8 Fair value measurement 6/12

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1 Disclosures required in connection with market risk are: Sensitivity analysis, showing the effects on profit or loss of changes in each market risk If the sensitivity analysis reflects interdependencies between risk variables, such as interest rates and exchange rates the method, assumptions and limitations must be disclosed. 7.5 Capital disclosures Certain disclosures about capital are required. An entity's capital does not relate solely to financial instruments, but has more general relevance. Accordingly, those disclosures are included in IAS 1, rather than in IFRS 7. 8 Fair value measurement 6/12 FAST FORWARD IFRS 13 Fair value measurement gives extensive guidance on how the fair value of assets and liabilities should be established. In May 2011 the IASB published IFRS 13 Fair value measurement. The project arose as a result of the Memorandum of Understanding between the IASB and FASB (2006) reaffirming their commitment to the convergence of IFRSs and US GAAP. With the publication of IFRS 13, IFRS and US GAAP now have the same definition of fair value and the measurement and disclosure requirements are now aligned 8.1 Objective IFRS 13 sets out to: Define fair value Set out in a single IFRS a framework for measuring fair value (c) Require disclosure about fair value measurements 8.2 Definitions 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 previous definition used in IFRS was 'the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction'. The price which would be received to sell the asset or paid to transfer (not settle) the liability is described as the 'exit price' and this is the definition used in US GAAP. Although the concept of the 'arm's length transaction' has now gone, the market-based current exit price retains the notion of an exchange between unrelated, knowledgeable and willing parties. 8.3 Scope IFRS 13 applies when another IFRS requires or permits fair value measurements or disclosures. The measurement and disclosure requirements do not apply in the case of: (c) Share-based payment transactions within the scope of IFRS 2 Share-based payment Leasing transactions within the scope of IAS 17 Leases; and Net realisable value as in IAS 2 Inventories or value in use as in IAS 36 Impairment of assets. Disclosures are not required for: Plan assets measured at fair value in accordance with IAS 19 Employee benefits Plan investments measured at fair value in accordance with IAS 26 Accounting and reporting by retirement benefit plans; and Part B Accounting standards 7: Financial instruments 217

2 (c) Assets for which the recoverable amount is fair value less disposal costs under IAS 36 Impairment of assets 8.4 Measurement Fair value is a market-based measurement, not an entity-specific measurement. It focuses on assets and liabilities and on exit (selling) prices. It also takes into account market conditions at the measurement date. In other words, it looks at the amount for which the holder of an asset could sell it and the amount which the holder of a liability would have to pay to transfer it. It can also be used to value an entity's own equity instruments. Because it is a market-based measurement, fair value is measured using the assumptions that market participants would use when pricing the asset, taking into account any relevant characteristics of the asset. It is assumed that the transaction to sell the asset or transfer the liability takes place either: In the principal market for the asset or liability; or In the absence of a principle market, in the most advantageous market for the asset or liability. The principal market is the market which is the most liquid (has the greatest volume and level of activity) for that asset or liability. In most cases the principal market and the most advantageous market will be the same. IFRS 13 acknowledges that when market activity declines an entity must use a valuation technique to measure fair value. In this case the emphasis must be on whether a transaction price is based on an orderly transaction, rather than a forced sale. Fair value is not adjusted for transaction costs. Under IFRS 13, these are not a feature of the asset or liability, but may be taken into account when determining the most advantageous market. Fair value measurements are based on an asset or a liability's unit of account, which is specified by each IFRS where a fair value measurement is required. For most assets and liabilities, the unit of account is the individual asset or liability, but in some instances may be a group of assets or liabilities Example: unit of account A premium or discount on a large holding of the same shares (because the market's normal daily trading volume is not sufficient to absorb the quantity held by the entity) is not considered when measuring fair value: the quoted price per share in an active market is used. However, a control premium is considered when measuring the fair value of a controlling interest, because the unit of account is the controlling interest. Similarly, any non-controlling interest discount is considered where measuring a non-controlling interest Example: principal or most advantageous market An asset is sold in two active markets, Market X and Market Y, at $58 and $57, respectively. Valor Co does business in both markets and can access the price in those markets for the asset at the measurement date as follows. Market X Market Y $ $ Price Transaction costs (4) (3) Transport costs (to transport the asset to that market) (4) (2) Remember that fair value is not adjusted for transaction costs. Under IFRS 13, these are not a feature of the asset or liability, but may be taken into account when determining the most advantageous market : Financial instruments Part B Accounting standards

3 If Market X is the principal market for the asset (ie the market with the greatest volume and level of activity for the asset), the fair value of the asset would be $54, measured as the price that would be received in that market ($58) less transport costs ($4) and ignoring transaction costs. If neither Market X nor Market Y is the principal market for the asset, Valor must measure the fair value of the asset using the price in the most advantageous market. The most advantageous market is the market that maximises the amount that would be received to sell the asset, after taking into account both transaction costs and transport costs (ie the net amount that would be received in the respective markets). The maximum net amount (after deducting both transaction and transport costs) is obtainable in Market Y ($52, as opposed to $50). But this is not the fair value of the asset. The fair value of the asset is obtained by deducting transport costs but not transaction costs from the price received for the asset in Market Y: $57 less $2 = $ Non-financial assets For non-financial assets the fair value measurement looks at the use to which the asset can be put. It takes into account the ability of a market participant to generate economic benefits by using the asset in its highest and best use. 8.5 Valuation techniques IFRS 13 states that valuation techniques must be those which are appropriate and for which sufficient data are available. Entities should maximise the use of relevant observable inputs and minimise the use of unobservable inputs. The standard establishes a three-level hierarchy for the inputs that valuation techniques use to measure fair value: Level 1 Level 2 Level 3 Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, eg quoted prices for similar assets in active markets or for identical or similar assets in non active markets or use of quoted interest rates for valuation purposes Unobservable inputs for the asset or liability, ie using the entity's own assumptions about market exit value Valuation approaches The IFRS identifies three valuation approaches. (c) Income approach. Valuation techniques that convert future amounts (eg cash flows or income and expenses) to a single current (ie discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts. Market approach. A valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (ie similar) assets, liabilities or a group of assets and liabilities, such as a business. Cost approach. A valuation technique that reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost). Entities may use more than one valuation technique to measure fair value in a given situation. A change of valuation technique is considered to be a change of accounting estimate in accordance with IAS 8, and must be disclosed in the financial statements. Part B Accounting standards 7: Financial instruments 219

4 8.5.2 Examples of inputs used to measure fair value Asset or liability Input Level 1 Equity shares in a listed company Unadjusted quoted prices in an active market Level 2 Licencing arrangement arising from a business combination Cash generating unit Finished goods inventory at a retail outlet Building held and used Royalty rate in the contract with the unrelated party at inception of the arrangement Valuation multiple (eg a multiple of earnings or revenue or a similar performance measure) derived from observable market data, eg from prices in observed transactions involving comparable businesses Price to customers adjusted for differences between the condition and location of the inventory item and the comparable (ie similar) inventory items Price per square metre for the derived from observable market data, eg prices in observed transactions involving comparable buildings in similar locations Level 3 Cash generating unit Financial forecast (eg of cash flows or profit or loss) developed using the entity s own data Three-year option on exchangetraded shares Historical volatility, ie the volatility for the shares derived from the shares historical prices Adjustment to a mid-market consensus (non-binding) price for the swap developed using data not directly observable or otherwise corroborated by observable market data 8.6 Measuring liabilities Fair value measurement of a liability assumes that that liability is transferred at the measurement date to a market participant, who is then obliged to fulfill the obligation. The obligation is not settled or otherwise extinguished on the measurement date Entity s own credit risk The fair value of a liability reflects the effect of non-performance risk, which includes but is not limited to the entity s own credit risk. This may be different for different types of liabilities : Financial instruments Part B Accounting standards

5 8.6.2 Example: Entity s own credit risk Black Co and Blue Co both enter into a legal obligation to pay $20,000 cash to Green Go in seven years. Black Co has a top credit rating and can borrow at 4%. Blue Co s credit rating is lower and it can borrow at 8%. Black Co will receive approximately $15,200 in exchange for its promise. This is the present value of $20,000 in seven years at 4%. Blue Co will receive approximately $11,660in exchange for its promise. This is the present value of $20,000 in seven years at 8%. 8.7 IFRS 13 and business combinations Fair value generally applies on a business combination. This topic is covered in Chapter 12, together with some further examples. 8.8 Disclosure An entity must disclose information that helps users of its financial statements assess both of the following: For assets and liabilities that are measured at fair value on a recurring or non-recurring basis, the valuation techniques and inputs used to develop those measurements. For recurring fair value measurements using significant unobservable inputs (Level 3), the effect of the measurements on profit or loss or other comprehensive income for the period. Disclosure requirements will include: (i) (ii) (iii) (iv) Reconciliation from opening to closing balances Quantitative information regarding the inputs used Valuation processes used by the entity Sensitivity to changes in inputs 8.9 Was the project necessary? The IASB is already considering the matter of the measurement basis for assets and liabilities in financial reporting as part of its Conceptual Framework project. It could therefore be argued that it was not necessary to have a separate project on fair value. The Conceptual Framework might have been the more appropriate forum for discussing when fair value should be used as well as how to define and measure it. However, it has been argued that a concise definition and clear measurement framework is needed because there is so much inconsistency in this area, and this may form the basis for discussions in the Conceptual Framework project. The IASB has also pointed out that the global financial crisis has highlighted the need for: Clarifying how to measure fair value when the market for an asset becomes less active; and Improving the transparency of fair value measurements through disclosures about measurement uncertainty. Part B Accounting standards 7: Financial instruments 221

6 8.9.1 Advantages and disadvantages of fair value (v historical cost) Fair value Advantages Disadvantages Relevant to users' decisions Subjective (not reliable) Consistency between companies Hard to calculate if no active market Predicts future cash flows Time and cost Lack of practical experience/familiarity Less useful for ratio analysis (bias) Misleading in a volatile market Historical cost Advantages Reliable Less open to manipulation Quick and easy to ascertain Matching (cost and revenue) Practical experience & familiarity Disadvantages Less relevant to users' decisions Need for additional measure of recoverable amounts (impairment test) Does not predict future cash flows 222 7: Financial instruments Part B Accounting standards

7 4 The International Accounting Standards Board has recently completed a joint project with the Financial Accounting Standards Board (FASB) on fair value measurement by issuing IFRS 13 Fair Value Measurement. IFRS 13 defines fair value, establishes a framework for measuring fair value and requires significant disclosures relating to fair value measurement. The IASB wanted to enhance the guidance available for assessing fair value in order that users could better gauge the valuation techniques and inputs used to measure fair value. There are no new requirements as to when fair value accounting is required, but the IFRS gives guidance regarding fair value measurements in existing standards. Fair value measurements are categorised into a three-level hierarchy, based on the type of inputs to the valuation techniques used. However, the guidance in IFRS 13 does not apply to transactions dealt with by certain specific standards. Required: (i) Discuss the main principles of fair value measurement as set out in IFRS 13. (7 marks) (ii) Describe the three-level hierarchy for fair value measurements used in IFRS 13. (6 marks) Jayach, a public limited company, is reviewing the fair valuation of certain assets and liabilities in light of the introduction of IFRS 13. It carries an asset that is traded in different markets and is uncertain as to which valuation to use. The asset has to be valued at fair value under International Financial Reporting Standards. Jayach currently only buys and sells the asset in the Australasian market. The data relating to the asset are set out below: Year to 30 November 2012 Asian European Australasian Market Market Market Volume of market units 4 million 2 million 1 million Price $19 $16 $22 Costs of entering the market $2 $2 $3 Transaction costs $1 $2 $2 Additionally, Jayach had acquired an entity on 30 November 2012 and is required to fair value a decommissioning liability. The entity has to decommission a mine at the end of its useful life, which is in three years time. Jayach has determined that it will use a valuation technique to measure the fair value of the liability. If Jayach were allowed to transfer the liability to another market participant, then the following data would be used. Input Amount Labour and material cost $2 million Overhead 30% of labour and material cost Third party mark-up industry average 20% Annual inflation rate 5% Risk adjustment uncertainty relating to cash flows 6% Risk-free rate of government bonds 4% Entity s non-performance risk 2% Jayach needs advice on how to fair value the liability. Required: Discuss, with relevant computations, how Jayach should fair value the above asset and liability under IFRS 13. (10 marks) Professional marks will be awarded in question 4 for the clarity and quality of the presentation and discussion. (2 marks) (25 marks) End of Question Paper 7

8 4 (i) Fair value has had a different meaning depending on the context and usage. The IASB s definition is 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. Basically it is an exit price. Fair value is focused on the assumptions of the market place and is not entity specific. It therefore takes into account any assumptions about risk. Fair value is measured using the same assumptions and taking into account the same characteristics of the asset or liability as market participants would. Such conditions would include the condition and location of the asset and any restrictions on its sale or use. Further, it is not relevant if the entity insists that prices are too low relative to its own valuation of the asset and that it would be unwilling to sell at low prices. Prices to be used are those in an orderly transaction. An orderly transaction is one that assumes exposure to the market for a period before the date of measurement to allow for normal marketing activities and to ensure that it is not a forced transaction. If the transaction is not orderly, then there will not have been enough time to create competition and potential buyers may reduce the price that they are willing to pay. Similarly, if a seller is forced to accept a price in a short period of time, the price may not be representative. It does not follow that a market in which there are few transactions is not orderly. If there has been competitive tension, sufficient time and information about the asset, then this may result in a fair value for the asset. (ii) IFRS 13 does not specify the unit of account for measuring fair value. This means that it is left to the individual standard to determine the unit of account for fair value measurement. A unit of account is the single asset or liability or group of assets or liabilities. The characteristic of an asset or liability must be distinguished from a characteristic arising from the holding of an asset or liability by an entity. An example of this is that if an entity sold a large block of shares, it may have to do so at a discount to the market price. This is a characteristic of holding the asset rather than of the asset itself and should not be taken into account when fair valuing the asset. 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 or, in the absence of a principal market, in the most advantageous market for the asset or liability. The principal market is the one with the greatest volume and level of activity for the asset or liability that can be accessed by the entity. The most advantageous market is the one which maximises the amount that would be received for the asset or minimises the amount that would be paid to transfer the liability after transport and transaction costs. An entity does not have to carry out an exhaustive search to identify either market but should take into account all available information. Although transaction costs are taken into account when identifying the most advantageous market, the fair value is not after adjustment for transaction costs because these costs are characteristics of the transaction and not the asset or liability. If location is a factor, then the market price is adjusted for the costs incurred to transport the asset to that market. Market participants must be independent of each other and knowledgeable, and able and willing to enter into transactions. IFRS 13 sets out a valuation approach, which refers to a broad range of techniques, which can be used. These techniques are threefold. The market, income and cost approaches. When measuring fair value, the entity is required to maximise the use of observable inputs and minimise the use of unobservable inputs. To this end, the standard introduces a fair value hierarchy, which prioritises the inputs into the fair value measurement process. Level 1 inputs are quoted prices (unadjusted) in active markets for items identical to the asset or liability being measured. As with current IFRS, if there is a quoted price in an active market, an entity uses that price without adjustment when measuring fair value. An example of this would be prices quoted on a stock exchange. The entity needs to be able to access the market at the measurement date. Active markets are ones where transactions take place with sufficient frequency and volume for pricing information to be provided. An alternative method may be used where it is expedient. The standard sets out certain criteria where this may be applicable. For example, where the price quoted in an active market does not represent fair value at the measurement date. An example of this may be where a significant event takes place after the close of the market such as a business reorganisation or combination. The determination of whether a fair value measurement is level 2 or level 3 inputs depends on whether the inputs are observable inputs or unobservable inputs and their significance. Level 2 inputs are inputs other than the quoted prices in level 1 that are directly or indirectly observable for that asset or liability. They are quoted assets or liabilities for similar items in active markets or supported by market data. For example, interest rates, credit spreads or yield curves. Adjustments may be needed to level 2 inputs and if this adjustment is significant, then it may require the fair value to be classified as level 3. Level 3 inputs are unobservable inputs. The use of these inputs should be kept to a minimum. However, situations may occur where relevant inputs are not observable and therefore these inputs must be developed to reflect the assumptions that market participants would use when determining an appropriate price for the asset or liability. The entity should maximise the use of relevant observable inputs and minimise the use of unobservable inputs. The general principle of using an exit price remains and IFRS 13 does not preclude an entity from using its own data. For example, cash flow forecasts may be used to value an entity that is not listed. Each fair value measurement is categorised based on the lowest level input that is significant to it. 18

9 Year to 31 December 2012 Asian Market European Market Australasian Market Volume of market units 4 million 2 million 1 million Price $19 $16 $22 Costs of entering the market ($2) ($2) (n/a) see note Potential fair value $17 $14 $22 Transaction costs ($1) ($2) ($2) Net profit $16 $12 $20 Note: As Jayach buys and sells in Australasia, the costs of entering the market are not relevant as these would not be incurred. Further transaction costs are not considered as these are not included as part of the valuation. The principal market for the asset is the Asian market because of the fact that it has the highest level of activity due to the highest volume of units sold. The most advantageous market is the Australasian market because it returns the best profit per unit. If the information about the markets is reasonably available, then Jayach should base its fair value on prices in the Asian market due to it being the principal market, assuming that Jayach can access the market. The pricing is taken from this market even though the entity does not currently transact in the market and is not the most advantageous. The fair value would be $17, as transport costs would be taken into account but not transaction costs. If the entity cannot access the Asian or European market, or reliable information about the markets is not available, Jayach would use the data from the Australasian market and the fair value would be $22. The principal market is not always the market in which the entity transacts. Market participants must be independent of each other and knowledgeable, and able and willing to enter into transactions. Input Amount ($ 000) Labour and material cost 2,000 Overhead (30%) 600 Third party mark-up industry average (20% of 2,600) 520 Total 3,120 Annual inflation rate (3,120 x 5% compounded for three years) 492 Total 3,612 Risk adjustment 6% 217 Total 3,829 Discounted at risk free rate of government bonds plus entity s non-performance risk 6% 3,215 The fair value of a liability assumes that it is transferred to a market participant at the measurement date. In many cases there is no observable market to provide pricing information. In this case, the fair value is based on the perspective of a market participant who holds the identical instrument as an asset. If there is no corresponding asset, then a valuation technique is used. This would be the case with the decommissioning activity. The fair value of a liability reflects any compensation for risk and profit margin that a market participant might require to undertake the activity plus the non-performance risk based on the entity s own credit standing. Thus the fair value of the decommissioning liability would be $3,215,