereas a valuation technique refers to a specific technique e.g. a particular option pricing model. The standard explains that valuation techniques used to measure fair value fall into the following approaches (only those applicable to financial instruments are listed): market approach; and income approach.

16 16 IFRS for Investment Funds Either of these approaches, or a combination of them, can be used to measure fair value if the techniques are appropriate in the circumstances. Most commonly, fair value measurements of financial instruments performed using a market approach will fall into Level 1 of the fair valuation hierarchy. However, if a market approach uses prices for similar, rather than identical, assets or uses matrix pricing, then it would not fall into Level 1 because it would not use inputs that are quoted prices (unadjusted) in active markets for identical assets or liabilities. Valuation techniques that fall under the market approach will also often derive market multiples from a set of comparable assets. A market multiple expresses the value of a business or other asset in terms of its ratio to a financial, operating or physical metric. For example, a price-to-earnings ratio expresses an entity s per-share value in terms of a multiple of its earnings per share. The multiple can then be applied to the metric of an entity with similar characteristics but different scale, subject to adjustments for differences between the entity and the selected comparable. Valuation techniques under the income approach convert future amounts such as cash flows or income streams to a current amount on the measurement date. Common valuation techniques falling under the income approach include present value techniques and option pricing models.

17 IFRS for Investment Funds What inputs into valuation techniques are commonly used by market participants? In determining the inputs to valuation models that comply with IAS 39, market information is considered whenever possible. Typical inputs to valuation models for financial instruments include the following. Inputs Time value of money i.e. risk-free interest rate Credit risk Liquidity (or closeout/bid-ask adjustments) Foreign exchange risk Commodity prices Equity prices Volatility Prepayment/ surrender risk Servicing costs Description A risk-free rate implies the interest rate for a completely credit risk-free investment. However, a truly risk-free rate does not exist in the market because all instruments carry a certain amount of risk. Therefore, a basic interest rate, derived from observable prices of high-quality instruments, such as futures or government bills, notes or bonds (US treasuries or UK gilts), is often used as a market proxy for the risk-free rate. However, in some countries government bonds may carry significant credit risk and may not provide a stable benchmark rate for instruments denominated in that currency. Some entities in that country may have a better credit standing. In such cases, basic interest rates may be determined with reference to the highest-rated corporate bonds issued in the currency of that jurisdiction. Well-accepted and readily observable general rates such as LIBOR may also be used as a benchmark rate, when appropriate. An appropriate credit spread may be derived from quoted prices for corporate bonds of similar credit quality and maturity to the instrument being valued, or rates charged to borrowers of a similar credit rating for a similar maturity. The liquidity adjustment represents the amount that would be incurred to close out a position. If a financial instrument is initially valued using mid-market data, such as an interest rate curve, a liquidity/ close-out adjustment is needed to arrive at an appropriate bid price (for assets) or ask price (for liabilities). Most common yield curves, such as LIBOR, have observable bid-ask spreads, which are generally available from news and pricing services, such as Reuters and Bloomberg (in both data point and graphic curve formats) and can be used to calculate the liquidity adjustment. Foreign currency rates are usually quoted in daily financial publications and electronic financial databases. Observable market prices are available for most commodities. Quoted market prices are often available for equity securities. For unquoted equity securities, valuation techniques based on discounted cash flows may be used to estimate fair value. Measures of the volatility of actively traded items can normally be estimated on the basis of historical market data or by using volatilities implied in current market prices. When historic measures are used, it is important to consider how future outcomes may differ from past experience. Expected prepayment patterns for financial assets and surrender patterns for financial liabilities can be estimated on the basis of historical data. When historic measures are used, it is important to consider how future outcomes may differ from past experience. The costs of servicing can be estimated using comparisons with current fees charged by other market participants. If the costs of servicing a financial instrument are significant and other market participants would face comparable costs, then they would be considered in determining fair value.

18 18 IFRS for Investment Funds Although a valuation model should maximise the use of relevant observable market data, some inputs into the model may be unobservable, which may cause the overall fair value measurement of the financial instrument to fall into Level 3 of the fair value hierarchy (see Question 2). Assessing whether inputs are observable and whether the unobservable inputs are significant may require judgement and a careful analysis of the inputs used to measure fair value, including the consideration of factors specific to the asset or liability. Examples of observable and unobservable inputs Observable inputs generally leading to Level 2 valuations Transaction prices in markets that are not active for identical instruments Quoted prices in active markets for similar, but not identical, instruments Transaction prices in markets that are not active for similar, but not identical, instruments Interest rates derived from quoted bond prices Quoted foreign exchange and interest rates e.g. forward currency rates and swap rates Implied volatilities derived from quoted option prices Credit spreads derived from quoted credit default swap prices Unobservable inputs leading to Level 3 valuations if they are significant Foreign currency interest rates that: are not observable; and cannot be corroborated by observable market data for the term of the financial instrument being valued Volatility for a share option derived from the share s historical prices, because it does not generally represent current market expectations about future volatility Assessing the significance of an unobservable input requires judgement, considering factors specific to an asset or a liability. When a fair value measurement is developed using inputs from multiple levels of the fair value hierarchy, the inclusion of a lower-level input in a fund s measurement may indicate that the input is significant because of the fund s decision to include it in the overall measurement of fair value. However, the final decision on whether an input is significant is a matter of judgement that will require funds to consider the importance of the input to the overall fair value measurement of the instrument. IFRS 13 Observable inputs IFRS 13 includes a definition of observable inputs: 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. See Question 2 for a discussion of valuation premiums and discounts.

19 IFRS for Investment Funds What if fair value estimates are sourced from brokers or pricing services? Funds often obtain prices from brokers or pricing services to determine the fair value of their holdings of financial instruments. When assessing the appropriateness of using such prices for the purposes of fair value measurement in financial statements, a fund has to consider: whether the price represents the fair value of the relevant financial instrument; and the level in the fair value hierarchy that the price represents. Does the price represent the fair value of the financial instrument? Prices sourced from a broker or pricing service may represent fair value estimated in accordance with IAS 39, but it cannot be automatically assumed that they do. A fund has to obtain an understanding of how the prices have been determined and satisfy itself that they represent fair value before using the prices for the purposes of its financial statements. Which level in the fair value hierarchy do the prices represent? Prices obtained from brokers or pricing services are not considered observable under IAS 39 simply because they were obtained from a third party. Whether those prices represent an observable or unobservable input depends on their nature and sources. The use of a pricing service or a broker does not change the analysis of the categorisation of the inputs in the fair value hierarchy. Accordingly, a fund should obtain an understanding of the source of the inputs used by the pricing service or broker. Depending on the outcome of this analysis, the price obtained from the pricing service potentially can be categorised as Level 1, Level 2 or Level 3. Consensus pricing services obtain information from multiple subscribers that submit prices to the pricing service. The pricing service returns consensus prices to each subscriber based on the data received. When assessing the consensus data, it is important to understand what the prices submitted represent. If the estimates submitted to the service do not represent executable quotes or are not based on observable prices, then the fair value measurement derived from the consensus price would be a Level 3 measurement. However, if the inputs to the price received from the pricing service are Level 1 or Level 2 inputs, then the use of those prices generally results in a Level 2 measurement. Similar considerations apply to prices obtained from brokers. A broker quote is generally an indicative price and not a binding offer. Even if it is a binding offer, it may not represent the price at which an orderly transaction would take place between market participants. Evaluation of a price obtained from a broker would include the following: understanding the nature of the price or quote provided (see the table on page 20); understanding the valuation technique used, if applicable e.g. sources of inputs, calibration process (see Questions 6 and 7); considering whether the price is consistent with other available market information e.g. if there are current market transactions in the same or a similar instrument available, then the broker price should be consistent with those transactions; and considering whether the broker has a substantial presence in the market and the experience and expertise to provide a reliable quote. When markets are not active, brokers or pricing services are likely to rely more on models because market transactions may occur infrequently.

20 20 IFRS for Investment Funds The table below provides examples of how some of the characteristics of prices obtained from brokers and pricing services could align with levels in the fair value hierarchy. Fair value hierarchy level Level 1 Level 2 Level 2 or Level 3 Level 3 Example An unadjusted quoted price from an active market for an identical instrument provided by a pricing service A broker quote that reflects actual current market transactions in a similar instrument An indicative price based on the broker s or pricing service s valuation models may represent a Level 2 or Level 3 input depending on the significance of the unobservable inputs used A consensus price if the estimates submitted to the service do not represent executable quotes or are not based on observable prices In the absence of an active market, if several broker quotes are obtained for the same instrument and the difference between these quotes is significant, then it is likely that one of the quotes better represents fair value i.e. the average of quotes should not generally be used. Accordingly, it is necessary to understand how the prices have been derived and whether the methods and assumptions used are consistent with the fair value principles in IFRS. IFRS 13 The standard provides specific guidance on using pricing services and brokers quotes that is consistent with the general principles currently in IAS 39 and outlined above.

21 IFRS for Investment Funds How do you determine the fair value of an investment in an open-ended investment fund? When valuing an investment in an open-ended fund under IAS 39, a question often arises over whether the fair value of a unit or shares (hereafter units ) issued by such a fund is equal to its pro rata share of net asset value (NAV). Because the instrument held by the investor is an ownership interest in the fund and not an interest in the underlying assets of the fund, the value of the two may not be the same. Examples of items to consider when valuing units in a fund include: actual transactions in the units with the fund and in the secondary market; the nature of the underlying assets and liabilities of the fund; and other rights and obligations inherent in the ownership interest e.g. in some instances, an interest in a fund may oblige the investor to meet future cash calls made by the fund. Any adjustments for rights or obligations should be consistent with the unit of account being measured. An evaluation of whether NAV is representative of fair value encompasses two steps, which are illustrated in the table below. The first step is to assess whether the NAV or another price is representative of a quoted price in an active market. If it is, then it has to be used to value the investment. If there is not a quoted price in an active market, then the second step is to assess whether the NAV is otherwise representative of the fair value of the investment in the fund. Is NAV representative of fair value? Step 1 Is NAV per unit representative of a quoted price in an active market at the measurement date (Level 1)? To assess whether the NAV or another price is representative of a quoted price in an active market, an investor should consider the manner in which units in the fund are traded. Often, units in open-ended investment funds are traded only with the fund or its agent at a published price, either NAV or NAV plus or minus an adjustment. Depending on how often the published unit prices are updated, and the trading volume at these prices, the published prices may represent a quoted price in an active market. NAV per unit may be a Level 1 measurement of fair value when it represents a quoted market price in an active market (as discussed in Question 3). If there is a quoted price in an active market for an investment in a fund (i.e. a Level 1 input), then the quoted price is determinative of fair value, whether or not it is equal to the NAV. Units in a fund may trade at a premium or discount to NAV due to the volume of supply and demand or other factors specific to the fund. For example, units may trade at a discount because a market participant may consider an investment in the fund less attractive than a direct investment in the underlying assets of the fund due to future investment management changes or the loss of control over portfolio management decisions. Conversely, market participants may be willing to pay a premium to invest in a fund managed by a specific investment manager.

22 22 IFRS for Investment Funds Is NAV representative of fair value? Step 2 Is NAV per unit otherwise representative of a fair value (Level 2 or Level 3)? To assess whether NAV is otherwise representative of the fair value of the investment in the fund, the investor exercises judgement taking into account all relevant facts and circumstances. Examples of factors that may be relevant include consideration of whether: the NAV is dated as of the investor s measurement date; the NAV is calculated in a manner consistent with IFRS fair value measurement principles; the investment can be redeemed at NAV at the measurement date (e.g. some funds may suspend redemptions, introduce a lock-up period or impose gates on redemptions 1 ); and there are no other terms attached to the investment (e.g. a commitment to make future investments). Funds also consider the nature and reliability of the evidence that supports the calculation of NAV. In determining whether NAV approximates fair value, the weight placed on the evidence provided by transactions with the fund (i.e. subscriptions and redemptions) is impacted by: market changes since the transaction activity occurred; the volume of both redemptions and subscriptions; the extent to which subscriptions were received from new investors; and limitations or expected limitations on the investor s ability to redeem in the future. If the investor concludes that there are rights or obligations attributable to the unit that are not reflected in the NAV measurement of the fund and so NAV requires adjustment to arrive at fair value, then NAV is not representative of fair value. If NAV is not representative of fair value but is used as an input into a valuation model, then the investor should still understand how NAV is calculated, including the key inputs and valuation techniques used by the fund to value the underlying assets and liabilities. IFRS 13 Valuation of investments in another fund IFRS 13 does not provide specific guidance on valuation of investments in another fund. The above guidance based on IAS 39 will continue to be relevant when applying IFRS Some investment funds (generally hedge funds) impose gates on redemptions, which are restrictions placed on the amount of withdrawals from the investment fund during a redemption period. The terms (e.g. the redemption amount, notice period etc.) surrounding such restrictions are normally stated in the investment fund s prospectus.

23 IFRS for Investment Funds How do you determine the fair value of a financial liability? In general, the approach to determining the fair value of financial liabilities under IAS 39 mirrors that for financial assets (see Question 1). However, IAS 39 refers to fair value being an amount at which a liability could be settled, which is unclear because the definition does not refer to the creditor, but to knowledgeable, willing parties. As a result, some differences in interpretation have arisen in practice. IAS 39 contains a specific requirement that the fair value of a financial liability with a demand feature is not less than the amount payable on demand, discounted from the first date on which the amount could be required to be repaid. IFRS 13 Transfer notion 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. The new definition no longer refers to the settlement of a liability. When measuring the fair value of a liability, it is assumed that the liability remains outstanding but is transferred to a market participant at the measurement date. IFRS 13 introduces specific requirements for the application of the fair value measurement framework to liabilities. The flowchart below summarises the approach as it relates to financial liabilities. 1. Fair value is based on the quoted price for the transfer of an identical or similar liability. If this is not available, then Fair value is based on a quoted price in an active market for an identical item held by another party as an asset. If this is not available, then Fair value is based on other observable inputs for an identical item held by another party as an asset. If this is not available, then Fair value is based on another valuation technique from the perspective of a market participant holding an identical item as an asset. If this is not available, then Fair value is based on a valuation technique from the perspective of a market participant that owes the liability.

24 24 IFRS for Investment Funds In our experience, there are many cases in which there is no observable market to provide pricing information about the transfer of a liability. Also, in many cases an entity may not be willing or able to transfer its liability to a third party. However, there may be an observable market for such items if they are held by other parties as assets. Therefore, the fair values of most financial liabilities are measured from the perspective of a market participant that holds an identical instrument as an asset. If a fund measures a liability from the perspective of a market participant that holds the identical instrument as an asset, then it has to adjust the price for any features that are present in the asset but not in the liability or vice versa. For example, an investment fund may have issued units with a guarantee from the fund s sponsor. From the perspective of the holder, the individual unit may be the combined instrument containing both the amount due from the investment fund and the guarantee. From the investment fund s point of view, the fair value measurement of the units issued follows the unit of account of the liability for financial reporting purposes. If that unit excludes the guarantee, then the fair value of the obligation excludes the impact of the guarantee. However, neither IAS 39 nor IFRS 9 states explicitly whether such a guarantee is part of the liability s unit of account. IFRS 13 retains the IAS 39 guidance on the fair value of a liability with a demand feature. Its fair value cannot be less than the amount payable on demand, discounted from the first date on which the amount could be required to be paid. Non-performance risk Currently, the definition of fair value for financial liabilities in IAS 39 refers to the price at which a liability could be settled. There can be diversity in whether and how entities adjust for own credit risk when measuring the fair value of their liabilities, particularly derivative liabilities. In some cases, this may be influenced by the belief that little if any discount for own credit risk would be obtained in a negotiated early settlement of the liability with the counterparty. As a result, an adjustment for own credit risk in measuring a derivative liability under IAS 39 might be lower than the adjustment for credit risk in measuring the corresponding asset recognised by the counterparty to the instrument. By contrast, the definition of fair value in IFRS 13 instead refers to the (exit) price at which a liability would be transferred to a market participant on the assumption that the non-performance risk, including the effect of the entity s own credit risk, remains the same before and after the transfer. In addition, in the absence of a quoted market price for the transfer of a liability, the liability s fair value should be measured from the perspective of a market participant that holds the liability as an asset. This would imply greater consistency between the calculation of own credit risk adjustments and counterparty credit risk adjustments in measuring derivative assets and liabilities. In principle, and assuming no differences in the unit of account, the credit risk adjustments made in the fair value measurement of a financial instrument should be the same for both counterparties to the instrument. The credit risk of both counterparties may be relevant to measuring the fair value of an instrument that may change from being an asset to a liability or vice versa e.g. an interest rate swap. Example 4 Fair values of units issued by limited life fund Fund L is a closed-ended investment fund with a limited life of seven years. On liquidation of L, investors in L s units are entitled to a pro rata share of its net assets. The units are not quoted in an active market. The units are rarely bought and sold between investors. To the extent that transactions took place in the past, the units were sold/bought at prices that were not equal to L s NAV per unit at the time. The issued units are classified and presented as a financial liability under IAS 32 Financial Instruments: Presentation. L invests in financial assets and measures the assets at fair value with gains and losses recognised in profit or loss. For its financial statements, L adopted the presentation shown in Example 7 of IAS 32, which is relevant for entities such as mutual funds whose share capital is not equity as defined by the standard. In line with the example, the statement of financial position describes the net assets of L (which exclude units issued) as Net assets attributable to unit holders. How does this presentation impact fair value disclosure requirements for a fund that reports under IFRS 13?

25 IFRS for Investment Funds 25 When the units are not measured at fair value, IFRS 7 requires an entity to disclose the fair value of each class of financial instruments in a way that permits it to be compared with its carrying amount. Example 7 of IAS 32 permits an entity to present, in its statement of financial position, a line item Net assets attributable to unit holders, being the difference between its total assets and total liabilities (excluding units issued). If a fund follows this presentation format, then it needs to assess, for the purposes of disclosure under IFRS 7, whether the line item Net assets attributable to unit holders (NAV) represents the aggregate fair value of the issued units. L cannot automatically assume that, because its assets are measured at fair value, the fair values of its issued units will be equal to NAV. L has to apply the flowchart on page 23 to measure the fair value of an individual unit. This may reflect a premium or a discount to NAV, depending on the circumstances. The aggregate fair value will be equal to the fair value of an individual unit times the number of units issued.

26 26 IFRS for Investment Funds 11. Are there instances when fair value cannot be reliably measured? Generally, under IAS 39 it is presumed that the fair value of all financial instruments is reliably measurable. This presumption can be overcome only for the following instruments that may be measured at cost less impairment: an equity instrument that does not have a quoted price in an active market and whose fair value cannot be reliably measured; and a derivative that is linked to and settled by the delivery of such an equity instrument. This exemption is only applied in rare cases when it can be demonstrated that a valuation technique generates a wide range of possible fair values and the probability of the various outcomes cannot be estimated. The exemption is very limited because it is unlikely that an investment would be bought if its fair value could not be estimated. An issue sometimes arises over whether a fund s investment in another fund can be valued reliably. In most cases, even if the other fund invests in unlisted instruments, it should be possible to determine the fair value of the investments in that fund. Example 5 Valuation of unquoted equity investment PE Fund P holds unquoted shares issued by Company C. The nature of C s operations is such that the valuation of C s shares generates a wide range of possible fair values and the probabilities of the various outcomes are difficult to estimate. There were no transactions in C s shares for the past three years. Can P use the exemption under IAS 39 to measure investment in C at cost less impairment? Although the valuation of shares issued by C is difficult, entities such as funds that undertake significant investing activities use some form of valuation technique for the purpose of evaluating investment decisions. In our view, in these circumstances the same techniques should be used subsequently to determine the fair values of investments. IFRS 9 Using cost as an approximation of fair value Under IFRS 9, investments in equity instruments are measured at fair value. The exception currently in IAS 39 to use cost to measure certain equity investments and derivatives linked to them has been removed. However, in certain limited circumstances the standard allows cost to be used as an approximation of fair value for unquoted equity instruments and certain contracts linked to them. This exception does not apply to equity investments held by particular entities such as financial institutions and funds. Funds that are currently using the IAS 39 exception to value certain investments in equity instruments would need to reconsider the valuation approach under IFRS 9.

27 IFRS for Investment Funds Is it possible to recognise a gain on initial recognition of a financial asset or financial liability? Sometimes, a fund acquires a financial instrument in one market and intends to sell it or to issue an offsetting instrument in a different market. An issue arises over whether the instrument may be initially measured at its fair value in the selling market and therefore a gain recognised on initial recognition ( day one gain ) under IAS 39. The best evidence of the fair value of a financial instrument on initial recognition is normally the transaction price (i.e. consideration paid or received). However, a day one gain may be recognised on initial recognition when the fair value that is higher than the transaction price is: evidenced by comparison with other observable current market transactions in the same financial instrument without modification or repackaging; or based on a valuation technique that uses only observable market data as inputs. Example 6 Day one gain Fund Z acquires a portfolio of impaired loans for 30 (its face value is 100). Z specialises in high-yield loans and has superior cash-collection processes in place. Z expects to recover a higher proportion of cash flows than a market participant would and, based on a discounted cash flow analysis, values the loan portfolio at 35. Can Z recognise a day one gain of 5 on this investment? In our view, it would be inappropriate to conclude that the transaction price of 30 does not represent the fair value of the loan portfolio at initial recognition. The valuation technique used by Z to arrive at the value of 35 takes into account Z s specific cash-collection processes, which is inappropriate (because it is entity-specific rather than reflecting a market participant s perspective) and unobservable. A subsequent sale transaction with an independent counterparty on the market would ignore Z s cash-collection processes. Consequently, Z should recognise the acquired portfolio of loans at the transaction price of 30. If a day one gain or loss is not recognised on the initial recognition of a financial instrument, then it is recognised subsequently only to the extent that it arises from a change in a factor (including time) that market participants would take into account when pricing the instrument. IFRS 13 Day one gain IFRS 13 does not substantively change the threshold for recognising day one gains. However, the consequential amendments introduced by IFRS 13 align the guidance on measurement in IAS 39 with the definitions in IFRS 13. Under the amended IAS 39 guidance, the initial measurement of the financial instrument is based on fair value as defined in IFRS 13, but the carrying amount of the financial instrument is adjusted to defer any difference between the fair value measurement and the transaction price. An exception arises when the fair value measurement is evidenced by a quoted price in an active market for an identical asset or liability i.e. a Level 1 input or based on a valuation technique that uses only observable market data. If this observability condition is met at initial recognition, then any difference is recognised in profit or loss immediately. If the observability condition is not met, then the deferred difference is subsequently recognised as a gain or loss only to the extent that it arises from a change in a factor (including time) that market participants would take into account when pricing the asset or liability.

28 28 IFRS for Investment Funds Other ways KPMG member firms professionals can help A more detailed discussion of the accounting issues that arise from the application of IFRS can be found in the 9 th Edition 2012/13 of our publication Insights into IFRS. In particular, fair value measurement requirements are discussed in Chapter 2.4A. The requirements of IFRS 13 Fair Value Measurement, which was issued in May 2011 and is effective for periods beginning on or after 1 January 2013, along with various application issues, are also discussed in First Impressions: Fair Value Measurement. Questions and interpretative responses on fair value measurement under US GAAP 1 and IFRS are included in Issues in Depth: Questions and Interpretative Responses for Fair Value Measurement. You may also find our publication IFRS Practice Issues for Banks: Fair value measurement of derivatives the basics useful. It discusses issues relevant to the valuation of derivatives under IFRS, including making adjustments for credit, liquidity and other factors at a portfolio level, and how some of the accounting requirements are made operational. In addition, you may find it helpful to visit kpmg.com/ifrs to keep up to date with the latest developments in IFRS and browse our suite of publications. Whether you are new to IFRS or a current user of IFRS, you can find digestible summaries of recent developments, detailed guidance on complex requirements and practical tools such as illustrative financial statements and checklists. For a sector-specific or local perspective, including further reading on the valuation of financial instruments, follow the links to the IFRS resources available from KPMG member firms around the world, which are also available at kpmg.com. All of these publications are relevant for those involved in external IFRS reporting. The In the Headlines series provides a highlevel briefing for audit committees and boards. Your need Briefing Application issues Interim and annual reporting GAAP comparison Sector-specific issues Publication series In the Headlines IFRS Newsletters The Balancing Items New on the Horizon First Impressions IFRS Practice Issues IFRS Handbooks Illustrative financial statements Disclosure checklist IFRS compared to US GAAP IFRS Sector Newsletters Application of IFRS Accounting under IFRS Impact of IFRS For access to an extensive range of accounting, auditing and financial reporting guidance and literature, visit KPMG s Accounting Research Online. This web-based subscription service can be a valuable tool for anyone who wants to stay informed in today s dynamic environment. For a free 15-day trial, go to aro.kpmg.com and register today. 1 FASB ASC Topic 820 Fair Value Measurements and Disclosures, as amended by ASU Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in US GAAP and IFRSs.

29 IFRS for Investment Funds 29 Also in this series Classification of financial assets and liabilities under IFRS 9 (May 2012) Liability vs equity classification for financial instruments issued by investment funds (February 2012) Segment reporting (December 2011) Presentation and measurement of financial assets carried at fair value (November 2011) Coming soon Presentation Functional currency Acknowledgements We would like to acknowledge the principal contributors to this publication. They are Ewa Bialkowska and Arina Tomiste of the KPMG International Standards Group.