Fair Value Discussions in the MD&A A Discussion Brief

Transcription

1 Fair Value Discussions in the MD&A A Discussion Brief THIS DOCUMENT WAS ORIGINALLY ISSUED BY A CPA CANADA LEGACY BODY.

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3 Fair Value Discussions in the MD&A A Discussion Brief This publication was originally published by The Canadian Institute of Chartered Accountants in It has been reissued by Chartered Professional Accountants of Canada.

4 Copyright 2012 The Canadian Institute of Chartered Accountants All rights reserved. This publication is protected by copyright and written permission is required to reproduce, store in a retrieval system or transmit in any form or by any means (electronic, mechanical, photocopying, recording, or otherwise). For information regarding permission, please contact permissions@cica.ca. This publication may be downloaded at

5 Preface Increasingly, financial statements involve fair value measurement and disclosures. The introduction of International Financial Reporting Standard (IFRS) 13 Fair Value Measurement provides a framework for measuring fair value, adds new financial statement disclosures, and raises the profile of fair value information. While the financial statements will provide significant amounts of disclosure under IFRS 13, Management s Discussion and Analysis (MD&A) needs to help investors understand the impact of fair values on an entity s performance and management s perspective on the various fair value disclosures. The CICA s Canadian Performance Reporting Board (CPRB) has published the Discussion Brief Fair Value Discussions in the MD&A to assist preparers and improve the discussion of fair values. The brief distinguishes between circumstances when fair values are incidental to an entity s core business and those when they are integral to an entity s financial reporting. The brief provides several suggestions to assist preparers. It addresses ways to improve the MD&A discussion when amounts are measured at fair value and matters to consider in enhancing the discussion of fair value disclosures. The CPRB welcomes comments on this material. They should be sent to: Chris Hicks, CPA, CA Principal, Guidance and Support The Canadian Institute of Chartered Accountants 277 Wellington Street Toronto, Ontario, M5V 3H2 or chris.hicks@cica.ca December, 2012 i

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7 Introduction The introduction of IFRS 13 Fair Value Measurement for fiscal years beginning on or after January 1, 2013 adds new disclosures about fair values in financial statements. While IFRS 13 does not change the number of items that must be reported at fair value, it raises the profile of those fair values already reported in the financial statements. The CPRB is publishing this guidance to assist preparers of financial reports in addressing the MD&A issues presented by these measurements and disclosures. IFRS 13 is a comprehensive standard that focuses on measurement and disclosure. Two elements of IFRS 13 have particular significance: IFRS 13 categorizes the use of fair value measurements as recurring and non-recurring. The former include the carrying values of many financial instruments, including all derivatives, certain forms of royalty interests, biological assets and, electively, investment properties, property, plant and equipment and certain intangible assets. The fair values of all financial instruments are subject to disclosure, as are investment properties not held at fair value. The most common non-recurring fair value disclosures arise in business combinations although they can also occur in certain provisions, and impairment measures under IAS 36. While impairment measures are exempt from the disclosure requirements of IFRS 13, IAS 36 has its own fair value related disclosures. IFRS 13 requires a classification of all fair value measurements into Level 1, 2, or 3 categories based on the degree of observable inputs used in their determination. Level 1 inputs use unadjusted observable prices in active markets for identical assets or liabilities; Level 2 inputs are derived from observable prices, while Level 3 inputs are based on unobservable inputs such as expected cash flows and present value computations. IFRS 13 requires a complete reconciliation of the opening and closing balances of recurring Level 3 measurements, the disclosure of unrealized amounts, the methods used in preparing estimates, significant assumptions, and quantitative measures of the sensitivity of Level 3 fair value measures to changes in significant assumptions. An extract of the disclosure requirements is presented in the Appendix. One consequence of the use of fair value measurements is that the results of operations are likely to differ from those depicted by historical cost accounting. Hence the MD&A discussion of the results of operations and financial position should reflect the difference that fair value measurements make. In addition, the IFRS 13 disclosure requirements regarding the classification of fair value measures by level of input give rise to issues related to comparability and uncertainty and estimation risk. These issues are also worthy of discussion in the MD&A. 1

8 Improving the MD&A Discussion of the Results of Operations and Financial Position When Fair Values are Employed The MD&A provides management s perspective on the results of operations and the financial position of the entity. The discussion and analysis usually considers the entity s reported results for the period, and analyzes, generally in a comparative mode, the factors that have caused the entity s revenues, costs, cash flows, and financial position to change from period to period. The inclusion of items measured at fair value can affect both the revenues and the costs associated with operations, as well as the carrying values of items on the statement of financial position. Accordingly, preparers should consider how the MD&A should discuss the effects of fair value measurement on the results of operations. In some cases, the impact of fair values on an entity s performance and financial position may be incidental to its core business. For example, an entity may have a financial asset carried at fair value that contributes to income but otherwise its revenues and expenses are not affected by fair value adjustments. In other cases, however, fair values may be integral to an entity s financial reporting, for example, a financial institution with trading assets and liabilities carried at fair value or a non-financial entity whose revenues are derived from contracts that contain significant embedded derivatives carried at fair value. When fair value impacts are incidental, the MD&A may best communicate performance by eliminating fair value adjustments from the discussion of core business performance and separately discussing their impact. When fair values are integral to an entity s financial reporting, however, the MD&A likely needs to be designed to help readers understand performance in fair value terms, explaining all the factors that have contributed to variances from comparatives and plans. For example, an entity may need to discuss variances in terms of changes in the quantities of assets held as well as those sold, and the impacts of variances in pricing parameters even though those effects are unrealized. In some instances, such as an investment entity, the suggestions in this guidance may need to be considered in the context of a large portfolio of financial instruments carried at fair value. In this situation, an investment entity manages its portfolios on a total fair value basis and it is the net gains or net losses which would be the most relevant for discussion in the MD&A. In this case, discussion of unrealized and realized amounts may not always provide additional useful information because any proceeds from the sale of investment assets are typically re-invested. As well, to ensure the MD&A is maintained at a reasonable length, some discussions may need aggregation. For example, in a diverse real estate portfolio, the MD&A may need to focus on 2

9 expected compared to actual returns, highlighting and analyzing areas where returns have varied significantly from expectations. Such an analysis may need to discuss a particular jurisdiction s market conditions for a particular class of property and other factors that have impacted that jurisdiction s attractiveness as an investment opportunity. Where fair values are less extensively used, however, the impact of fair value changes may be not as evident from other elements of the MD&A and the different effects of fair value measures should be highlighted. The processes by which fair values are estimated, and the impact of these matters on financial reports is, however, likely to be of interest to users of financial reports whenever fair values based on other than direct observation of prices are employed. These following suggestions should help address these issues: The profit analysis should distinguish between historical cost and fair value measures when these appear in the same financial statement line item Under IFRSs, an item of revenue or expense may consist of both historical or amortized amounts plus changes in the fair value of other items. For example, revenues may include sales measured conventionally at the date of delivery plus changes in the fair value of a portfolio of derivatives arising from post-delivery price adjustment clauses. Similarly, finance costs may include interest expense computed on an amortized cost basis as well as changes in the fair values of derivatives related to financing activities. Since items measured at fair value will have a different pattern for recognition than those measured at historical cost, the timing of revenue and expense recognition will change and result in volatility in revenues not attributable to conditions at the date of delivery. In these circumstances, the MD&A of results should distinguish between the components measured in different ways, i.e., there should be an analysis of historical cost revenues, and separately, revenues arising from changes in fair values. In addition, the volatility in the income statement due to unrealized items measured at fair value may create larger differences between income and cash flow from operations than those experienced under historical cost. The MD&A should highlight these differences if they are significant to the interpretation of the results of operations or cash flows from operations. In addition to distinguishing the components measured at historical cost from those measured at fair value, the MD&A should expand the results analysis to reflect those additional factors affecting income from assets or liabilities held at fair value. For example, the overall fair value change for a group of assets or liabilities will depend on several factors in addition to the number of units sold, such as the change in the number of units held and the change in their per unit value. For an entity providing services this may not be significant (other than for financial instruments), but for entities that hold assets such as investment properties, the change in 3

10 overall fair value needs to be explained in terms of both the change in the number of units held but not sold and the relevant change in fair value per unit. Example 1: The 15% increase in revenues in the year ended 20X2 is partly attributable to revenues recognized on delivery and partly related to changes in the fair value of post-delivery price adjustment clauses which are treated as separate contracts for accounting purposes. In 20X1, the 10% increase in revenues is attributable to revenues recognized on delivery, offset by reductions in the fair value of post-delivery price adjustments. 20X2 20X1 Increase in revenues 3,000,000 2,000,000 % increase from prior year Comprising: Revenue recognized on delivery 2,500,000 3,000,000 Changes in fair value of price adjustment clauses 500,000 (1,000,000) Of the $500,000 change in the fair value of embedded derivatives arising from price adjustment clauses in 20X2, $400,000 relates to contracts which matured in the period and the remaining $100,000 represents an unrealized gain on contracts that arose during the period. In general, as the price adjustment clauses are settled within 90 days of origination, the gains relate to price adjustments for sales delivered in the current year. A larger class of factors should be considered in explaining performance Fair values determined through Level 1 inputs reflect unadjusted quoted prices for an identical item in an active market. Changes in such quoted prices can occur for many reasons, including the mere payment of contractual amounts, changes in real and nominal interest rates, country specific interest rates, an entity s credit risk, changes in the volatility of future prices, the effects of dividends, and liquidity factors on the value of financial instruments. For Level 2 or 3 estimates, if models employing discounted cash flows are used, movements in fair value are affected by factors such as changes in expectations of cash flows, changes in discount rates, and changes in contingent or uncertain cash flows in the case of uncertain future amounts. Consequently, when explaining variations in profit and loss involving fair values, the traditional discussion of sales volumes, prices, costs and margins has to be supplemented with changes in significant valuation factors. One factor alone may dominate changes in fair values, but it is possible that many may be involved, and they can affect the net result in different ways, particularly if a class of instruments includes both assets and liabilities, such as in the case of derivatives. In assessing movements in fair value, the MD&A will need to carefully identify the factors that affect the entity s performance and the direction of their impact. 4

11 Example 2: The $250,000 change in the fair value of the price adjustment clauses was primarily driven by changes in the market price for anthracite in the quarter; minor amounts can be attributed to the change in interest rates and creditworthiness of counterparties. In the comparative quarter in 20X1, $(375,000) of the change in value of $(500,000) in the price adjustment clauses arose from changes in the creditworthiness of a major customer in Japan that was adversely affected by the tsunami and other related events in the first quarter of 20X1. Fair value analysis requires consideration of both realized and unrealized amounts, separately from the changes in valuation parameters An analysis of changes to an item carried at fair value cannot be restricted to unrealized amounts. Consideration needs to be given to all the changes from period to period, including cash transactions. For example, consider an asset that is a contractual right to two equal payments, due a year apart at a fixed rate of interest. At the end of the first year, the cash received needs to be taken into account to measure the yield on the asset. If any other parameters change, such as the discount rate, or the expected amount of cash to be received, these would be additional explanations for value adjustments. Depending on circumstances, to be complete, this analysis will often involve consideration of the disposition of the opening balance in the comparative period. Example 3: The change in the value of the derivatives on the statement of financial position to $3,000,000 at December 31 20X2 from $2,000,000 at December 31 20X1 represents the liquidation of the opening balance of $2,000,000, and the addition of $10,000,000 from changes in the fair value of price adjustment clauses, reflecting the continued rising price of anthracite during 20X2, less the settlement of $7,000,000 during the year. In the comparative period, the initial carrying value for price adjustment clauses of ($3,000,000) that reflected the falling prices of anthracite in 20X0, was liquidated during 20X1. During 20X1 the price of anthracite started to rise, resulting in $6,000,000 in increases to the fair value of price adjustment clauses recorded in 20X1, $4,000,000 of which were liquidated by December 31 20X1. Consider the extent to which fair value balances have changed for other than market reasons The carrying values of assets held at fair value may change as a result of new investment and dispositions as well as changes from the passage of time and changes in valuation parameters. For example, a change in the fair value of an investment property can result from cash invested in the property to renovate it. Biological assets such as a timber resource can change in value as the result of harvesting and replanting as well as the passage of time and changes in valuation parameters. 5

12 Accordingly, the analysis of changes of fair values in the MD&A must consider the fact that not all changes in carrying value will stem from passive changes in financial variables. The activities of management can also have a direct effect and need to be identified when relevant. Example 4: During 20X2, we increased our investment in Warbuf Holdings Inc. with a $6,000,000 cash contribution and later received a dividend of $1,000,000. This investment, originally acquired in 20X1 for $500,000 had involved a net zero cash outlay at the end of 20X1 after receipt of a dividend of $500,000 in that year. The fair value increase of 20X1 was not re-experienced in 20X2, however, when the effects of intense competition in the industry resulted in a $2,000,000 reduction in fair value. 20X2 20X1 Fair value, beginning of year 1,000,000 Increase in investment in year 6,000, ,000 Dividends received in the year (1,000,000) (500,000) Change in fair value (2,000,000) 1,000,000 Fair value, end of year 4,000,000 1,000,000 It may be appropriate to identify the realized yield as well as the fair value yield on assets and liabilities The change in fair value of an asset or group of assets may provide a valid comparison across all assets in a given period. But in many cases what investors may wish to understand is the total yield on an asset over its lifetime, i.e., its realized yield. This may not be discernible from the periodic analysis of changes in fair values provided by fair value measurements. As a consequence, it may be appropriate in the MD&A to track the realized yield on assets over their lifetimes as well as the periodic yield. This information can assist investors in projecting the cash yields that are provided by assets (as the fair value yield is not necessarily cash) as well as make projections of returns over asset lifetimes. For example, where revenue contracts feature spot prices plus price adjustments that are treated as derivatives, the MD&A should identify the price ultimately realized for shipments, including both the delivered spot price and the total subsequent price adjustment. The same ideas apply to hedged items. Example 5: Revenues during the year 20X2 were $3,000,000, reflecting $2,500,000 in revenue recorded at shipment with an average spot price for anthracite of $10/long ton. The rising price of anthracite during the year resulted in an average realized price including price adjustment clauses settled during the year of $12/long ton for shipments made during 20X2. In the comparative period, the average spot price for anthracite recorded at shipment was $8/long ton, and the average realized price including price adjustment clauses settled during 20X1 was $7.50/long ton. 6

13 It may be appropriate to provide an integrated analysis of all related fair value measurements and disclosures The use of fair values for some items and historical or amortized cost for other items can result in an accounting mismatch. That is, related balances are carried on different bases, making combined analysis difficult. For example, an entity may elect to carry investment properties at fair value but the mortgages on those properties at amortized cost (i.e., the fair value option has not been elected for these financial liabilities). To facilitate the interpretation of changes in the fair value of the investment properties, particularly those arising from changes in yield, it can be useful to compare the change in the fair value of the property with the change in the fair value of any corresponding mortgage or property debt. As a financial instrument, the aggregate fair value of such instruments would be disclosed in accordance with IFRS 7. The MD&A could provide an integrated analysis of the changes in yields for both the fair value of assets and the liabilities that would be relevant to financial statement users. Example 6: During the year, our investment in Rio Brio Developments S.A., which is held at fair value, decreased by $10 million. This was primarily the result of increases in the discount rate used in determining fair value, reflecting the change in the market for real estate investments in Spain. Rio Brio Developments is financed in part by $50 million in non-recourse notes issued to certain European banks. If these notes, which are carried at their amortized cost, were carried at fair value, as reported in Note 32 of the financial statements, the change in their balance for the year would be a decrease of $9 million. See the discussion in the Outlook section of this report for additional information on Rio Brio Developments. Enhancing the Discussion of Fair Value Disclosures IFRS 13 requires an entity to provide various fair value disclosures, including categorizing them according to Level 1, 2, and 3 inputs. Yet, while entities are required to provide this disclosure, it is often not clear how management utilizes fair value information in its decision-making processes. Frequently, the MD&A analysis of such disclosure simply reviews the financial statement data without providing further management insight. The following suggestions are intended to enhance the MD&A reader s comprehension of the fair value financial statement disclosures. While the examples focus on IFRS 13 s significant disclosure requirements for Level 3 assets, some of the disclosure would also be applicable to Level 2 assets. 7

14 Explain that fair value is a buyer s price and discuss its decision relevance to the entity In many cases, entities use fair values internally for measuring all assets that are carried at fair value. In other cases, however, fair value is not the value that management considers relevant in its decision-making. For example, an entity may believe that fair value, representing a buyer s perspective in the relevant marketplace, understates the potential for an asset to increase in value. Hence the decisions of management to hold the asset are based on expectations that the asset can ultimately be realized for other than its current fair value. If so, then management should discuss its perspective on the reported fair value. Example 7: In determining fair value, we have adopted the perspective of buyers in the market for such assets who are assumed to consider the market s uncertainty and illiquidity in their pricing. Our perspective on the market s uncertainty and illiquidity may differ from such buyers and this may impact our decision to hold or sell a particular asset at the estimated fair value. These differences are likely to be minimal or non-existent in the case of Level 1 and 2 assets. Identify the participants in the relevant markets used to determine fair value One element of the definition of fair value is that it represents the value attributed to participants in an identified market. These participants determine the pricing parameters that are used to determine the fair value. The identification of market participants is thus an important step in the determination of fair value. To assist in providing perspective on fair value behaviour, an entity should consider identifying those participants in the MD&A, if not by name, then by nature, i.e., whether they are competitors, customers, or suppliers; or by size and location, i.e., local entities, multinationals, or other descriptors. This may make the parameters used to determine fair value more relevant to readers, who would otherwise have no idea of how to assess the implications of the parameters chosen to determine fair value. Example 8: In estimating the fair value of our Level 3 assets, which represent primarily our investments in Rio Brio Developments, we have determined the potential buyers of such investments to be property developers that have international operations with assets in excess of $1 billion and operations in Europe as well as elsewhere. These potential buyers, who are assumed to have adequate liquidity and are considered to be going concerns, expect to realize significantly positive returns for the assumption of any risk. Returns on projects these potential buyers acquire in current market conditions will generally exceed returns expected from normal course investments in projects they initiate. Be precise in quantitative disclosures One objective of fair value disclosure is to improve comparability and reduce measurement uncertainty associated with fair value measures. To this end, entities are to disclose the values attributed to various parameters, such as discount rates used to determine the present value 8

15 of cash flows. However, sometimes entities disclose such parameters in very broad ranges resulting in a wide range of discount rates. Such a range of discount rates potentially raises more questions than it answers. Which asset or liability uses the high rate? What is the cause of the wide range of values? Is the highly discounted amount a significant asset? Where is the yield recorded in income? Such uncertainties can be eliminated if the entity discloses the specific circumstance in which a high discount rate is used. Example 9: In determining the fair values for Level 3 assets, we have utilized discount rates appropriate to the related marketplaces, ranging from 13% to 35%. The higher discount rates are used for cash flows related to the $1,500,000 investment in asset-backed commercial paper. Identify factors that have caused changes in fair values in user-friendly terms A requirement of IFRS 13 is to identify transfers that have taken place between levels of recurring fair values during the period. The purpose of this disclosure is to highlight any changes in the degree of uncertainty and estimation risk in the various fair value estimates, and therefore provide users with an understanding of why the uncertainty or the estimation risk is reduced or increased. In some cases, however, the explanations provided for the changes are themselves unclear. For example, it has been stated that a transfer between levels has occurred because of more transparency in a marketplace for an asset. This may not convey much insight to users seeking to understand the reduction in uncertainty or estimation risk signalled by the transfer between levels. Is it because there are more observable sales? Are there new protocols for disclosing sales activity? Are there new investors entering or old investors returning to the marketplace? These descriptors would provide more insight than phrases such as increased transparency. Example 10: During the period, the estimated fair value of our investment in Rio Brio Developments increased by 5% or $150,000 due to improvements in the market for investments in Spain. Specifically, the passage of fiscal and economic reforms in Spain reduced the observed borrowing rates for the nation by 300 basis points, and a net inflow of $30 billion in new capital indicated a return of some liquidity to the marketplace. However, the excess supply of real estate and the political uncertainty in the region offset the long-term benefits expected from these developments. Identify the holdings of various levels of assets and liabilities by business units It will not be possible to identify from mandated financial statement disclosures which business units have applied the various input levels of fair value measurement. If the incidence of fair value measurements is relatively uniform across the organization, it may not matter which business unit carried assets and liabilities at the various levels of fair value measurements. However, if the extent of fair value measurement varies significantly across the entity, it may be meaningful to disclose the business units in which various levels of fair values are used. This 9

16 disclosure would highlight those areas where measurement uncertainty predominates and may limit the implications of that uncertainty to a specific business unit. While such units need not match the definitions of business segments used for segment reporting, the MD&A would be enhanced if this information could be aligned with segment disclosures. Example 11: Our investments in Level 3 assets are held by various operations. Derivatives arising from post-delivery price adjustments are held in the mining segment. The investment in Rio Brio Developments is held by the Property Development Group. Investments in asset-backed commercial paper are held by the central treasury operations and are not allocated to any specific group. Explain why the entity has Level 3 assets or liabilities Often, there is a significant degree of estimation risk inherent in the valuation of a Level 3 asset or liability. For assets in particular, one of the implicit issues is why an entity would enter into transactions that are carried at fair value but capable of measurement only by reference to unobservable inputs. In some cases, such as non-recurring business combinations, the nature of the transaction is self-explanatory. In other cases, where the entity acquires such assets directly (as would be disclosed in the periodic reconciliation of the Level 3 assets) it may be that, despite the uncertainty, the entity expects to reap an adequate return from the investment. Alternatively, the asset may have migrated from a different category Level 1, for example when a market became unexpectedly inactive. It is likely that the entity s exit strategy for such assets will be different than for those Level 3 assets that it acquired directly, and readers should understand the history of such assets and liabilities to understand the implications for future performance of the investment (or the liability). Example 12: As portrayed in the financial statements at note 14, we hold two types of Level 3 assets: derivatives which arise from price adjustment clauses in purchase and sale agreements that are customary in our industry, and investments in asset-backed commercial paper ( ABCP ) acquired in We hold the derivatives in order to facilitate sales to customers on competitive terms. The ABCP investment was intended to be a short-term investment, and was originally rated AAA, but its performance has not been consistent with the original rating. We intend to maximize the cash returns from this investment by holding it until it is liquidated by the issuer or prices in the secondary market improve. Relate the Level 3 income or loss to the entity as a whole IFRS 13 requires disclosure of the combined amount of realized and unrealized income from Level 3 assets and liabilities. Disclosure of this amount is intended to communicate the extent to which assets and liabilities subject to Level 3 inputs have affected income or loss for the period. However, it is rare for entities to try to put this amount into context. The easiest way to discuss the significance of this amount is to express it as a percentage of the profit or loss for the period, or other relevant profit or loss sub-total (which may be a non-gaap financial 10

17 measure). If the amount is relatively small then this expression should provide some relief to readers. On the other hand, if the amount is relatively large then it would be something about which the MD&A should provide additional insight. Example 13: During Q2, losses on derivatives arising from post-delivery price adjustment clauses were $3,000,000. This amounts to a 7% reduction in the recorded revenue on a year-to-date basis, which is the appropriate basis of comparison as the derivatives primarily relate to year-to-date sales transactions. The impact on the quarter, which is a 15% reduction in periodic revenue, reflects the severity of the change in prices observed in the period, compared to a zero percent change in the prior period. The effect of this change has been to reduce margins by 30% in the quarter and by 15% on a year-to-date basis. Address the potential liquidity issues presented by Level 3 measurements Level 3 estimates are derived from unobservable inputs. In many cases this suggests that the subject asset or liability is not traded or tradable and is therefore illiquid. We understand that in some extreme cases readers of financial reports have deducted amounts of Level 3 assets from the entity s equity to provide a liquid measure of the entity s net assets. However, lack of observable inputs does not automatically mean that an asset will not be promptly liquidated in accordance with its contractual terms. It may be very certain that an asset will be converted into cash at a fixed date, but its fair value may nevertheless be subject to significant estimation risk in the interim period. While not traded (or even tradable), an asset may be generating cash flows in accordance with its contractual terms and in substantial amounts. To emphasize this, the MD&A should communicate information about the source and amount of cash realized from Level 3 assets and liabilities, which is an integral part of the Level 3 periodic reconciliation. Note that if such assets are not generating cash and are indeed illiquid, then there is another implication for the MD&A from the holdings of Level 3 assets but this may be a topic for discussion in the MD&A analysis of the entity s liquidity. Example 14: Our investment in Level 3 assets consists of $4,000,000 in derivatives arising from post-delivery price adjustment clauses and $1,300,000 in ABCP. The derivatives, while not having an observable price, are generally liquidated on the terms established in the sales contracts, which are generally within 90 days after the delivery of the underlying commodity. The ABCP, which we have held since 2007, is being gradually liquidated as the underlying assets are settled. In 20X2, we realized $100,000 on this investment. The secondary market is very thin, and there are in our estimation substantial liquidity premiums charged for transactions in this market. This investment, constituting less than 5% of our portfolio of marketable securities, is not a significant source of liquidity and we do not believe it should be necessary to realize this amount in the near future. 11

18 Stratify Level 3 balances along lines that differentiate risks As noted, Level 3 assets and liabilities indicate a certain degree of uncertainty about expected cash flows. This may include uncertainty encompassed in parameters relating to the effects of market-wide risk on a security s value as well as estimation risk related to the type of inputs used to estimate the asset s fair values. However, not all assets that have Level 3 classifications have the same degree of estimation risk. For example, some Level 3 balances may have very short contractual lifetimes, whereas others may extend for significant periods of time. One way of communicating the degree of risk implicit in a Level 3 balance is to provide additional data that corresponds to the risk implicit in the instrument. For example, in the discussion of Level 3 fair values of contractual obligations it may be relevant to provide a table illustrating the distribution of a weighted average measure of the time cash flows are expected to be outstanding. This would indicate that while the inputs to its valuation are not observable, a portion of the instrument is expected to mature within a given time period and hence they expose the entity to less risk. There may be other ways to categorize Level 3 amounts by observable parameters, such as characteristics of the underlying counterparty. Such discussions give the user more insight into the nature of the uncertainty posed by the Level 3 exposure. Example 15: Our investments in Level 3 assets consist of derivatives arising from post-delivery price adjustment clauses of sales contracts, and investments in ABCP that derive cash flows from a portfolio of underlying investments in loans, notes receivable, and various credit enhancement contracts. The most likely timing for the undiscounted cash flows from these contracts is characterized in the following table: Most likely timing for cash flows Instrument Total 0-1 year 2-3 years 4-5 years Beyond 5 years Derivatives $4,000,000 4,000,000 ABCP $1,300, , , , ,000 Discuss potential consequences of sensitivity analyses in a larger context IFRS 13 requires a quantitative assessment of the sensitivity of recurring Level 3 financial assets and liabilities that are susceptible to changes in specific parameters. Although this disclosure may highlight the sensitivity of a particular category of Level 3 asset or liability to a particular factor, it is limited in the insights it provides about the entity as a whole. One way to offset the narrowness of the application of the requirement is to consider the implications of such changes for all similar types of assets and liabilities carried at fair value, at least in narrative form. In that way, while the information needed to comply with disclosure requirements for specific Level 3 assets is provided, the broader implications of changes in parameters can be 12

19 assessed for the relevant class of assets or liabilities, if not for the entity as a whole. As noted, this need not be a quantitative analysis but may be directional or qualitative in nature. Example 16: In estimating the fair value of the ABCP, the most sensitive parameter is the estimated rate at which the cash flows are realized from the underlying investments. If these cash flows were to experience a 10% delay (i.e., a cash flow expected in year 5 were to arrive in 5.5 years, and a cash flow in year 10 in 11 years), the effect on the estimated fair value, adjusting only for this change in the underlying cash flows, would be to reduce the estimated fair value by $30,000 or 2%. This amount, expressed as a percentage of our reported total shareholders equity as of December 31, 20XY, would be less than 1%. The risk of a delay in cash flows of our other financial assets that would affect shareholders equity by 1% is estimated to be negligible, given the contractual nature of these assets and the creditworthiness of our customers. Conclusions Fair value measurements and disclosures in financial statements introduce an additional range of factors to consider in understanding an entity s performance. As well, some disclosures about fair values have the potential to be misinterpreted by financial report users. An MD&A that follows minimum disclosure requirements, may not provide all the information needed for investors to understand the impact of fair values and fair value disclosures. Accordingly, it is important for management to provide a clear explanation in the MD&A about how fair value adjustments have impacted performance and insights about fair value measurements and disclosures. The ideas provided above are intended to assist preparers in developing such MD&A discussions. The CPRB believes that following some or all of these suggestions will assist in enhanced communications, and encourages their application where they are appropriate. As noted above, in some circumstances the MD&A may already provide a significant degree of discussion of changes in fair values. In other circumstances, however, particularly for nonfinancial entities, the impact of fair value changes may not be consistent throughout the financial reporting process. These recommendations should assist users in their analysis in such situations. 13

20 Appendix: Excerpts from IFRS 13 Fair Value Measurement Disclosure 93. an entity shall disclose, at a minimum, the following information for each class of assets and liabilities (see paragraph 94 for information on determining appropriate classes of assets and liabilities) measured at fair value (including measurements based on fair value within the scope of this IFRS) in the statement of financial position after initial recognition: (a) for recurring and non-recurring fair value measurements, the fair value measurement at the end of the reporting period, and for non-recurring fair value measurements, the reasons for the measurement (b) for recurring and non-recurring fair value measurements, the level of the fair value hierarchy within which the fair value measurements are categorised in their entirety (Level 1, 2 or 3). (c) for assets and liabilities held at the end of the reporting period that are measured at fair value on a recurring basis, the amounts of any transfers between Level 1 and Level 2 of the fair value hierarchy, the reasons for those transfers and the entity s policy for determining when transfers between levels are deemed to have occurred (see paragraph 95). Transfers into each level shall be disclosed and discussed separately from transfers out of each level. (d) for recurring and non-recurring fair value measurements categorised within Level 2 and Level 3 of the fair value hierarchy, a description of the valuation technique(s) and the inputs used in the fair value measurement. If there has been a change in valuation technique (e.g. changing from a market approach to an income approach or the use of an additional valuation technique), the entity shall disclose that change and the reason(s) for making it. For fair value measurements categorised within Level 3 of the fair value hierarchy, an entity shall provide quantitative information about the significant unobservable inputs used in the fair value measurement (e) for recurring fair value measurements categorised within Level 3 of the fair value hierarchy, a reconciliation from the opening balances to the closing balances, disclosing separately changes during the period attributable to the following: (i) total gains or losses for the period recognised in profit or loss, and the line item(s) in profit or loss in which those gains or losses are recognised. (ii) total gains or losses for the period recognised in other comprehensive income, and the line item(s) in other comprehensive income in which those gains or losses are recognised. 14

21 (iii) purchases, sales, issues and settlements (each of those types of changes disclosed separately). (iv) the amounts of any transfers into or out of Level 3 of the fair value hierarchy, the reasons for those transfers and the entity s policy for determining when transfers between levels are deemed to have occurred (see paragraph 95). Transfers into Level 3 shall be disclosed and discussed separately from transfers out of Level 3. (f) for recurring fair value measurements categorised within Level 3 of the fair value hierarchy, the amount of the total gains or losses for the period in (e)(i) included in profit or loss that is attributable to the change in unrealised gains or losses relating to those assets and liabilities held at the end of the reporting period, and the line item(s) in profit or loss in which those unrealised gains or losses are recognised. (g) for recurring and non-recurring fair value measurements categorised within Level 3 of the fair value hierarchy, a description of the valuation processes used by the entity (including, for example, how an entity decides its valuation policies and procedures and analyses changes in fair value measurements from period to period). (h) for recurring fair value measurements categorised within Level 3 of the fair value hierarchy: (i) for all such measurements, a narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs if a change in those inputs to a different amount might result in a significantly higher or lower fair value measurement (ii) for financial assets and financial liabilities, if changing one or more of the unobservable inputs to reflect reasonably possible alternative assumptions would change fair value significantly, an entity shall state that fact and disclose the effect of those changes. The entity shall disclose how the effect of a change to reflect a reasonably possible alternative assumption was calculated. For that purpose, significance shall be judged with respect to profit or loss, and total assets or total liabilities, or, when changes in fair value are recognised in other comprehensive income, total equity. (i) for recurring and non-recurring fair value measurements, if the highest and best use of a non-financial asset differs from its current use, an entity shall disclose that fact and why the non-financial asset is being used in a manner that differs from its highest and best use. 94. The number of classes may need to be greater for fair value measurements categorised within Level 3 of the fair value hierarchy because those measurements have a greater degree of uncertainty and subjectivity. Determining appropriate classes of assets and liabilities for which disclosures about fair value measurements should be provided requires judgement 15

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