Aug 28, 20229 min read

Fund Accounting Pricing process- IFRS 13 Fair Value Measurement used in Pricing process..

Updated: Dec 27, 2022

Many IFRS standards require you to measure the fair value of some items. Just name the examples: financial instruments, biological assets, assets held for sale and many other.

In the past, there was limited guidance on how to set fair value; the guidance was spread throughout the standards and often very conflicting.

Therefore, IFRS «s Fair Value Measurement was issued. Also, IFRS 13 is a result of a convergence project between IFRS and US GAAP and currently, the rules for measuring fair value are almost the same in IFRS and in US GAAP.

Why IFRS 13

The objectives of IFRS 13 are:

• to define fair value;

• to set out in a single IFRS a framework for measuring fair value; and

• to required is closures about fair value measurements.

Fair value is a market-based measurement, not an entity-specific measurement. It means that an entity:

• shall look at how the market participants would look at the asset or liability under measurement

• shall not take own approach(e.g. use) into account.

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What is fair value?

Fair value is 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 is the notion of an exit price.

When an entity performs the fair value measurement, it must determine all of the

following:

• the particular asset or liability that is the subject of the measurement (consistently with its unit of account)

• for a non-financial asset, the valuation premise that is appropriate for the measurement (consistently with its highest and best use)

• the principal (or most advantages l market for the asset or liability.

• the valuation techniques appropriate for the measurement, considering:

the availability a[data with which to develop inputs that represent the assumptions that market participants would use when pricing the asset or liability; and
the level of the market value hierarchy within which the inputs are categorized.

Asset or liability

The asset or liability measured at fair value might be either: • a stand-alone (individual) asset or liability (for example, a share or a pizza oven) • a group of assets, a group of liabilities, or a group of assets and liabilities (for example, controlling interest represented by more than 5o% of shares in some company, or cash-generating unit being pizzeria).

Whether the asset or liability is stand-alone or a group depends on its unit or account. Unit of account is determined in accordance with the other IFRS standard that requires or permits fair value measurement (for example, IAS 36 Impairment of Assets).

When measuring fair value, an entity takes into account the characteristics of the asset or liability that a market participant would take into account when pricing the asset or liability at measurement date.

These characteristics include for example: • the condition and location of the asset • the restrictions on the sale or use of the asset. Transaction

A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants at the measurement date under current market conditions.

Orderly transaction The transaction is orderly when 2 key components are present: • there is adequate market exposure in order to provide market participants the ability to obtain knowledge and awareness of the asset or liability necessary for a market-based exchange • market participants are motivated to transact for the asset or liability (not forced).

Market participants Market participants are buyers and sellers in the principal or the most advantageous market for the asset or liability, with the following characteristics: • independent • knowledgeable • able to enter into transaction • willing to enter into transaction. Principal vs. the most advantageous market

A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place either: • in the principal market for the asset or liability; or • in the absence of a principal market, in the most advantageous market for the asset or liability.

Principial market is the market with the greatest volume and level of activity for the asset or liability. Different entities can have different principal markets, as the access of an entity to some market can be restricted (please watch the video below for deeper explanation).

The most advantageous market is the market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability, after taking into account transaction costs and transport costs.

Application to non-financial assets

Fair value of a non-financial asset shall be measured based on its highest and best use from a market participant's perspective.

The highest and best use takes into account the use of the asset that is: • physically possible — it takes into account the physical characteristics that market participants would consider (for example, property location or size); • legally permissible — it takes into account the legal restrictions on use of the asset that market participants would consider (for example, zoning regulations); or • financially [ possible — it takes into account whether a use of the asset generates adequate income or cashflows to produce an investment return that market participants would require. This should incorporate the costs of converting the asset to that use.

The highest and best use of a non-financial asset may be on a stand -alone basic or may be achieved in combination with other assets and/or liabilities (as a group) When the highest and best use is in an asset/liability group, the synergies associated with the asset/liability group may be reflected in the fair value of the individual asset in a number of ways, for example, by some adjustments via valuation techniques.

Application to financial liabilities and own equity instruments

A fair value measurement of a financial or non-financial liability or an entity’s own equity instruments assumes it is transferred to a market participant at the measurement date, without settlement, extinguishment, or cancellation at the measurement date.

in the first instance, an entity shall set the fair value of the liability or equity instrument by the reference to the quoted market price of the identical instrument, if available.

If the quoted price of identical instrument is not available, then the fair value measurement depends on whether the liability or equity instrument is held by other parties as assets or not:

• If the liability or equity instrument is held by other party as an asset, then

If there is the quoted price in an active market by other party as an asset, then use a valuation technique from the perspective of market participant actors specific for the asset, but not for the liability/equity instrument)
If there is no quoted price in an active market for the identical instrument held by another party, then use other observable inputs or another valuation technique

• If the liability or equity instrument is not held by other party as an asset, then use a valuation technique from the perspective of market participant

This is illustrated in the followings amplified scheme:

Non-performance risk

The fair value of a liability reflects the effect of non-performance risk — the risk that an entity will not fulfill its obligation.

Non-performance risk includes, but is not limited to an entity’s own credit risk.

For example the risk of non-performance can be reflected in the different borrowing rates for different borrowers due to their different credit rating. As a result, they would need to discount the same amount with the different discount rate, thus the present value of a liability would differ.

Transfer restrictions An entity shall not include a separate input or an adjustment to other inputs relating to the potential restriction preventing the transfer of the item to somebody else.

Demand feature The fair value of a liability with a demand feature is not less than the amount payable on demand discounted from the first date that the amount could be required to be paid. Financial assets and financial liabilities with offsetting positions

IFRS 13 requires a market-based measurement, not for an entity-based measurement. However, there is an exception to this rule:

If an entity manages a group of financial assets and financial liabilities on the basis a[ its NET exposure to market risks or counterparty risks, an entity can opt to measure the fair value of that group on the net basis, and that is:

• The price that would be received to sell a net long position (asset) for particular risk exposure, or

• The price that would be paid to transfer a net short profit on (liability) for particular risk exposure.

This is an option and an entity does not necessarily need to follow it. In order to apply this exception, an entity must fulfill the following conditions:

• It must manage the group of financial assets/liabilities based on its net exposure to market/credit risk according to its documented risk management or investment strategy,

• It provides information on that basis about the group of financial assets/liabilities to hey management personnel,

• It measures those financial assets and liabilities of[air value in the statement of financial position at the end of each reporting period (so not at amortized cost, or other measurement basis).

Fair value at initial recognition

When an entity acquires an asset or assumes a liability, the price paid/received or the transaction price is an entry Price.

However, IFRS 13 defines fair value as the price that would be received to sell the asset or paid to transfer the liability and that's an exit price. In most cases, transaction or entry price equals to exit price or fair value. But there are some situations when transaction price is not necessarily the same as exit price or fair value: • The transaction happens between related parties

• The transaction takes place under duress or the seller is forced to accept the price in the transaction

• 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 market in which the transaction takes place is different from principal or the

most advantageous market.

If the transaction price differs from the fair value, then an entity shall recognize the resulting gain or loss to profit or loss unless another IFRS standard specifies other treatment.

Valuation techniques

When determining fair value, an entity shall use valuation techniques:

• Appropriate in the circumstances

• For which sufficient data are available to measure fair value

• Maximizing the use of relevant observable inputs

• Minimizing the use of unobservable inputs.

Valuation techniques used to measure fair value shall be applied consistently.

However, an entity con change the valuation technique or its application, if the change results in equally or more representative of fair value in the circumstances.

An entity accounts for the change in valuation technique in line with IAS 8 as for a change in accounting estimate.

IFRS 13 allows 3 Valuation approaches:

• Market approach reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost).es, or a group of assets and liabilities, such as a business

• Cost approach: reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost).

• Income approach: converts future amounts (e.g. cash flows or income and

expenses) to a single current (i.e. discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts.

Fair Value hierarchy

IFRS13 introduces a fair value hierarchy that categorizes inputs to valuation techniques into 3 levels. The highest priority is given to Level 1 inputs and the lowest priority to Level 3 inputs.

An entity must maximize the use of Levels inputs and minimize the use o[LeveI3 inputs.

Level 1 inputs Level s inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. An entity shall not make adjustments to quoted prices, only under specific circumstances, for example when a quoted price does not represent the fair value (ie when significant event takes place between the measurement date and market closing date).

Level 2 inputs

Level z 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

Level 3 inputs are unobservable inputs for the asset or liability.

An entity shall use Level 3 inputs to measure fair value only when relevant observable inputs are not available.

The following scheme outlines the fair value hierarchy together with examples of

inputs to valuation techniques:

Disclosure

IFRS 13 requires extensive disclosure of sufficient information to asses: • Valuation techniques and inputs used to develop fair value measurement for both recurring and non-recurring measurements; • The effect of measurements on profit or loss or other comprehensive income for recurring fair value measurements using significant Level 3 inputs.

Recurring fair value measurements are those presented in the statement of financial position at the end of each reporting period (for example, financial instruments).

Non-recurring fair value measurements are those presented in the statement of financial position in particular circumstances (for example. an asset held for sale in line with IFRS st.

As the disclosures are really extensive, here, the examples of the minimum requirements are listed: • Fair value measurement at the end of the reporting period;

• The reasons for measurement (for non-recurring)

• The level in which they are categorized in the fair value hierarchy,

• Description of valuation techniques and inputs used;

• And many others.