Chapter 3

Fair Value Measurement

Prepared by
Kent Wilson
 Learning Objectives
1. Explain the need for an accounting standard on fair
value measurement

2. Understand the key characteristics of “fair value”

3. Explain the steps in determining the fair value of

non-financial assets

4. Understand how to measure the fair value of

liabilities
 Learning Objectives
5. Explain how to measure the fair value of an entity’s
own equity instruments

6. Discuss issues relating to the measurement of the

fair value of financial instruments

7. Prepare the disclosures proposed by IFRS 13

8. Discuss the issues associated with the measurement

and use of fair values
 The Need for a Standard on Fair
Value Measurement

Prior to the introduction of IFRS 13 many standards

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

The main objectives of IFRS 13 are:

1.To define fair value
2.To establish a framework for measuring fair value
3.To require disclosures about fair value measurement
 The Definition of Fair Value

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

“...the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between
market participants at the measurement date.”

 Why change the definition?

1. The new definition requires the use of an exit price
2. To provide clarity to the term “settling”
3. To establish that fair value occurs at the measurement date
Elements of the Definition

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

 Based on:
The perspective of the entity that holds the asset or
owes the liability
Expectations about future cash flows that will be
generated by the asset/liability subsequent to the
sale/transfer
 Elements of the Definition

 Orderly transactions
“ a transaction that assumes exposure to the market for a period
before the measurement date to allow for marketing activities that
are usual and customary for transactions involving such assets or
liabilities”

 Key Issues:
 Refers to transactions made under normal market
conditions
 Excludes sales made under liquidation or “fire sale”
conditions
 Excludes non-arms length sales
Elements of the Definition

 Market participants need to meet these

criteria:
 Must be independent from each other
 Must be knowledgeable about the asset or liability
 Must have the ability to enter into the transaction
 Must not be forced or compelled
 Elements of the Definition

Transaction and Transport Costs

 Transactions costs are incremental direct costs that would not
have been incurred had the decisions to sell the asset/transfer
the liability not been made

 Transport costs are the costs incurred to transport an asset from

its current location to its principal market

 Both affect the determination of fair value and are relevant in

determining the most advantageous market

 HOWEVER, the price used to measure FV is NOT adjusted for

these costs
Application to Non-Financial
Assets

 IFRS 13 applies to:

 Non-financial assets
 Liabilities and an entity’s own equity instruments

 Four step process in making a FV measurement:

1. Determine the asset or liability that is to be measured

2. Determine the valuation premise that is appropriate
3. Determine the principal or most advantageous market
4. Determine the appropriate valuation technique
Step 1: Determine the Asset or Liability
That is the Subject of the Measurement

 Involves considering characteristics that market

participants would take into account when pricing an
asset or liability

 Relevant questions to consider include:

 What is the location of the asset?
 What is the condition of the asset?
 Are there any restrictions on sale or use of the asset?
 Is the asset or liability a stand-alone asset or it is a
group of assets?
Step 2: Determine the Valuation
Premise that is Appropriate
 Fair value is measured by considering the highest and
best use of an asset:
“...the use of a non-financial asset by market
participants that would maximise the value of the
asset or the group of assets and liabilities (eg a
business) within which the asset would be used.”

 These uses must be physically possible, legally

permissible and financially feasible.

 The highest and best use is from the perspective of the

market participant, not the holder
Step 2: Determine the Valuation
Premise that is Appropriate
 In combination valuation premise:
 FV is determined under this premise where market participants
would obtain maximum benefit principally through using the
asset in combination with other assets and liabilities as a
group
 The asset will be sold as an individual asset, not as a group, but
the asset will be used by the market participant in conjunction
with other assets

 Stand-alone valuation premise

 FV is determined under this premise where market participants
would obtain maximum benefit principally through using the
asset on a stand-alone basis
Step 3: Determine the Principal or
Most Advantageous Market

 FV measurement assumes that the transaction takes place

in the principal market or in the absence of a principal
market, the most advantageous market

 Principal market: the market with the greatest volume

and level of activity

 Most advantageous market: the market that would

maximise the amount received/paid after deducting
transaction and transport costs
Step 4: Determine the Appropriate
Valuation Technique

 The objective of the valuation technique selected is to

estimate the price at which an orderly transactions would
take place between market participants under current
market conditions
 Three possible valuation techniques exist:
1. The market approach
2. The cost approach
3. The income approach
 Judgement is required to select the most appropriate
technique for the situation
Step 4: Determine the Appropriate
Valuation Technique

Inputs:
When applying a technique the use of observable inputs
needs to be maximised and unobservable inputs
minimised
Observable inputs are developed using market data,
such as publicly available information
Unobservable inputs are those where market data is not
available and are developed using the best information
available
To achieve consistency and comparability IFRS 13
provides a hierarchy of inputs.
 Fair value Hierarchy

Level 1 Inputs:
“...quoted prices in active markets for identical
assets or liabilities that the entity can access at the
measurement date.”

 A market is not active if there are few recent

transactions or price quotes vary substantially over time

 Level 1 inputs must be for identical items – for

buildings, items may be similar, but will not be identical
 Fair Value Hierarchy

Level 2 Inputs:
“...inputs other than quoted prices included within
Level 1 that are observable for the asset or liability,
either directly or indirectly.”

 Included within this definition are:

 Quoted prices for similar assets in active markets
 Quoted prices for identical items in inactive markets
 Inputs other than quoted prices that are
 Inputs that are derived from or corroborated by
observable market data
 Fair Value Hierarchy

Level 3 Inputs
“...unobservable inputs for the asset or liability.”

 Level 3 inputs would be used include

when valuing:
 Cash generating units
 Trademarks
 Accounts receivable
 Application to Liabilities

 Prior to IFRS 13 the measurement of a based on the amount

required to settle the present obligation

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

 Fair value measurement assumes that the liability is transferred

to another market participant at the measurement date

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

 Financial Liabilities:

 There is often an observable market and a quoted price may be

obtained to measure the FV of the liability
 Measurement will depend on whether there or not a corresponding
asset is held by another entity
 Application to liabilities

Corresponding Asset:

 Measurement should be in the following order:

 The quoted price of the asset in an active market
 The quoted price for the asset in an inactive market
 A valuation under a technique such as the income or market
approach – refer Example 3.7
 Application to Liabilities

No Corresponding Asset:

 Measurement must be done by applying a valuation technique from

the perspective of a market participant that owes the liability
 A present value technique could be applied

 Refer Examples 3.8 & 3.9

 Application to Liabilities

Non performance risk:

 The fair value of a liability will reflect the effect of non-
performance risk
“...the risk that an entity will not fulfil an obligation.
Non-performance risk includes, but may not be
limited to, the entity’s own credit risk”
 Refer Example 3.10
Application to Equity Instruments

 Measurement of equity instruments may be needed where

an entity undertakes a business combination and issues its
own equity instruments in exchange for a business

 The principles in relation to liabilities also apply to equity

instruments

 The company must measure the fair value of the equity

instrument from the perspective of a market participant
who holds the instrument as an asset
Issues in Measuring Financial
Instruments

Inputs based on bid and ask prices:

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

 The price within a bid - ask spread that is most

representative of fair value should be used
 A mid-market price may be used as a practical expedient
 Issues in Measuring Financial
Instruments
Offsetting positions

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

 Where these assets and liabilities are managed as a group, IFRS 13

allows an entity to measure the net financial asset or net financial
liability

 This exception may be only be applied where an entity manages

the group of financial assets and liabilities on a net exposure basis
as a part of its documented risk management strategy.
 Disclosure

IFRS 13 requires an entity to disclose information that

enables users to assess both of the following:
The valuation techniques and inputs used to develop measurements
of assets & liabilities measured at fair value
When using significant unobservable inputs (Level 3), the effect of the
measurements on profit or loss or other comprehensive income for the
period
Questions About FV Measurement

1. How reliable are the FV numbers?

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

3. Are the FV measure not based on directly observable market

prices costly to determine?

4. Should measures based on unobservable inputs be called FV?

5. Can FV be prescribed before the finalisation of the Conceptual

Framework?