NEED TO KNOW. IFRS 13 Fair Value Measurement

2. Scope, effective date and transition 5

2.1. When to apply fair value measurement 5

2.2. Scope exclusion – measurement and disclosures 5

2.3. Scope exclusions – disclosures only 5

2.4. Examples of the scope of IFRS 13 6

2.5. Effective date and transition 6

3. Rationale for a fair value standard 7

4. Main definitions 8

4.1. Fair value 8

4.2. Market participant 9

4.3. Orderly transaction 10

4.4. Principal market and most advantageous market 10

4.5. Highest and best use 11

4.6. Unit of account 12

4.7. Transport costs 12

5. Measurement – key factors and considerations 13

5.1. The asset or liability 13

5.2. Exit price vs. entry price 15

5.3. The market concept 16

5.4. Market participant 20

5.5. The price 21

5.6. Fair value at initial recognition 22

5.7. Non-financial assets 24

5.8. Liabilities and own credit risk (including equity issued by the entity) 29

5.9. Bid and ask prices 39

5.10. Premium and discount 41

6. Valuation techniques 46

7. Fair value hierarchy 50

7.1. Level 1 inputs 51

7.2. Level 2 inputs 53

7.3. Level 3 inputs 54

9. Convergence with US GAAP 58

10. IASB Educational material 59

10.1. Unquoted equity instruments within the scope of IFRS 9 59

11. Definitions 67

11.1. Definitions IFRS 13 67

Appendix A – Example IFRS 13 disclosures for 31 December 2013 69

The objectives of IFRS 13 (IFRS 13.1) are to:

– Define fair value

– Provide a single set of requirements for measuring fair value (for scope exclusions, see section 2.2 below) – Specify the disclosure requirements for fair value measurement.

IFRS 13 does not specify when items are to be measured at fair value measurements. Those requirements are included in other IFRSs.

Certain IFRSs require or permit specific items to be measured at fair value:

– At each reporting date (fair value on a recurring basis)

– In other certain instances, e.g. impairment (fair value on a non-recurring basis) or at initial recognition.

IFRS 13 applies to all financial and non-financial items with limited scope exclusions. Some IFRSs require fair value disclosures for items measured at (amortised) cost, and IFRS 13 provides the specific disclosure guidance for each of these.

The fair value measurement project started as part of the convergence project between the IASB and the US Financial

Accounting Standards Board (FASB). The outcome is that IFRS 13 is by and large comparable to the fair value measurement

standard in US GAAP (Accounting Standard Codification topic 820).

IFRS 13 Fair Value Measurement applies when another IFRS requires or permits either (IFRS 13.5):

– Fair value measurements, and/or

– Disclosures about fair value measurements.

In developing IFRS 13, the International Accounting Standards Board (IASB) reviewed all pre-existing requirements

regarding fair value measurements and disclosures contained within other IFRSs. As a result, almost all of these pre-existing requirements are now included within the scope of IFRS 13 (see below).

2.2. Scope exclusion – measurement and disclosures

The measurement and disclosure requirements of IFRS 13 do not apply (IFRS 13.6) to:

– Share-based payment transactions within the scope of IFRS 2 Share-based Payment – Leasing transactions within the scope of IAS 17 Leases

– Measurements that appear similar to fair value, but which are not the same, such as:

– Net realisable value in IAS 2 Inventories – Value in use in IAS 36 Impairment of Assets.

BDO comment

IFRS 2 and IAS 17 both use the term ‘fair value’ in a way that differs in certain respects from the definition of fair value in IFRS 13.

Therefore, when applying the fair value measurement in respect of transactions within the scope of IFRS 2 and IAS 17, an entity must apply the requirements of those standards and not the requirements of IFRS 13.

2.3. Scope exclusions – disclosures only

The disclosure requirements of IFRS 13 do not apply (IFRS 13.7) to:

– Plan assets measured at fair value in accordance with IAS 19 Employee Benefits

– Retirement benefit plan investments measured at fair value in accordance with IAS 26 Accounting and Reporting by Retirement Benefit

– Assets for which recoverable amount is fair value less costs of disposal in accordance with IAS 36.

BDO comment

As a consequence of the introduction of IFRS 13, the disclosure requirements of IAS 36 in respect of fair value less cost of

disposal have been enhanced.

As noted above, IFRS 13 does not establish which items are to be measured and/or disclosed at fair value, with these requirements being included in other IFRSs. Examples are:

– Loans and receivables: Although these are measured after initial recognition at amortised cost, they are within the scope of IFRS 13. This is because IAS 39 Financial Instruments: Recognition and Measurement requires them to be recognised initially at fair value, as well as disclosure of fair value being required at each subsequent reporting date (if this is materially different from the amortised cost carrying amount)

– Fixed assets which are subsequently measured in accordance with the revaluation model in IAS 16 Property, Plant and Equipment are within the scope of IFRS 13 in terms of both measurement and disclosure

– Revenue is within the scope of IFRS 13 regarding measurement (as IAS 18 Revenue paragraph 9 requires revenue to be measured at the fair value of the consideration received or receivable), but not regarding disclosures

– Investment property, regardless of whether this is measured in accordance with the fair value model or the cost model under IAS 40 Investment Property. Even when the cost model is followed, investment property is within the scope of IFRS 13, as IAS 40.79(e) requires fair value to be disclosed (therefore requiring measurement).

2.5. Effective date and transition

IFRS 13 applies for annual periods beginning on or after 1 January 2013 with early adoption permitted (IFRS 13.C1). It is applied prospectively as of the beginning of the annual period of the initial application. Prior period comparative information is not restated (IFRS 13.C2).

The disclosure requirements of IFRS 13 do not need to be applied to the comparative information provided for periods

beginning before the date of the initial application IFRS 13 (IFRS 13.C3).

statements, in some cases with an option of fair value measurement. The Conceptual Framework for Financial Reporting (and the former Framework for the Preparation and Presentation of Financial Statements) did not support fair value as the sole measurement attribute.

Through the years, many published IFRSs have included a requirement, or option, for entities to measure or disclose the fair value of assets, liabilities or their own equity instruments. Because these requirements were included in each individual IFRS, they became dispersed and in many cases did not articulate a clear and consistent measurement or disclosure objective.

Some IFRSs contained limited guidance about how to measure fair value, while others contained extensive guidance.

These inconsistencies contributed to diversity in practice resulting in reduced comparability among different entities’

financial statements. The introduction of IFRS 13 Fair Value Measurement, while not interfering with the scope of fair value

measurement, aims to reduce the extent of this diversity and inconsistency.

Fair value is (IFRS 13.9):

‘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.’

This definition of fair value is sometimes referred to as an ‘exit price’.

BDO comment

The IFRS 13 Fair Value Measurement definition of fair value is somewhat different to the definition that existed in previous individual IFRSs. However, it does have some similarities with standards that have been published in the last few years, such as IFRS 3 Business Combinations which includes the following definition (IFRS 3 Appendix A):

‘The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction’.

However, one key difference between the IFRS 13 and IFRS 3 definitions relates to liabilities:

– IFRS 13: refers to the ‘transfer’ of a liability – IFRS 3: refers to the ‘settlement’ of a liability.

This could lead to difference in the measurement of fair value (see below).

Other differences exist between the two definitions, but they are unlikely to cause significant measurement differences, for example:

– IFRS 13 specifies an ‘orderly transaction’ (see below), which in practice is usually how liabilities would be ‘settled’

– The IFRS 3 definition relates to the transaction and to the parties, but this is merely part of the term ‘market participants’ in

the IFRS 13 definition (see below).

IFRS 13 Appendix A notes that market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics:

(a) They are independent of each other, i.e. they are not related parties as defined in IAS 24 Related Party Disclosures, although the price in a related party transaction may be used as an input to a fair value measurement if the entity has evidence that the transaction was entered into at market terms

(b) They are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary

(c) They are able to enter into a transaction for the asset or liability

(d) They are willing to enter into a transaction for the asset or liability (i.e. they are motivated, but not forced or otherwise compelled, to do so).

BDO comment

The characteristics within the definition of a market participant clarify certain aspects of the previous definition, such as:

– The expression ‘knowledgeable’ parties is clarified by characteristic (b) – The expression ‘willing parties’ is clarified by (d)

– The expression ‘in an arm’s length transaction’ is clarified by (a) in the definition above.

IFRS 13 Appendix A notes that an orderly transaction is:

‘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; it is not a forced transaction (e.g. a forced liquidation or distress sale).’

BDO comment

IFRS 13 assumes that the transaction price reflects the price that would apply in the normal course of business, and therefore in an ‘orderly transaction’:

– The seller is engaged in marketing activities that are usual and customary for such a transaction (i.e. it is not a forced liquidation or distressed sale). Therefore the subsequent price agreed is the maximum price receivable in consideration for the asset

– The buyer, having made efforts to understand the value from his perspective (such as performing due diligence), subsequently determines the maximum price they are willing to pay.

The following therefore would not be considered ‘orderly transactions’ under IFRS 13:

– A transaction that was entered and performed in a relatively short time, which is not sufficient to carry on marketing activities and due diligence efforts that are usual and customary for transactions involving such items

– There is only one potential buyer for the item

– The seller is compelled to enter into and complete the transaction (for example, due to financial requirements or regulatory instruction).

4.4. Principal market and most advantageous

‘Principal market’ (IFRS 13 Appendix A):

‘The market with the greatest volume and level of activity for the asset or liability.’

‘Most advantageous market’ (IFRS 13 Appendix A):

‘The market that maximises the amount that would be received to sell the asset or minimises the amount that would be paid to transfer the liability, after taking into account transaction costs and transport costs’ (IFRS 13.A).

BDO comment

The principal (or most advantageous) market is specific to each entity.

It is possible that two different entities will establish two different markets as their principal (or most advantageous) market

for the same item. This is because one entity will have access to a different principal (or most advantageous) market for the

same item. For example, two subsidiaries in the same group might sell the same item, but the principal market for each of them

might be their own domestic market.

IFRS 13 Appendix A notes that highest and best use (HBU) is:

‘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 (e.g. a business) within which the asset would be used.’

BDO comment

HBU relates to non-financial assets only. This is because, unlike other items (such as liabilities and financial assets), non- financial assets can be used or exploited within several different models, for example:

– Held for own use – Leased to others – Sold.

If held for use, it can be used either:

– On its own

– Used together with other assets or other assets and liabilities.

For example, a specialised item of property, plant and equipment might have little value on its own, but have significant value

when used with other assets.

IFRS 13 Appendix A notes that unit of account is:

‘The level at which an asset or a liability is aggregated or disaggregated in an IFRS for recognition purposes.’

BDO comment

IFRS 13 does not establish the unit of account to be used, and instead requires inputs to valuation techniques to be consistent with the characteristics of the asset or liability that market participants would take into account when setting a price. The unit of account may be established in the applicable IFRSs that require or permit fair value measurement, but this is not always the case.

For example, when determining the fair value of an entity’s investment in equity instruments (e.g. shares held in another entity), the unit of account may be either:

– Each individual instrument (i.e. the total fair value would be equal to the fair value of each share (P) multiplied by the number of shares held (Q) (i.e. P x Q))

– The holding as a whole (i.e. the total fair value may be determined by including a control premium).

At its March 2013 meeting, the board of the IASB discussed the unit of account issue due to a number of questions which had been raised by constituents.

The IASB tentatively decided that the unit of account for investments in subsidiaries, joint ventures and associates is the investment as a whole. However, the majority of board members (but not all) also tentatively agreed that the fair value measurement of an investment composed of quoted financial instruments should be equal to (P x Q). This was on the basis that quoted prices in an active market provide the most reliable evidence of fair value.

Those board members that did not agree indicated their tentative intention to present an alternative view on the issue in the forthcoming Exposure Draft. The IASB’s discussions have continuing during the remainder of 2013.

In its November 2013 public statement on European common enforcement priorities for 2013 financial statements, the European Securities and Markets Authority noted that:

‘The standard [IFRS 13] recognises that, in some cases, an adjustment (premium or discount) will be made to inputs observable in the market (e.g. a control premium when measuring the fair value of a controlling interest). However, the same paragraph states that fair value measurement shall not incorporate a premium or discount that is inconsistent with the unit of account relevant for that item. As the IASB is currently discussing the matter, ESMA expects issuers to disclose clearly their analysis regarding unit of account, until the standard is clarified.’

4.7. Transport costs

IFRS 13 Appendix A notes that transport costs are:

‘the costs that would be incurred to transport an asset from its current location to its principal (or most advantageous) market.’

5.1. The asset or liability

Fair value measurement is specific to each asset or liability. Consequently, fair value measurement needs to take into account the specific characteristics of the asset or liability if market participants would take those characteristics into account when pricing the asset or liability at the measurement date, for example (IFRS 13.11):

– The condition, location and restrictions (if any) on the sale or use of the asset.

IFRS 13 Fair Value Measurement illustrative examples IE28 and IE29 provide examples relating to the impact of restrictions

imposed on assets, and the effect of those restrictions should market participants take them into consideration when pricing

(i.e. fair valuing) the asset. A key point is that, if they are to affect the fair value measurement, any restrictions must apply

to the asset itself. Restrictions that apply to the entity that holds the asset are not taken into account, because a potential

purchaser would not be subject to those restrictions.

The following examples are based on IFRS 13.IE28 and 29:

Example 5.1(a): restriction on the sale of an equity instrument (of another entity)

An entity holds an equity instrument of another entity (a financial asset) for which sale is restricted (legally or contractually) for a specified period. Such a restriction could, for example, limit a sale to only qualifying investors.

The restriction is a characteristic of the instrument and, therefore, would be transferred to market participants (who will purchase it).

In this case, the fair value of the instrument would be measured on the basis of the quoted price for an otherwise identical unrestricted equity instrument of the same issuer that trades in a public market, adjusted to reflect the effect of the restriction.

The adjustment would reflect the amount which market participants would demand due to the risk relating to the inability to access a public market for the instrument for the specified period. The adjustment will vary depending on all the following:

a) The nature and duration of the restriction

b) The extent to which buyers are actually limited by the restriction (e.g. there might be a large number of qualifying investors)

c) Qualitative and quantitative factors specific to both the instrument and the issuer.

Example 5.1(b): Restrictions on the use of an asset

A local government contributes land in an otherwise developed residential area to a commercial entity, which is constructing a hotel on the land. The local government specifies that a hotel must continue to be located on the land in perpetuity, as long as the commercial entity owns the land and hotel.

Upon review of relevant documentation, the commercial entity determines that the responsibility to meet the restriction would not be transferred to market participants who might purchase the land and hotel. Consequently, the restriction on the use of the land is specific to the entity. Furthermore, the entity is not restricted from selling the land and hotel. Without the restriction on the use of the land, it could be used as a site for residential development.

In addition, the land is subject to an easement (a legal right that enables a utility entity to run power lines across the land).

An analysis of the effect on the fair value measurement of the land arising from the restriction and the easement is as follows:

a) Government’s restriction on use of land: as the restriction on the use of the land is specific to the entity, because the restriction would not be transferred to market participants. Therefore, the fair value of the land would be the higher of its fair value used in conjunction with a hotel and its fair value as a site for an alternative use such as residential development, regardless of the restriction on the use of the land by the commercial entity. For further discussion regarding the concept of highest and best use (HBU) see below

b) Easement for utility lines: as the easement for utility lines is specific to (a characteristic of) the land, it would be transferred

to market participants with the land. Therefore, the fair value measurement of the land would take into account the

effect of the easement, regardless of whether the HBU is as a hotel or as a site for an alternative use.

5.2. Exit price vs. entry price

IFRS 13 Appendix A makes a distinction between an entry price and an exit price.

When an asset is acquired or a liability is assumed in an exchange transaction, the transaction price is the amount:

– Paid to acquire the asset, or – Received to assume the liability.

This amount is the entry price.

In contrast, the fair value of the asset or liability (under IFRS 13) is the amount that would be:

– Received to sell the asset, or – Paid to transfer the liability.

This amount is the exit price.

Entities do not necessarily sell assets at the prices paid to acquire them. Similarly, entities do not necessarily transfer liabilities at the prices received to assume them.

The difference between the two values may (or may not, depending on the applicable guidance) lead to the recognition of a

day one gain or loss (see below).

5.3. The market concept

One of the major principles of IFRS 13 is the market concept (i.e. reference in IFRS 13 to ‘market participants’, ‘market conditions’, ‘market transactions’, ‘market information’, ‘principal market’, ‘most advantageous market’).

Also, IFRS 13.2 notes that:

‘Fair value is a market-based measurement, not an entity-specific measurement…’.

Fair value is the price obtained from selling an asset (or paid for transferring a liability) in transaction that takes place in either (IFRS 13.16):

– The principal market, or

– The most advantageous market (where no principal market exists).

In order to establish the principal (or the most advantageous) market, an entity needs to evaluate potential markets.

IFRS 13.17 states that an entity does not have to undertake an exhaustive search to find the principal (or the most advantageous) market. Nevertheless, all information that is available must be considered. Where there is no information to the contrary, the market in which the entity usually transacts for the item is presumed to be the principal (or the most advantageous) market.

Once an entity identifies the principal market, the fair value must be measured in that market, even if another market (or markets) exist that are more advantageous (IFRS 13.18).

Only in the absence of a principal market (i.e. all potential markets have the same volume and level of activity for the item, or the volume and level of activity cannot be established) is the entity required to identify the most advantageous market.

In addition, the potential market must be accessible as at measurement date (IFRS 13.19).

Markets that are not accessible as at measurement date must not be considered in determining the principal (or the most advantageous) market. It should be noted, that the entity does not have to demonstrate an ability to sell a particular asset (or transfer a particular liability) at the measurement date to illustrate accessibility (IFRS 13.20).

The process of identifying the most advantageous market takes into account transaction costs and transportation costs. For non-financial assets, where the asset’s location/proximity to market participants is a relevant consideration, the associated transport costs are likely to be reflect in the market price set by market participants.

However (in terms of fair value measurement) they are not a characteristic of the item, because transaction costs:

– Do not affect the determination of fair value

– Are accounted for under other applicable IFRSs.

Example 5.3(a): Identifying the principal (or the most advantageous) market

Assume that two markets exist for commodity A, where location is one of the characteristics of the item. Entity B normally transacts commodity A in market X. Nevertheless, Entity B also gathered available information regarding the volume and level of activity of market Y.

Market X Market Y

Volume (annual, in millions CU) 20 100

Transactions (per day) 15 55

Price (at period end, CU) 100 97

Transport costs (CU) (6) (2)

Potential fair value (CU) 94 95

Transaction costs (CU) (2) (4)

Net proceeds (CU) 92 91

Figure 1: Example 5.3(a) – Market data

Entity B takes into account all reasonable available information regarding markets X and Y. Accordingly, because it has been able to obtain the information, it establishes that market Y is the principal market as this market has the highest volume and level of activity. As a result, the fair value of commodity A is CU95 (transaction costs are not incorporated in deriving fair value in a principal market).

It should be noted that:

– Once a principal market is established, the fact that other markets may be more advantageous is ignored

– The presumption that the principal market is the one in which the entity normally transacts is not always appropriate – Transaction costs in the principal market are accounted for in accordance with other applicable IFRSs and do not form

part of the fair value calculation (see also example 5.3(d)).

Example 5.3(b): Identifying the principal (or the most advantageous) market

The facts are the same as in example 5.3(a), except that the information regarding the volume and level of activity in

markets X and Y is not available, and therefore Entity B is unable to determine which market is the principal market. Consider the following scenarios:

a) Assume no change to transaction costs per example 5(a)

b) Assume that the transaction costs in market X have risen by CU2 to CU4 (there is no change to the transaction costs in market Y).

Scenario a) – Assume no change to transaction costs in example 5(a)

The most advantageous market is the market that maximises the net proceeds, after incorporating transaction costs. In this scenario market X has net proceeds totalling CU92, while market Y has net proceeds totalling CU91.

Therefore market X is the most advantageous market, and the fair value is therefore CU94 (although transaction costs have been taken into account in establishing the most advantageous market, fair value still excludes transaction costs).

Scenario b) – Assume transaction costs have risen to CU4 in market X

The most advantageous market is the market that maximises the net proceeds, after incorporating transaction costs. In this scenario market X will have net proceeds totalling CU90 (after accounting for a CU2 increase in transaction costs), while market Y has net proceeds totalling CU91.

Therefore market Y is now the most advantageous market, and the fair value is therefore CU95.

Example 5.3(c): Market accessibility

A commodity trader entity has a 31 December year end. The entity also issues quarterly interim financial reports. One of the interim period end dates (30 June) traditionally falls on holiday. The entity is transacting in the marketplace whenever it is open for trade. Due to the public holiday the marketplace is closed at the measurement date (i.e. 30 June), and therefore no transactions take place at that date.

However, the fact that the market is not active at the reporting date, does not, in itself, preclude the market for being including when the commodity trader entity is considering which is its principal (or the most advantageous) market.

BDO comment

It can be demonstrated that due to accessibility (or lack thereof), different entities will have different principal (or the most

advantageous) market. Consider a commercial entity, engaging with a bank for a derivative. While the bank can trade the

specific derivative on the dealer market (inter-bank market), that market is not accessible to the commercial entity. Another

example may arise where an importer may sell large proportion of its imported goods (such as cars) to several large leasing

entities at a substantial discount in comparison with prices charged to others. The leasing entities are contractually required to

use the importer as their sole supplier and, consequently, the market available to the importer is not accessible by others.

Example 5.3(d): Interest rate swap at initial recognition (based on IFRS 13.IE24-26)

Entity A (a retailer) enters into an interest rate swap in a retail market with Entity B (a bank) for no initial consideration (i.e. transaction price is zero). Entity A can access only the retail market. Entity B can access both the retail market (as it did with Entity A) and the interbank market (i.e. with bank counterparties).

From the perspective of Entity A, the retail market is the principal market for the swap. If Entity A were to transfer its rights and obligations under the swap, it would do so with a dealer counterparty in that retail market. In that case the transaction price (zero) would represent the fair value of the swap to Entity A at initial recognition, i.e. the price that Entity A would receive to sell or pay to transfer the swap in a transaction with bank counterparty in the principal market. That price would not be adjusted for any incremental (transaction) costs that would be charged by that bank counterparty.

From the perspective of Entity B, the interbank market is the principal market for the swap. If Entity B was to transfer its

rights and obligations under the swap, it would do so with a bank in that market. Because the market in which Entity B

initially entered into the swap is different from the principal market, the transaction price (zero) would not necessarily

represent the fair value of the swap to Entity B at initial recognition. If the fair value differs from zero, Entity B has a

day 1 gain or loss (for the recognition of day 1 gains or losses, see the discussion below).

5.4. Market participant

The above discussion regarding the market in which an entity may transact is sometimes theoretical as many items are rarely bought or sold on a standalone basis. Moreover, many liabilities include restrictions that prevent their transfer. Even then, fair value measurement is still made from the perspective of market participant.

For example, when measuring the fair value of customer-related intangible assets acquired in a business combination that is accounted for in accordance with IFRS 3 Business Combinations, the acquirer considers types of potential market participants (e.g. a financial investor, or a competitor). As there may be no apparent exit market for a customer relationship intangible asset, management may consider whether there are strategic buyers that would benefit from the customer relationships.

It is common for entities to build up their customer base in correlation with efforts made to expand their business. Hence, the entity can identify potential participants in its industry, assuming that the market participant is acting to enhance its business activities, and from there determine hypothetical market participants. An entity should make assumptions that are consistent with a market participant’s (economic) perspective. That is, a market participants’ interest is to maximise the price received on selling assets and to minimise the price paid to transfer liabilities.

IFRS 13.23 notes that the process of considering potential market participants need not relate to specific market participants.

Instead an entity should develop a profile of potential market participants. The profile should consider factors specific to the asset or liability, the principal (or most advantageous) market for the asset or liability, and market participants with whom the entity would transact with in that market.

In accordance with the definition in IFRS 13.A, market participants are considered to be knowledgeable regarding the asset or liability being valued. For this to be the case, market participants will usually perform various procedures (e.g. due diligence) within a reasonable period allowed by the seller. The seller itself is a market participant, and in order to achieve an orderly transaction (refer section 4.3) must allow for marketing activities that are usual and customary for transactions involving such item.

BDO comment

The completion of due diligence by a potential buyer is also essential to the seller, as the seller will not accept a price deduction

due to potential buyer not receiving all relevant information.

5.5. The price

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (i.e. an exit price) regardless of whether that price is directly observable or estimated using another valuation technique (IFRS 13.24). Therefore under IFRS 13, fair value is reflective of a market-based measurement, taken from a market participant’s perspective.

Consequently, fair value cannot be specific to the entity measuring the asset or liability, as the intention of the entity itself is irrelevant. For example, an entity may for instance intend to:

– Use or sell an asset

– Extinguish or transfer a liability.

These intentions are entity specific, and therefore irrelevant in determining market participant’s perspectives and assumptions.

Under IFRS 13, fair value is based on the exit price (see above), and not the transaction price or entry price (the price that was paid for the asset or that was received to assume the liability). Conceptually, entry and exit prices are different. The exit price concept is based on the current (i.e. as at measurement date) expectations about the sale or transfer price from the perspective of market participants.

There are arguments against the use of exit prices, including that exit prices are irrelevant when an entity intends to use the asset. However, even in these instances, exit prices are still appropriate, as the exit price reflects expectations about future cash flows by selling the asset to a market participant who would then also use the asset. This is because a market participant will not pay an amount which is greater than it expects to generate from the use or sale of the asset

(IFRS 13.BC39).

A similar logic applies to liabilities, in that the price determined by a market participant would reflect expectations about

cash outflows necessary to fulfil the obligations of the liability (IFRS 13.BC40).

5.6. Fair value at initial recognition

Generally, the transaction price (entry price) will equal the fair value (exit price), although (as per above) there is a conceptual difference between the two.

It is therefore important to understand that transaction costs will not cause a difference between entry price and exit price.

For example, consider a transaction in which two market participants participate in an orderly transaction for an asset.

The price paid by the buyer to the seller is CU40. The buyer and the seller pay their personal broker a commission of 2.5%

(i.e. CU1), and 5% (i.e. CU2), respectively:

– From the perspective of the buyer, the entry price is CU40, as the commission paid totalling CU1 is not part of the entry price

– From the perspective of the seller, the exit price is also CU40, as again, the commission paid totalling CU2 is not part of the exit price.

When determining whether fair value at initial recognition equals the transaction price, an entity must take into account factors specific to the transaction and to the asset or liability. IFRS 13.B4 describes situations in which the transaction price may not represent the fair value of an asset or a liability at initial recognition. These situations and others may include:

– Transactions between related parties

– Transactions that take place under duress or under a forced sale (e.g. the seller is experiencing financial difficulty or the acquirer is obliged to purchase the asset or assume the liability because of law or a court decision)

– The unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value (the asset or liability measured at fair value is only one of the elements in the transaction such as in a business combination)

– The market in which the transaction takes place is different from the principal market (or most advantageous market).

The existence of any of the factors above does not constitute conclusive evidence of a difference between fair value and the transaction price. For instance, the definition of fair value (see above) regarding a transaction between related parties can permit the use of the transaction price as an input to the calculation.

Any difference between the transaction price and fair value is commonly known as a day one gain or loss. The International Accounting Standards Board (IASB) decided that determining whether or not to recognise a day one gain or loss was beyond the scope of the fair value measurement project.

As a result, if another IFRS requires or permits an entity to measure an asset or a liability initially at fair value, and the

transaction price differs from fair value, the entity either will or may recognise the resulting gain or loss in profit or loss unless

that IFRS specifies otherwise (e.g. financial instruments not subject to Level 1 fair value measurement, and profit from a

transaction with a controlling entity which is not at fair value might be recognised directly in equity).

Example 5.6(a): Accounting for differences between the transaction price and fair value

Entity B is a wholly owned subsidiary of Entity A. Entity A is engaging in constructing and marketing of office buildings.

Entity B is in the investment property sector. Entity A has just finished marketing 29 out of 30 floors of an office building, each of which has been sold for CU5 million. The last floor is then purchased by Entity B for CU4 million. Assuming that the fair value of each floor is CU5 million, in accordance with paragraph 4.25 of the Framework For Financial Reporting (the

‘Conceptual Framework’), the difference between transaction price and fair value (i.e. CU1 million) is accounted for by Entity B as capital contribution from Entity A, and is recognised directly in equity.

Financial instruments are measured at fair value at initial recognition. Both IFRS 9 Financial Instruments and IAS 39 Financial Instruments: Recognition and Measurement address the issue of day one gains or losses. Prior to the publication of IFRS 13, IFRS 9 and IAS 39 required that day one gains or losses were not to be recognised in profit or loss, unless:

a) The fair value is evidenced by a quoted price in an active market for identical asset or liability, or b) The fair value is based on a valuation technique whose variables include only observable data.

IFRS 13 did not change these requirements, but amendments were made to IAS 39 and IFRS 9 to clarify that the fair value of financial instruments at initial recognition should be measured in accordance with IFRS 13 and that any deferred amounts arising from the application of the recognition threshold in IAS 39 and IFRS 9 (i.e. an unrecognised day one gain or loss) are separate from the fair value measurement. The effect of this is that a valuations model would be calibrated to arrive at the transaction price, with inputs to the valuations model only being adjusted for changes to valuation inputs that arise subsequent to the date of initial recognition (IFRS 13.64).

Other IFRSs under which a day one gain or loss might be recognised are:

a) IFRS 3 Business Combinations (gain on bargain purchase)

b) IAS 41 Agriculture.

5.7. Non-financial assets

IFRS 13 requires the fair value of a non-financial asset to be measured based on its highest and best use (HBU) from a market participant’s perspective. This requirement does not apply to financial instruments, liabilities or equity.

The concept of HBU is not new, although it has not explicitly been part of IFRS (the basis for conclusions to IAS 40 Investment Property, prior to the issue of IFRS 13, made reference to International Valuation Standards which include HBU as a general valuation concept). The specific inclusion of HBU has resulted in a convergence of IFRS with valuation standards and practices.

IFRS 13.28 states that HBU of a non-financial asset takes into account the use of the asset that is physically possible, legally permissible, and financially feasible, as follows:

(a) A use that is physically possible takes into account the physical characteristics of the asset that market participants would take into account when pricing the asset (e.g. the location or size of a property)

(b) A use that is legally permissible takes into account any legal restrictions on the use of the asset that market participants would take into account when pricing the asset (e.g. the zoning regulations applicable to a property) (c) A use that is financially feasible takes into account whether a use of the asset that is physically possible and legally

permissible generates adequate income or cash flows (taking into account the costs of converting the asset to that use) to produce an investment return that market participants would require from an investment in that asset put to that use.

HBU is determined from the perspective of market participants (IFRS 13.29). Therefore, the intentions and the use of the non-financial asset by the reporting entity are irrelevant in determining fair value. However, IFRS 13.29 also states that an entity need not perform an exhaustive search for other potential uses of a non-financial asset if there is no evidence to suggest that the entity’s current use of an asset is not its HBU.

Example 5.7(a): Entity vs. market participant considerations (alternative use)

Entity A currently owns an office building that is accounted for as an investment property in accordance with IAS 40. Due to a shortage of residential buildings in the area (reflected by increased rental rates able to be charged by lessors), it is possible that the fair value of the building would be maximised by changing its use to that of a residential building. However, in order for the type of use to be changed, local regulatory approval would be required as well as significant subsequent redevelopment of the building. The alternative use (i.e. as a residential building) is required to be considered in Entity A’s fair value measurement if, and only if, market participants would also consider that alternative use when pricing the asset.

In such cases, in determining the fair value consideration needs to be given to the level of uncertainty associated with

obtaining regulatory approval for the change in use, as well as the related future capital expenditure and future cash flows to

be derived from the building. Prior to the introduction of IFRS 13, IAS 40.51 did not permit such cash flows to be considered

in determining the fair value of an investment property.

Example 5.7(b): Entity vs. market participant considerations (financial feasibility)

Entity A owns vacant land, which is measured at fair value, and is unable to secure funding to finance development of the vacant land. This inability is forecast to continue for the foreseeable future. While Entity A may be (financially) unable to carry out development of the vacant land, other market participants might be able to do so and therefore would consider the future development of the vacant land in pricing the asset. In this situation, the future capital expenditure and future cash flows from developing the vacant land would be considered in determining the fair value of the vacant land for the purposes of Entity A’s financial statements (as these factors would be considered by market participants).

Example 5.7(c): Entity vs. market participant considerations (defensive values)

Entity A purchases an intangible asset for its ‘defensive value’ (e.g. a competitor’s brand purchased in a business combination).

The rationale for the purchase is that the acquirer wishes to acquire the asset to prevent it from being used by competitors.

The defensive value of the intangible asset would not be relevant to the calculation of the asset’s fair value (other than in the relatively rare circumstances that other market participants would also use the asset in a defensive manner).

In circumstances where assets are held for defensive purposes, it will often be the case that:

– The value in use of the defensively held asset is lower than its fair value (as the asset is not currently being used), and – The benefit (which is indirect) from defensively holding the asset is equal to or higher than its fair value (this is implicit, as

otherwise the entity would not have purchased it).

These two amounts are often irrelevant in determining fair value, as a market participant’s intention would typically be to

use the asset in the ordinary course of business.

As noted above, an entity will often use non-financial assets in a manner which reflects their HBU and this is presumed by IFRS 13 (IFRS 13.29). Therefore, it is only necessary to consider alternative uses of those assets where there is evidence that their current use is not consistent with their HBU. Common examples of non-financial assets are described below.

Example 5.7(d): Land

An entity acquires land as part of a transaction that meets the definition in IFRS 3 of a business combination. The land is currently developed for industrial use as a site for a factory. The current use of land is presumed to be its HBU unless market or other factors suggest a different use. In this case, nearby sites have recently been developed for residential use as sites for high-rise apartment buildings. On the basis of that development, recent zoning and other changes to facilitate that development, the entity determines that the land currently used as a site for a factory could be developed as a site for residential use (i.e. for high-rise apartment buildings) because market participants would take into account the potential to develop the site for residential use when pricing the land.

The HBU of the land would be determined by comparing both of the following:

(a) The fair value of the land as currently developed for industrial use (i.e. the land as used in combination with other assets, such as the factory, or with other assets and liabilities)

(b) The value of the land as a vacant site for residential use, taking into account the costs of demolishing the factory and other costs (including the uncertainty about whether the entity would be able to convert the asset to the alternative use, including obtaining any necessary permission from the authorities) that would be incurred in converting the land to a vacant site (i.e. the land as used on a stand-alone basis).

The fair value of the land would be determined on the basis of the HBU. In situations involving real estate appraisal, the determination of HBU might take into account factors relating to the factory operations, including its assets and liabilities.

BDO comment

The HBU concept is relevant not only for the current use of the non-financial asset (e.g. lock up, use, lease, or held for sale).

When using the asset, the entity will evaluate whether the HBU is achieved alone or in combination with other assets/liabilities (see also below).

If the fair value of the land is maximised on the basis of it being a vacant site, this implies that the value of the factory itself

is zero (other than scrap value).

Example 5.7(e): Research and development project

An entity acquires a research and development (R&D) project in a business combination. The entity does not intend to complete the project. If completed, the project would compete with one of its own projects (to provide the next generation of the entity’s commercialised technology). Instead, the entity intends to hold (i.e. lock up) the project to prevent its competitors from obtaining access to the technology. In doing this, the acquired project is expected to provide defensive value, principally by improving the prospects for the entity’s own competing technology. To measure the fair value of the project at initial recognition, the HBU of the project would be determined on the basis of its use by market participants.

For example:

(a) Continue development: The HBU of the R&D project would be to continue development if market participants would continue to develop the project and that use would maximise the value of the group of assets or of assets and liabilities in which the project would be used (because the asset would be used in combination with other assets or with other assets and liabilities). That might be the case if market participants do not have similar technology, either in development or commercialised. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project, assuming that the R&D would be used with any associated assets and liabilities and that those assets and liabilities would be available to market participants.

(b) Cease development (‘lock up’): The HBU of the R&D project would be to cease development if, for competitive reasons, other market participants would lock up the project and that use would maximise the value of the group of assets or of assets and liabilities in which the project would be used. That might be the case if market participants have technology in a more advanced stage of development that would compete with the project, if it was completed, and the project would be expected to improve the prospects for their own competing technology if locked up. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project, assuming that the R&D would be used (i.e. locked up) with its complementary assets and the associated liabilities and that those assets and liabilities would be available to market participants.

(c) Cease development (not economically viable): The HBU of the R&D project would be to cease development if market participants would discontinue its development. That might be the case if the project is not expected to provide a market rate of return if completed and would not otherwise provide (defensive or other) value if locked up. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project on its own (which might be zero).

When determining HBU, an entity should include all costs that market participants would incur. For example, land may currently be being utilised for farming purposes, however other alternative uses may currently be under consideration (e.g. commercial or residential property). In such a situation, two different values should be estimated to derive the HBU of the land:

1. Value through continuing current use: Value should reflect the benefits of continuing to operate the land for farming, and 2. Value through an alternative use for the land : Value should include all costs (e.g. legal costs, viability analysis, traffic

studies), associated with re-zoning the land to the alternative use.

In addition, demolition and other costs associated with preparing the land for alternative use should be included in the

estimate of fair value. An effort to re-zone land contains an element of uncertainty related to whether the proposed re-

zoning obtains approval. The fair value of the land should reflect the uncertainty. Therefore associated re-zoning costs

should not be considered if approval for re-zoning is unlikely to succeed.

HBU in combination with other assets/liabilities

The HBU of a non-financial asset might be achieved in combination with a group of other assets or with a group of other assets and liabilities (IFRS 13.31). In such cases:

– Fair value is based on the use of the asset in such an asset/liability group. It is assumed that the asset would be used within such a group and that the other assets and liabilities would be available to market participants

– The asset/liability group cannot include liabilities that are used to fund assets outside that group – Assumptions about HBU should be consistent for all non-financial assets in such a group

– Such an asset/liability grouping does not have to be consistent with the level of aggregation or disaggregation specified in other IFRSs.

Example 5.7(f): Asset group

An entity acquires assets and assumes liabilities in a business combination, including assets A, B and C. Asset C is billing software integral to the business developed by the acquired entity for its own use along with Assets A and B (i.e. the related assets). The entity measures the fair value of each of the assets individually, consistently with the specified unit of account for the assets. The entity determines that the HBU of the assets is their current use and that each asset would provide maximum value to market participants principally through its use in combination with other assets (or with other assets and liabilities).

In this situation, the entity would assess the assets in the context of the market in which they were initially acquired (i.e. the entry and exit markets from the perspective of the entity are the same). Market participant buyers with whom the entity would enter into a transaction in that market have characteristics that are generally representative of both strategic buyers (e.g. competitors) and financial buyers (investors that do not have complementary investments) and include those buyers that initially bid for the assets.

Differences between the indicated fair values of the individual assets relate principally to the use of the assets by those market participants within different asset groups:

a) Strategic buyer: The entity determines that strategic buyers have related assets that would enhance the value of the group within which the assets would be used. Those assets include a substitute for Asset C, which would be used for only a limited transition period and could not be sold on its own at the end of that period. Because strategic buyers have substitute assets, Asset C would not be used for its full remaining economic life. The fair values of Assets A, B and C within the strategic buyer asset group which reflecting the synergies from the use of the assets within that group are CU360, CU260 and CU30, respectively. The indicated fair value of the assets as a group is therefore CU650.

b) Financial buyer: The entity determines that financial buyers do not have substitute assets that would enhance the value of the group within which the assets would be used. As financial buyers do not have substitute assets, Asset C would be used for its full remaining economic life. The fair values of Assets A, B and C within the financial buyer asset group are CU300, CU200 and CU100, respectively. The indicated fair value of the assets as a group is therefore CU600.

The fair values of Assets A, B and C would be determined on the basis of the use of the assets as a group within the strategic

buyer group (CU360, CU260 and CU30), as this is their HBU. Although the use of the assets within the strategic buyer

group does not maximise the fair value of each of the assets individually, it maximises the fair value of the assets as a group

(CU650 vs. CU600).

5.8. Liabilities and own credit risk (including equity issued by the entity)

The general principle for measuring the fair value of liabilities (and an entity’s own equity instruments) in accordance with IFRS 13.34 is that fair value assumes that a financial or non-financial liability or an entity’s own equity instrument (e.g. equity interests issued as consideration in a business combination) is transferred to a market participant at the measurement date.

The transfer (leading to an exit price) of a liability or an entity’s own equity instrument assumes the following:

(a) A liability would remain outstanding and the market participant transferee would be required to fulfil the obligation.

The liability would not be settled with the counterparty or otherwise extinguished on the measurement date (b) An entity’s own equity instrument would remain outstanding and the market participant transferee would take on

the rights and responsibilities associated with the instrument. The instrument would not be cancelled or otherwise extinguished on the measurement date.

The concept of a transfer of liabilities (i.e. that subsequently the liability will ‘belong’ to the counterparty) is essential to the previously discussed exit price concept of IFRS 13. The notion of transfer price is coherent with the fair value of liabilities, as this is the price which one market participant is willing to pay another market participant to relieve them from fulfilling the liability. Naturally, the market participant transferee will settle only for a price that, which in their perspective, is representative of the expected cash outflows to fulfil the obligation, or the cash outflows to subsequently transfer the liability on to another market participant.

Prior to IFRS 13, the fair value of a liability was defined as the amount for which a liability could be settled, between knowledgeable, willing parties in an arms-length transaction (IFRS 3 Appendix A).

The Conceptual Framework paragraph 4.17 also notes that:

‘The settlement of a present obligation usually involves the entity giving up resources embodying economic benefits in order to satisfy the claim of the other party. Settlement of a present obligation may occur in a number of ways, for example, by:

(a) Payment of cash (b) Transfer of other assets (c) Provision of services

(d) Replacement of that obligation with another obligation, or (e) Conversion of the obligation to equity.

An obligation may also be extinguished by other means, such as a creditor waiving or forfeiting its rights.’

As the notion of transferring a liability is not mentioned among the above alternate examples of settlement in the Conceptual Framework, it was not clear whether settlement value referred to transfer value or the extinguishment value.

IFRS 13 now clarifies that the definition of fair value (IFRS 13.9) is made with reference to the transfer value rather than the extinguishment value.

BDO comment

It should be noted that extinguishment value is not necessarily the transfer value. In some cases, an additional risk premium above the expected pay-out may be required due to the uncertainty regarding the ultimate amount of the liability. The risk premium paid to a third-party may differ from the settlement value that the direct counterparty would be willing to accept. In addition, the party assuming a liability may have to incur certain costs to manage the liability or may require a profit margin.

It is worth noting that it may be cheaper for an entity to serve or fulfil an obligation rather than just transfer it to a market participant. This is because the entity may have an efficiency advantage over a market participant regarding its own obligation and the margin that the counterparty would demand for assuming the liability. This advantage is not recognised in profit or loss at measurement date, but will instead be recognised through lower costs or lower payments during execution/settlement of the obligation.

In practice, there may be significant differences between settlement value and transfer value. Among the differences is the

impact of credit risk, which is often not considered in the settlement of a liability.

The potential difference between settlement value and transfer value can be illustrated with the following example:

Example 5.8(a): Interest rate swap at initial recognition (based on IFRS 13.IE24-26)

Entity A has a bank loan, with a face value of CU500, which attracts a market rate of interest. Nevertheless, due to market concern regarding non-performance risk of entity A, that market value of the loan is lower than its face value (i.e. CU480). As the Bank will not agree (at least not in normal course of business) to discount the amount paid by entity A for extinguishing the loan, entity A will pay CU500 (the full face value), which is the settlement value.

The transfer value is the price of a hypothetical transaction between entity A and market participant (B) that is seeking financing similar to the bank loan, with a similar credit profile (as noted in IFRS 13.42). Market participant B is indifferent about whether finance is obtained through a new bank loan (similar to entity A’s loan) or assuming entity A’s loan. Market participant B has the same credit profile as entity A.

Due to the non-performance risk of entity A, the market value of the loan is only CU480. Because B has the same credit profile as A, if B were to take out a loan, the bank would only lend only the lower amount of CU480 in return for the same cash flows as are due in respect of entity A’s existing loan. This is because the bank would require a higher interest rate to compensate it for the increased credit risk. Therefore, the transfer value is CU480.

This price is also the fair value for a market participant holding the identical liability as an asset, consistent with the guidance of measuring such liabilities in IFRS 13.37 (see below).

IFRS 13 assumes that non-performance risk is the same before and after the transfer of a liability. This assumes that the hypothetical transaction for the transfer of the liability is executed between equivalent entities, with the same credit status.

The basis for conclusions (IFRS 13.BC94) notes that:

‘In a fair value measurement, the non-performance risk related to a liability is the same before and after its transfer. Although the IASB acknowledges that such an assumption is unlikely to be realistic for an actual transaction (because in most cases the reporting entity transferor and the market participant transferee are unlikely to have the same credit standing), the IASB concluded that such an assumption was necessary when measuring fair value for the following reasons:

(a) A market participant taking on the obligation would not enter into a transaction that changes the non-performance risk associated with the liability without reflecting that change in the price (e.g. a creditor would not generally permit a debtor to transfer its obligation to another party of lower credit standing, nor would a transferee of higher credit standing be willing to assume the obligation using the same terms negotiated by the transferor if those terms reflect the transferor’s lower credit standing)

(b) Without specifying the credit standing of the entity taking on the obligation, there could be fundamentally different fair values for a liability depending on an entity’s assumptions about the characteristics of the market participant transferee (c) Those who might hold the entity’s obligations as assets would consider the effect of the entity’s credit risk and other risk

factors when pricing those assets (see paragraphs BC83–BC89).’

IFRS 13 provides a hierarchy of methods for establishing the fair value of a liability. IFRS 13.37 notes that:

‘When a quoted price for the transfer of an identical or a similar liability or entity’s own equity instrument is not available and the identical item is held by another party as an asset, an entity shall measure the fair value of the liability or equity instrument from the perspective of a market participant that holds the identical item as an asset at the measurement date.’

In comparison with assets, observable active markets for an entity’s liabilities and equity instruments issued are much less likely to exist in practice. This is due to contractual and legal restrictions on liability and equity transfers.

Even for quoted debt or equity securities, the market serves as an exit mechanism for the investor, rather than for the issuer. As a result, the quoted price reflects the exit price from the investor’s perspective only. IFRS 13 distinguishes such situations from the situation in which an exit market exists directly for the liability (or equity) instrument. When a quoted transfer price is not available from the issuer’s perspective, but the instrument is held by an investor as an asset, the fair value measurement should be from the investor perspective.

IFRS 13.BC89 explains that the fair value from the perspectives of investor and issuer must be the same in an efficient market, as any arbitrage situation would be eliminated. For example:

Assuming that the fair value of transferring a liability is lower than the fair value of the corresponding asset:

– In this instance, by transferring of the liability (for lower price) the entity would then issue more instruments as investors are willing to pay more for the corresponding asset. Therefore, the price for the liability and the price for the asset would adjust until the arbitrage opportunity was eliminated.

Assuming that the fair value of transferring a liability is higher than the fair value of the corresponding asset:

– In this instance, a market participant would acquire the liabilities from other parties (for a higher price received) and use the funds to purchase the corresponding asset (for a lower price paid). Therefore, the price for the liability and the price for the asset would adjust until the arbitrage opportunity was eliminated.

The IASB also considered whether measuring the fair value of the asset rather than the fair value of the liability would result

in different fair values because, for example, the asset is liquid whereas the liability may not be. In practice, it is typically

easier for an asset holder to sell to market participants, than for the issuer of the liability to transfer the liability to market

participants. The IASB eventually decided that no conceptual reason exists to explain the difference in the fair values.