IASB PROPOSALS ON FAIR VALUE MEASUREMENT: Q&A

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Claude Watkins
6 years ago
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1 IASB PROPOSALS ON FAIR VALUE MEASUREMENT: Q&A This staff briefing note reflects current views and understanding of the IASB proposals and may be updated from time to time On 28 May 2009, the International Accounting Standards Board (IASB) published an exposure draft (ED), Fair Value Measurement. The ED is accompanied by two separate documents: Basis for Conclusions and Illustrative Examples. On 29 June 2010, the IASB published a further exposure draft on one aspect of its proposals, Measurement Uncertainty Analysis for Fair Value Measurements: Limited Re-exposure of Proposed Disclosure. And on 2 July 2010, it published a comprehensive project summary, Developing Common Fair Value Measurement and Disclosure Requirements in IFRSs and US GAAP. This includes information on tentative decisions taken by the IASB in the light of responses to the May 2009 ED. 1. Why is the IASB looking at fair value measurement? This is a project that the IASB started work on several years ago. It s mainly about ensuring that IFRS is internally consistent on the subject of fair value and that, as far as possible, it s harmonised with US GAAP. The IASB published a discussion paper, Fair Value Measurements, in November 2006, which was based on the US standard, FAS 157, also Fair Value Measurements, which appeared in September So, contrary to what might be expected, this project is not an outcome of the controversy surrounding fair value accounting in the financial crisis. 2. What does the ED propose? Its key proposal is that fair value should be defined 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 fact that the asset or liability being measured is on the balance sheet indicates that it was not sold or transferred at the measurement date, so the transaction referred to in the definition is a hypothetical one. The significant features of the definition are: Fair value is defined as an exit price (ie, a selling price or disposal price), rather than an entry (or buying) price or an exchange price; It is a market price; so it may not reflect the value of the asset (or liability) to the business that holds it; The reference to an orderly transaction means that it s assumed the disposal is not, eg, in a forced liquidation or fire sale; For liabilities, exit means transferring the liability to somebody else, rather than settling it by payment or performance (which are the usual methods); and The transaction is between market participants, ie, for the purpose of this exercise the business disposing of the asset (or liability) has to think of itself as just another participant in the market. 1

2 The ED also contains a good deal of guidance and some important disclosure proposals more on both these points below. 3. Would the proposals extend existing IFRS requirements for fair value? No. The ED does not propose any extensions to existing IFRS requirements for fair value. It s purely about the definition of fair value, guidance on measuring it, and disclosures, where fair value requirements exist anyway. In fact, the IASB has decided that three of its existing fair value requirements don t really fit with the definition in the ED! In two cases, it proposes to replace the term fair value in existing requirements for: the measurement of share-based transactions in IFRS 2, Share-based Payment; and the measurement of reacquired rights in IFRS 3, Business Combinations. In the third case on the measurement of a financial liability with a demand feature (IAS 39, Financial Instruments: Recognition and Measurement, paragraph 49) it proposes to exclude the existing requirement from the scope of the ED s proposals. 4. Are there any other restrictions on the proposals scope? No, apart from paragraph 49 of IAS 39, the ED s proposals would apply in every case where fair value is permitted or required under IFRS. 5. What does the guidance say? The guidance covers a number of potentially difficult or controversial issues, including: the market in which the hypothetical disposal is assumed to take place; what should be assumed about the market participants; whether transaction costs should be taken into account; whether transport costs should be taken into account; what to do when an asset has alternative uses; whether the value should be adjusted when a block of assets is sold; use of mid-market prices; how to measure the transfer price of a liability even when the liability is never transferred; whether to take non-performance risk into account in measuring a liability; what to do at initial recognition; three approaches to valuation (the market approach, the income approach and the cost approach) and the related valuation techniques; and valuation inputs and the three-level fair value hierarchy. Further details are set out below in an Appendix. 6. Does the income approach mean that fair value can be measured at value in use? No. The income approach uses valuation techniques to convert future amounts (eg cash flows or income and expenses) to a single present (discounted) amount. It is just a way of helping to work out what market participants would pay (or require) for the item. 7. Does the cost approach mean that fair value can be measured at replacement cost? No. The cost approach reflects the amount that would currently be required to replace the service capacity of an asset (often referred to as current replacement cost). Again it is just a way of helping to work out what market participants would pay (or require) for the item. 2

3 8. What disclosure requirements are proposed? The disclosure requirements are fairly extensive, but the objective is that: For assets and liabilities measured at fair value, an entity shall disclose information that enables users of its financial statements to assess the methods and inputs used to develop those measurements and, for 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. Many of the required disclosures are based on the fair value hierarchy (see Appendix). For example, fair values would have to be disclosed categorised by level, and transfers between levels would have to be disclosed. There would be additional disclosures for Level 3 measurements. For example, for these measurements, If changing one or more of the unobservable inputs used in a fair value measurement to a different amount that could have reasonably been used in the circumstances would have resulted in a significantly higher or lower fair value measurement, an entity shall disclose the effect of using those different amounts and how it calculated that effect [wording of June 2010 proposals] Additional disclosures would also be required where the highest and best use of an asset (see Appendix) differs from its current use. 9. What are the June 2010 proposals about? The only substantive new proposal in the limited re-exposure published in June 2010 concerns the disclosures on unobservable inputs for Level 3 measurements now referred to as a measurement uncertainty analysis. The proposal is that: When preparing a measurement uncertainty analysis [a]n entity shall take into account the effect of correlation between unobservable inputs if such correlation is relevant For example, to use an illustration in the IASB s re-exposure draft, there tends to be a correlation between the rate at which mortgages are repaid early (the prepayment rate) and the rate of default on mortgages. So, in making disclosures on the fair value of residential mortgage-backed securities, the proposals would require such correlations to be taken into account in measuring and disclosing the effects of reasonable variations in unobservable inputs, rather than ignored. 10. How will all this change current practice? There are a large number of fair value requirements in IFRS, so it s difficult to make generalisations with confidence, but our current thoughts are as follows. On measurement, it s possible that actual amounts for fair value measurements will not change very much. However, the processes that preparers go through in arriving at fair value measurements may well change and be significantly more extensive in many cases. So until people have actually been through these processes, it s difficult to be confident what the effects will be on the figures appearing in accounts. On disclosure, the likely effect (except for financial instruments) is that disclosures will increase probably by a good deal in some cases (eg, where there are a large number of Level 3 measurements). 11. What happens next? The IASB has requested comments on its June 2010 proposals by 7 September Visit where you can download the exposure draft. 3

4 The IASB s July 2010 comprehensive project summary indicates that it expects to issue an IFRS in the first quarter of There is then the EU endorsement process to be gone through. So changes are unlikely to come into effect before 2012 at the earliest. The ASB will consider in due course how far any proposed changes in IFRS should be adopted into UK GAAP. But given its stated policy of convergence, it is quite likely that any changes will be reflected in UK GAAP. 12. What is the ICAEW doing? The ICAEW submitted comments to the IASB in May 2007 on the discussion paper that preceded the ED (ICAEW REP 38/07) and in September 2009 on the ED itself (ICAEW REP 106/09). The ICAEW also gave evidence at an IASB roundtable on fair value measurement held in December The Financial Reporting Committee (FRC) of the Financial Reporting Faculty is currently preparing a response to the IASB s June 2010 exposure draft. The ICAEW closely monitors UK and international developments in this area, and their possible practical repercussions, and has been active in promoting a balanced international debate over measurement in financial reporting, especially over the use of fair value. Our thought leadership programme also continues to focus on measurement issues. 13. How can I get involved? The FRC is keen to receive the views of any interested ICAEW members and groups. Please send them to frfac@icaew.com For further details on relevant publications and events and how to get involved contact katerina.nicholas@icaew.com Last amended 9 July

5 APPENDIX QUESTION 5 The more difficult areas covered by the guidance are, in more detail: The relevant market The IASB has now tentatively concluded that the disposal should be assumed to take place in the principal market for the asset or liability. This supersedes the proposal in the ED that the disposal should be assumed to take place in the most advantageous market to which the business has access. However, the IASB has also tentatively concluded that, in the absence of a principal market, the disposal should be assumed to take place in the most advantageous market. Market participants Market participants are assumed to be independent of each other, but to be as knowledgeable as the reporting entity about the asset or liability. This becomes important when we consider other points in the valuation process. As, in many cases, there will be no actual market for the asset or liability in question, the preparer has to estimate what other market participants might be willing to pay or accept for the item. Transaction costs Any transaction costs incurred in disposing of the asset (or liability) are not to be netted off (or added) in arriving at the fair value. Transport costs Transport costs, defined as the costs that would be incurred to transport an asset to its most advantageous market, should be netted off in arriving at fair value. Such costs are not therefore regarded as transaction costs of disposal. Alternative uses Preparers will often have to estimate what other market participants might be willing to pay or accept for an item. In doing so, in the case of an asset with alternative uses, they should assume that other market participants will use the asset in its highest and best use. This is the use that would maximise its value. The ED identifies two categories of use, which it refers to as valuation premises. The IASB has now tentatively concluded that it should change its terminology on this point (see below), but the ED describes the two categories as: in use (ie, the asset s value will be maximised if it is used with other assets to provide products or services); and in exchange (ie, the asset s value will be maximised if it is sold). In working out what is the highest and best use, the assumption that other market participants are all as knowledgeable as the reporting entity becomes important. The reporting entity may, for example, use the asset jointly with many other assets in a complex production process. It is helpful that it can be assumed that other market participants will know all about this and will realise (where this is indeed the case) that the asset is worth more as an integral part of this production process than, eg, as scrap metal. However, the highest and best use for market participants is not necessarily that in which the asset is currently employed or that for which it is intended. For example, a business may hold an R&D project for defensive purposes and not intend to develop it. But its highest and best use for market participants may be to develop it. It should not be assumed that the highest and best use approach means that, where an in use valuation premise is appropriate, the fair value will turn out to be the asset s value in use. Similarly, where an in exchange valuation premise is appropriate, this does not mean that the asset s fair 5

6 value will be its realisable value. In each case, the objective is still to work out how much the asset would be sold for in an orderly transaction between market participants. As indicated above, the IASB has now tentatively concluded that it should change its terminology for describing valuation premises. It now proposes that: rather than referring to an in use premise, it should refer to an asset being used in combination with other assets or with other assets and liabilities ; and rather than referring to an in exchange premise, it should refer to an asset being used on a stand-alone basis. Blocks of assets Where a business holds a block of identical assets, their fair value should be determined by multiplying the fair value of a single item by the number of items held. No adjustment (up or down) should be made to reflect the fact that the holding is a block. However, the IASB has now tentatively concluded that it needs to clarify that the prohibition on the use of blockage factors does not extend to other premiums or discounts eg, a control premium. Mid-market prices The ED proposes that fair value should be measured as an exit price. This means that where quoted market prices are used as inputs, the reporting entity should use an appropriate price within the bid-ask spread. However, the ED would not preclude the use of mid-market pricing or other pricing conventions used by market participants as a practical expedient. The transfer price of a liability There are few transfers of liabilities, so working out what they would be transferred at will usually involve reliance on indirect evidence. Some liabilities (eg, quoted corporate debt) are traded as assets. In such cases, the fair value of the liability should be taken as the fair value of the corresponding asset. In other cases, there may be similar liabilities that are traded as assets. In these cases, appropriate adjustments can be made to arrive at the fair value of the liability for which a measurement is required. Where there is no corresponding asset, the reporting entity has to estimate the price that market participants would demand to assume the liability. This could be done by estimating the cash flows that other market participants would incur in fulfilling the obligation and discounting them to a present value. Non-performance risk In valuing a liability, non-performance risk should be taken into account. So, where market participants would discount the value of a business s liabilities because there is a risk that it will not repay them, the business should reflect this discount in arriving at the fair value of its liabilities. Initial recognition The ED proposes that the price at which an asset or liability was acquired is the best evidence of its fair value at initial recognition unless: the transaction was between related parties; the transaction was forced; the unit of account in the transaction was not the one to be used for measurement purposes; ie, if the price included a premium or discount because the transaction was the disposal of a block of assets (or liabilities); or the market for the transaction was not the most advantageous one for the business in terms of disposing of the item. 6

7 In which case, the business will have to look at other evidence to establish the fair value at initial recognition. Approaches to valuation and valuation techniques The ED prescribes three permitted alternative approaches to valuation: The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities ; The income approach uses valuation techniques to convert future amounts (eg cash flows or income and expenses) to a single present (discounted) amount ; and The cost approach reflects the amount that would currently be required to replace the service capacity of an asset (often referred to as current replacement cost). The valuation techniques adopted have to be consistent with these approaches. The reporting entity also has to use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value. Valuation inputs and the fair value hierarchy The ED proposes that the valuation techniques used by a business shall maximise the use of relevant observable inputs and minimise the use of unobservable inputs. Observable inputs are inputs that are developed on the basis of available market data and reflect the assumptions that market participants would use when pricing the asset or liability. The ED proposes a three-level fair value hierarchy for prioritising inputs: Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date : Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly (ie, as prices) or indirectly (ie derived from prices) ; Level 3 inputs are inputs for the asset or liability that are not based on observable market data (unobservable inputs). Higher level inputs are to be preferred to lower level inputs. Once a measurement has been made, it needs to be categorised into one of the three levels. The rule here is that a measurement should be categorised into the lowest level whose inputs have been significant to it. Eg, a quoted market price that required significant adjustment on the basis of unobservable inputs would be a Level 3 measurement. What is significant is a matter of judgement. The fair value hierarchy is already in place for financial instruments under IFRS 7, Financial Instruments: Disclosures, as amended by Improving Disclosures about Financial Instruments (Amendments to IFRS 7). 7

Applying IFRS. IFRS 13 Fair Value Measurement. Fair Value Measurement

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