The Measurement and Valuation of Financial Instruments

Financial instruments measured at amortised cost are simply based on the market prices at which assets were initially acquired and liabilities were initially incurred. In contrast, financial instruments measured at fair value are based on current market prices (Poon, 2004). For valuation based on amortised cost, the expectations of cash flows and priced risks determined at initiation are used to account for financial instruments throughout their lives (Ryan, 2007:5). Valuation using amortised cost is not as worrisome as the valuation process using fair value, simply because the initial market price is readily available on the transaction date and except for some circumstances where measures for impairment may be used to reduce this initial valuation, the amortised cost will largely remain unchanged over the life of given financial instruments.

The process is a bit more complicated with the measurement of financial instruments using fair value. Fair value utilises current market prices, and these may not be readily available in some situations. The FASB and IASB have issued SFAS 157 and IFRS 13 to clarify how to measure financial instruments using fair value principles.

IFRS 13 sets out a fair value hierarchy that categorises the inputs to valuation techniques used to measure fair value into three levels11. This hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to Level 3 inputs which are based on unobservable inputs (van Zijl, 2011). Figures 2.1 and 2.2 put this hierarchy in perspective.

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This hierarchy was adopted from IFRS 7 into IFRS 13 and is consistent with the one described by the FASB in SFAS 157.

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Figure 2.1 Fair Value Hierarchy

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 or indirectly.

Level 3 Inputs for the asset or liability that are unobservable, including the entity’s own data, which are adjusted if necessary to reflect market participants’ assumptions.

Source: International Accounting Standards Board (IASB), International Financial Reporting Standard 7 (IFRS 7), Financial Instruments: Disclosures, Paragraph 27A

Figure 2.2

Application of Fair Value Hierarchy Levels

Yes No

No Yes

No No

Yes

Source: IFRS Practice Issues: Fair Value Hierarchy produced by the KPMG International Standards Group; December, 2009.

Paragraph 61 of IFRS 13 directs an entity to use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs. Examples of markets in which inputs might be observable include exchange markets, dealer markets, brokered markets and principal-to-principal

Quoted price in an active market? Any significant unobservable inputs? Price is adjusted? Level 1 Level 3 Level 2 Valuation technique applied

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markets12. Paragraph 62 of IFRS 13 stipulates that the objective of using a valuation technique is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. Paragraph 67 of IFRS 13 also stipulates that an entity must focus its valuation techniques on the use of relevant observable inputs; the use of unobservable inputs should be kept to a minimum. However, IFRS 13 is sensitive to the challenges placed on an entity to meet this requirement. Thus, in some cases, a single valuation technique will be appropriate (for example, when valuing an asset or a liability using quoted prices in an active market for identical assets or liabilities). In other instances, however, multiple valuation techniques will be appropriate (for example, when valuing a cash-generating unit). If multiple valuation techniques are used to measure fair value, the results are to be evaluated considering the reasonableness of the range of values indicated by those results. Paragraph 63 of IFRS 13 provides that the fair value measurement would be the point within that range that is most representative of fair value in the given circumstances.

Also, valuation techniques used to measure fair value are to be applied consistently. In particular, paragraph 66 of IFRS 13 provides that a change in a valuation technique or its application (for example, a change in its weighting when multiple valuation techniques are used, or a change in an adjustment applied to a valuation technique) is appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances. Paragraph 66 also provides that revisions resulting from a change in the valuation technique or its application are accounted for as a change in accounting estimate in accordance with IAS 8. However,

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the disclosures in IAS 8 for a change in accounting estimate are not required for revisions resulting from a change in valuation technique or its application.

There are three widely used valuation techniques stated in IFRS 13. They are: the market approach, the cost approach, and the income approach.

• The market approach uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities or a group of assets and liabilities, such as a business [paragraph B5].

• The cost approach reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as depreciated current replacement cost) [paragraph B8].

• The income approach converts future amounts (for example, cash flows or income

and expenses) into a single current (that is, discounted) amount. When the income approach is used, the fair value measurement is determined on the basis of current market expectations about those future amounts [paragraph B10].

There is a significant difference between IAS 39 and IFRS 13/SFAS 157 with reference to the use of the bid and ask prices for fair valuation of financial assets and liabilities. IAS 39 required the use of “bid” prices for asset positions and “ask” prices for liability positions. Unlike IAS 39, paragraph 70 of IFRS 13 provides that the price within the bid-ask spread that is most representative of fair value in the circumstances is to be used as the fair value measure in the firm’s financial statements (PWC, 2011; KPMG, 2012). Thus, IFRS 13 does not completely do away with the IAS 39 fair value principles; since the only stipulation that must be met under paragraph 71 of IFRS 13 is that such bid ask prices must be the most representative fair value in the circumstances.

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Where such prices are not the most representative fair value, management may choose another price within the bid-ask spread that is most representative of fair value. Also, paragraph 71 of IFRS 13 does not prohibit the use of mid-market pricing or other pricing conventions that are used by market participants as a practical expedient for approximating fair values. However, once management has established which convention is to be used, it must follow its accounting policy consistently from thereon in.