IFRS 13: Fair Value Measurement- Part 1

 Under IFRS, fair value is one of the vital measurement basis for the measurement or disclosure of few assets and liabilities. Some of the IFRSs contained limited guidance about how to measure fair value, whereas others contained extensive guidance and that guidance was not always consistent and sometimes ambiguous. Inconsistencies in the requirements for measuring fair value and for disclosing information about fair value measurements have contributed to diversity in practice and have reduced the comparability. This resulted in the issue of IFRS 13 – Fair value measurements, providing single source of guidance on all fair value measurement, clarity in definition, reducing earlier ambiguity and enhancing disclosures etc.

IFRS 13 provides framework for measuring fair value, enhancing consistency and comparability in financial reporting. In this blog we’ll discuss, evaluate the definition of fair value and its key aspects and determine how to apply the same in arriving at the fair value under IFRS 13. IFRS 13 defines fair value and provides the various approaches to arrive at the fair value of an asset or a liability using different levels of inputs.

Definition of Fair Value (FV)

 

IFRS 13 defines fair value as:

1.The price that would be received to sell an asset or paid to transfer a liability;

2.In an orderly transaction;

3.Between market participants;

4.At the measurement date.

Fair value is the exit price and is a market-based measurement and not entity specific measurement. Thus, FV is not affected by an entity’s intentions towards the asset, liability or equity item that is being fair valued.

Fair value is an estimate of price based on the exit price from the perspective of market participants in an orderly transaction who hold the asset or owe the liability at the measurement date.

Such an estimate of price for an asset or a liability shall be based on identical or similar asset or a liability. However, when such price is not observable, then estimate shall be based on another valuation technique which maximises the use of observable inputs and minimises the use of unobservable inputs.

IFRS 13 requires management to determine four aspects while determining FV:

1.Asset or liability subject to measurement (unit of account);

2.The (orderly) transaction

3.Market participants;

4.The (exit) price.

 

We will now check each one of the above aspects which will contribute to arrive at the fair value of the asset or a liability.

1. Asset or liability subject to measurement (Unit of account)

The fair value is for a particular asset or liability or group of assets or liabilities depending on the requirements of respective IFRS for which entity is calculating fair value. One should also consider physical characteristics of the asset subject to fair value.

This essentially defines the level of aggregation or disaggregation while calculating fair values of the assets/ liabilities.

 

Example 1 - Entity Specific restrictions

An entity ABC is having a land which has a restriction to develop into a commercial house because of restricted business objective in which currently the entity operates. The entity wants to sell the land and there would not be any restriction for a buyer of the land to develop a commercial house, since this restriction is entity specific. Hence, it will not be considered while calculating fair value of the land.

 

Examples 2 - Asset / Liability specific restrictions

A car has been bought for private use and there is a restriction of not to use the car for any commercial purposes.  Commercial vehicle is having more fair value than private vehicle. Since the restriction to use the vehicle is asset specific and market participant will also consider the asset specific restrictions while calculating fair values for such asset, hence this condition will be considered while evaluating fair value of the car.

 

2. The (orderly) transaction

A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction.

An orderly transaction is the transaction which takes place in the principal market or in case of absence of principal market, the most advantageous market.

Principal market –

It is the market with greatest volume and level of activity for the asset or liability.

For e.g. Stock price of TML on NSE is INR 600 (Volume – 1.5 million) and stock price on BSE is INR 610 (Volume – 1 million); thus, principal market is NSE, thus fair value would be INR 600.

Most advantageous market –

It is the market that maximises the amount to be received for sell of the asset or minimises the amount to be   transferred of liability.
– While determining this market – entity would reduce transaction costs from the exit price only to evaluate       maximum cash recovery amongst available markets. After deciding ‘most advantageous market’, fair value of that market would be arrived by adding back the transaction cost to the exit price.

1.Transportation cost is not a transaction cost, it is a physical attribute of the asset under measurement.

2.An entity need not undertake an exhaustive search for all possible markets to determine the principal market or most advantageous market.

3.Most advantageous market is to be considered for fair value determination only when there is no information available for the principal market.

4.The entity must have access to the principal (or most advantageous) market at the measurement date as different entities with different business activities may have access to the different markets.

5.Although an entity must be able to access the market, the entity does not need to be able to sell the particular asset or transfer the liability on the measurement date to be able to measure fair value.

6.It is a hypothetical sale transaction on a measurement date that establishes a basis for estimating the price which will be considered as a fair value of an asset or a liability.

Example 3

Shares of a company which is listed at BSE and NSE have different closing prices at the year end. The price at BSE has greatest volume and activity whereas at NSE it is less in terms of volume transacted in the period. Since BSE has got highest volume and significant level of activity comparing to other market although the closing price is higher at NSE, the closing price at BSE would be taken.

 

Example 4

Diamond (a commodity) has got a domestic market where the prices are less compared to the price available for export of similar diamonds. The Government has a policy to cap the export of Diamond, maximum up to 10% of total output by any such manufacturer. The normal activities of diamond are being done in the domestic market only i.e. 90% and balance 10% only can be sold via export. The highest level of activities with the highest volume is being done in the domestic market. Hence, the principal market for diamond would be the domestic market.  Export prices are more than the prices in the principal market, and it would give the highest return as compared to the domestic market. Therefore, the export market would be considered as the most advantageous market. However, if principal market is available, then its prices would be used for fair valuation of assets/ liabilities.

 

3. Market participants

Market participants are buyers and sellers in the principal market or the most advantageous market that are:

1.Independent i.e. not related parties;

2.Knowledgeable i.e. having reasonable understanding about the asset/ liability and the transaction;

3.Able to transact;

4.Willing to transact in the asset or liability.

It is assumed that the market participants act in their best economic interest i.e. market participants seek to maximise the fair value of an asset or minimise the fair value of a liability.

 

4. The (exit) price

1.Under IFRS 13, fair value estimate is based on the "exit price" and does not consider entry price or replacement cost etc.

2.IFRS 13, prohibits to adjust transaction cost in the fair value estimate as it is specific to transaction.

3.Transaction cost do not include 'transport costs'. Location is generally the characteristic of the asset and thus, the exit price shall be adjusted for the transport cost that would be incurred to transfer asset from current location to principal market.

 

Example 5

An entity sells certain commodity which are available actively at location ‘X’ and which is considered to be its principal market (being significant volume of transactions and activities takes place). However, fair value of the commodity is required to be assessed for location ‘Y’ which is far from location ‘X’ and requires a transport cost of Rs.100. Since the transport cost is not a transaction cost and it is not specific to any transaction, but it is inherent cost which required to be incurred while bringing such commodity from location X to location Y, it will be considered while evaluating fair value from the principal market.

 

Example 6

XYZ Limited holds an asset that is traded in three different markets. XYZ generally trades in Market 3, however, the details of other markets are as below:

 

a) Calculate the fair value based on information provided.

b) Assume that principal market is not determinable for absence of total volumes in each market and calculate fair value.

Solution

1. Fair value is the exit price of the asset in the principal market or in absence of principal market, the most advantageous market. Principal market is the market with highest volume, which is readily determinable. In above example, Market 1 is the market with the highest volume amongst all three markets and will be considered as principal market. Hence, exit price in Market 1 will be considered as fair value.
   
   Exit price is the price that would be received to sell an asset in question. Exit price to be determined after considering the transport costs but before the transaction costs. Transport cost is the cost associated with physical characteristics (location) of the asset and not with the sale transaction of an asset. Transactional characteristics cannot be considered while arriving at the exit price. It is thus, prohibited to adjust transaction costs while arriving at the exit price. Thus, fair value of the asset in case ‘XYZ’ is 57.

2. Assuming, principal market is not readily determinable, evaluation of exit price will be based on the ‘most advantageous market’. Most advantageous market is evaluated based on highest cash recovery amongst the available markets. Cash recovery is highest in Market 3 after considering the expense towards the transaction costs. This makes Market 3 as most advantageous market. The exit price in Market 3 will be considered as fair value in second scenario. Exit price in market 3 is 59 before adjusting transaction costs and NOT 57. It means that, transaction costs shall be deducted only to determine the highest cash recovery and consequently the most advantageous market. Thus, fair value of asset in second scenario is 59.

We hope this blog helps to understand the fair value definition, various aspects management requires to determine under IFRS 13, and other factors need to be considered while measuring fair value of asset or liability, with the help of suitable examples & question as well. In our next blog we’ll outline some other concepts of fair value measurement like– consideration for non-financial assets, valuation techniques and fair value hierarchy.

Thank you for reading this article. Stay tuned for more simplified insights on accounting standards!