Lecture 2

Fair Value Measurement

 Picker, et al. (2012). Chapter 3, p.67-

83.
 IFRS 13
 Learning Objectives.

After completing the lecture and the tutorial session, you should be
able to:
 explain the need for an accounting standard on fair value
measurement.
 understand the key characteristics of the term ‘fair value’.
 explain how to measure the fair value of an entity’s own equity
instruments.
 Discuss issues relating to the measurement of the fair value of
financial instruments.
 Prepare the disclosure required by IFRS 13 Fair Value Measurement
 Discuss the issues associated with the measurement and use of fair
value.
 The Need for a Standard on Fair
Value Measurement.

 The IASB issues standards require assets prescribe various ways of

measuring assets.
 The two main measures used are cost and fair value.
 For example:
 PPE qualifies for recognition as an asset is to be initially measured at cost
(IAS 16 paragraph 15).
 Intangible assets are also to be measured initially at cost (IAS 38
paragraph 24).
 Recognition and Measurement of Financial Instruments as financial
assets are required to be measured at fair value.
 Both IAS 16 and IAS 38 allow entities the choice, subsequent to initial
recognition, of measuring assets using the costs model or the
revaluation model.
 The other measurement used in the accounting standards
are net realisable value, fair value less costs of disposal,
recoverable amount and value in use.
 Three reasons for issuing exposure draft on Fair Value
Measurement in May 2009.
a) To establish a single source of guidance for all fair value
measurements required or permitted by IFRSs to reduce
complexity and improve consistency in their application.
b) To clarify the definition of fair value and related guidance in
order to communicate the measurement objective more
clearly.
c) To enhance disclosure about fair value and its derivatives in
measurement.
 Fair Value

 Prior to issue of IFRS, fair value was defined as ‘the

amount for which an asset could be exchanged, a
liability settled, between knowledgeable, willing
parties in an arm’s length transaction’.
 IFRS 13 (IN8) 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 (exit price),
 Orderly transaction.
 Hypothetical price.
 Sell an asset/transfer a liability.
 Market participants.
 No adjustments for transaction costs.
 Principal/most advantageous market
 Fair Value Process

1. Determine the unit of account

2. Determine the highest and best use
3. Determine the appropriate market
1. Principal market
2. Most advantageous market
3. Hypothetical market
4. Valuation technique
1. Market approach
2. Income approach
3. Cost approach
 The Fair Value Hierarchy

 Level 1 – Quoted prices in identical markets

 Level 2 – Inputs other than quoted prices that are
observable
 Level 3 – Inputs that are not based on observable
market data
 Reasons for changing definition.
 The exchange transaction is hypothetical.
 The exchange transaction is orderly.
Therefore, the reasons as stated in paragraph BC30 are as
follows:
1) No specification was provided in the previous
definition as to whether the entity was buying or
selling.
2) It was unclear what was meant by ‘settling’ a liability in
the previous definition.
3) No clear statement about the settlement dates in the
previous definition.
 Current Exit Price

 The price that an entity receives in selling an asset or paid

to transfer a liability (IFRS 13, Appendix A).
 Exit price is an important feature of the definition on the
perception of holding and asset or liabilities owing to
others by an entity.
 An exit price for an asset or liability acquired or assumed
might differ from an exchange price – entry or exit price if:
 An entity’s intended use of an acquired asset differ from its
highest and best use.
 A liability is measured on the basis of settling it with the
creditor rather than transferring to a third party.
 Ernst & young (2009, p. 5) as cited by Picker et al.
(2012, p. 70) questioned the equivalents of exit prices
and entry prices.
 Similarly, Group of 100 (G100) questioned the use of
an exit price to measure the fair value.
 Orderly Transactions

 Previously, fair value is measured by considering a

hypothetical transaction in a market.
 To determine that fair value, the entity will make
observations in the current markets.
 The markets to be observed must be those containing
orderly transactions.
 Similarly, prices between entities which are not at
arm’s length are not prices from orderly transactions.
 Market Participants

 IFRS 13 (Appendix A) defines market participants as:

 “Buyers and sellers in the principal market for the asset or
liability that have all of the following characteristics:
a) Independent of each other.
b) Knowledgeable of the economic event regarding asset or liability
in the market.
c) Able to enter into transaction for the asset or liability.
d) Willing to enter into the transaction for the asset or liability.
Transaction and Transport Costs

 Incremental direct costs to sell an asset or transfer a

liability.
 “The costs that would be incurred to transport an
asset from its current location to its principal market”
(IFRS 13, Appendix A).
 Both transport and transaction costs affect the
determination of the fair value of an asset or liability.
Application to Non-Financial Assets

 IFRS 13 considers its application to non financial assets,

liabilities and an entity’s own equity instrument.
 Appendix B (IFRS 13) considers that there are four steps
that an entity undertake to make fair value measurement.
1. Particular asset or liability that is the subject of the
measurement.
2. For non-financial asset, the valuation premise that it is
appropriate for the measurement.
3. The principal market for the asset or liability.
4. The valuation technique (s) appropriate for the
measurement.
What is the particular asset that is
the subject of the measurement?

 IFRS 13 (paragraph 11) provides key principle when

determining the asset to be measured.
 The characteristics include; the condition and location
of the asset, and restrictions, if any, on the sale or use
of the asset.
The valuation premises appropriate
for measurement of fair value

 Fair Value is measured by considering the highest and best

use of the 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 within which the asset would be
used.
 The use must be physically possible, legally permissible and
financially feasible (IFRS 13, paragraph 28)
In-combination valuation premises
Stand-alone valuation premise.
The principal market for the assets.

 The market with the greatest volume and level of

activity for the asset or liability (IFRS 13, Appendix A).
 Economic transactions take place in the principal
market for the asset or liability.
 In the absent of the principal market, the most
advantageous market.
Valuation techniques available for
measurement

 The market approach.

 Market prices or market multiples.
 The cost approach.
 Replacement cost
 The income approach.
 Present value
 Option pricing models
 Discounted cash flows
 How do you determine the
hypothetical market?

 Determine the characteristics of a market participant

to which it would hypothetically sell the asset if it
were seeking to do so.
 Then identify the assumptions that those market
participants would consider when pricing the asset
 What if there are multiple uses for
the assets? Do I need to seek out all
of them?

 The reporting entity need not undertake all possible

efforts to obtain information
 A reporting entity should use information reasonably
available to it.
 A reporting entity should examine realistic scenarios as to
how the assets would be used
 Judgment should be based on
 the nature of the assets,
 prior history, knowledge about the market,
 or other relevant information.
 IFRS 13 does not provide the hierarchy of the
technique.
 The technique must be appropriate to the circumstance.
 The must be sufficient data available to apply the
technique.
 Multiple techniques are also required in some instances.
 The technique used for fair value measurement must be
consistently applied.
 Inputs to valuation techniques.
 The assumptions that market participants would use
when pricing the assets or liability including assumptions
about risk such as inherent risk in particular valuation
technique to measure fair value ( price model), and the
risk inherent in the inputs to the valuation technique.
 Regardless of which technique is used, assumption will
be made in the application of the technique.
 It is necessary to maximise the use of observable inputs
and minimise the use of unobservable inputs by
choosing a valuation technique.
 Fair value hierarchy – prioritising inputs.
 Inputs are prioritise into three levels.
 Fair value hierarchy gives the highest priority to quoted
market price in active market for identical assets and
liabilities and lowest priorities to unobservable inputs.
 Observable inputs must be relevant.
 The availability of inputs and their relative subjectivity
potentially affects the selection of valuation techniques.
 Level 1 Inputs.
 Quoted prices (unadjusted) in active markets for
identical assets or liabilities that the entity can excess at
the measurement date (IFRS 13, Appendix A).
 Level 2 Inputs
 Inputs other than quoted prices included within level 1
that are observable for the asset or liability, either4
directly or indirectly.
 Level 3 Inputs.
 Unobservable inputs for the asset or liability.
 Application to Liabilities

 Prior to IFRS 13, amount required to settle the present

obligation.
 Fair value is the amount paid to transfer a liability (IFRS 13).
 The three steps in the measurement process are:
1. Entity must determine; the particular liability that is the
subject of the measurement,
2. the principal market for the asset or liability, and
3. the valuation technique (s) appropriate for the
measurement.
 Illustrative Example 1

On the 1 January 2014 Kangaroo Ltd issued at par K2 million

BBB-rated exchange-traded 5-year fixed rate debt
instruments with an annual 10% interest coupon.
On the 31 December 2014, the instrument is trading as an
asset in an active market at K929 per K1, 000 of par value
after payment of accrued interest. Kangaroo Ltd used the
quoted price of the asset in the active market as its initial
input into the fair value measurement of its liability. This
measure is K1, 858,000 (K929/K1,000xK2,000,000)
In determining whether the price of the asset can be
used to measure the liability, Kangaroo Ltd needs to
assess whether the price of the assets includes any
factors that would not be included in the price of the
liability – such as the effect of the third-party credit
enhancements. If there is none then the liability can be
measured at a fair value of K1, 858,000.
Illustrative Example 2: Present value
technique.

On the 1 January 2014, Maiya Ltd issued at par in a private

placement a K2 million BBB-rated 5-year fixed rate debt
instrument with an annual 10% coupon rate.
At 31 December 2015, Maiya Ltd still carried a BBB credit
rating. Market conditions including interests rates and credit
spreads for a BBB-quality credit rating and liquidity, remain
unchanged from the date of issue of the debt instrument.
However, Maiya Ltd’s credit spread had deteriorated by 50
basis points because of a change in its risk of non-
performance. If the instrument were issued at 31 December
2014, the instrument would need an interest rate of 10.5%
Using the present value technique, the fair value of debt
instrument at 31 December 2015 would be calculated as:

K2,000,000 x 0.670735 = K1, 341, 470

K200, 000 x 3.1359 = 627,180
K1,968,650

The fair value is then K1,968, 650

0.670735 = (PV of single sum at end of 4 years at 10.5%)

3.1359 = (PV of an annuity for 4 years at 10.5%)