Understanding fair value measurement is critical for accurate financial reporting, yet the topic can seem complex.
This post breaks down fair value measurement in a straightforward way, explaining the key valuation techniques and the input hierarchy under IFRS accounting standards.
You'll learn the core approaches to fair value measurement, see illustrative examples of how each level of the hierarchy works, and come away with clarity on this important concept.
Introduction to Fair Value Measurement
Fair value refers to the estimated price that would be received when selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Using fair value enables companies to measure assets and liabilities consistently, enhancing comparability and transparency of financial reporting.
What is Fair Value?
Fair value is defined in IFRS 13 as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It is an exit price from the perspective of market participants that hold the asset or owe the liability.
Some key points about fair value:
- It is a market-based measurement, not an entity-specific measurement
- It should consider the characteristics of the asset/liability if market participants would take those into account when pricing the asset/liability
- It is measured at a specific date - the measurement date
- It assumes an orderly transaction between market participants, not a forced liquidation sale
In short, fair value aims to estimate a price for an asset or liability based on what the current market conditions and participants demand.
Why is Fair Value Important?
Using fair values is viewed as providing more relevant information for financial statement users for certain assets and liabilities. Historical costs may not reflect current market conditions that impact the value of assets/liabilities.
Fair value also enhances comparability between entities that hold similar assets/liabilities. It is a market-based measure rather than an entity-specific one. This allows financial statement users to better compare businesses within an industry.
Additionally, fair value provides more transparency into the current worth of a company's assets and liabilities. This gives investors, creditors, and others a clearer picture of financial position.
Understanding the Fair Value Hierarchy Under IFRS
IFRS 13 establishes a fair value hierarchy that categorizes the inputs used in fair value measurement into three levels:
- Level 1 - Quoted prices in active markets for identical assets and liabilities
- Level 2 - Inputs other than quoted market prices included in Level 1 that are observable, either directly or indirectly
- Level 3 - Unobservable inputs
The level of input dictates the level of the fair value hierarchy. The highest priority is given to Level 1 as it reflects current actual market prices. The lowest priority is Level 3 which requires significant management judgement and estimation.
This hierarchy aims to provide increased consistency and comparability in fair value measurements. It also indicates the relative subjectivity in estimating fair values.
What is the hierarchy of fair value measurement?
The fair value hierarchy gives priority to quoted prices in active markets for identical assets or liabilities as the most reliable evidence of fair value (Level 1). If such quoted prices are not available, priority is given to observable inputs for the asset or liability either directly or indirectly (Level 2). If observable inputs are not available, unobservable inputs are used to measure fair value, but this gives rise to uncertainty in the fair value measurement (Level 3).
The three levels of the fair value hierarchy under IFRS 13 are:
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Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. This gives the most reliable evidence of fair value.
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Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Examples include quoted prices for similar assets or liabilities in active markets, quoted prices for identical assets or liabilities in inactive markets, inputs other than quoted prices that are observable for the asset or liability, and market-corroborated inputs.
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Level 3 - Unobservable inputs for the asset or liability. The entity develops these unobservable inputs using the best information available in the circumstances.
The fair value hierarchy gives the highest priority to Level 1 inputs and the lowest priority to Level 3 inputs. Entities should aim to maximize the use of relevant observable inputs (Level 1 and 2) and minimize the use of unobservable inputs (Level 3) when measuring fair value.
What are the valuation techniques for fair value measurement?
ASC 820-10-35-24A outlines three main valuation approaches for determining fair value:
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Market approach - Uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. Common techniques include matrix pricing and comparable public company analysis.
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Income approach - Converts future cash flows or income to a single present value. Valuation techniques include discounted cash flow models and dividend discount models.
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Cost approach - Reflects the amount that would be required currently to replace the service capacity of an asset. This approach often uses replacement cost or reproduction cost as an indicator of fair value.
Each approach has its own strengths and weaknesses depending on the situation. For example, the market approach works well when there is an active market with frequent transactions, but lacks precision when the market data is limited. The income approach can capture important fundamental factors, but relies heavily on assumptions and estimates of future performance.
To increase consistency and comparability, IFRS 13 establishes a fair value hierarchy that categorizes inputs used in valuation techniques into three levels. The fair value hierarchy gives the highest priority to quoted prices in active markets (Level 1) and the lowest priority to unobservable inputs (Level 3).
Which hierarchy establishes a priority of valuation techniques to use when measuring fair value?
ASC 820-10 establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement).
Specifically, the fair value hierarchy under ASC 820-10 has three levels:
- Level 1 - Quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. This provides the most reliable evidence of fair value.
- Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, and inputs other than quoted prices that are observable for the asset or liability.
- Level 3 - Unobservable inputs for the asset or liability. These should be used to measure fair value to the extent that relevant observable inputs are not available. This allows for situations in which there is little market activity for the asset or liability at the measurement date.
In summary, Level 1 inputs provide the most reliable fair value measurement, while Level 3 inputs provide the least reliable. Entities should aim to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.
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What are the 3 approaches of valuation the fair value?
The three main valuation approaches for determining fair value under IFRS 13 are:
- Market Approach
- Income Approach
- Cost Approach
The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. For example, quoted prices for identical assets in active markets would be considered Level 1 inputs under the fair value hierarchy.
The income approach converts future cash flows or income to a single present value. It reflects current market expectations about future amounts. Some examples of valuation techniques included in the income approach are present value techniques, option pricing models, and the multi-period excess earnings method.
The cost approach reflects the amount that would be required currently to replace the service capacity of an asset. This approach may be appropriate for valuing assets that are specialized in nature and rarely sold.
According to IFRS 13, an entity should use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value. The three approaches should be applied consistently from period to period unless a change would result in better estimates of fair value.
IFRS 13 Valuation Techniques
This section outlines the main valuation approaches used to estimate fair value under IFRS 13.
Market Approach: IFRS 13 Valuation Technique
The market approach uses prices and other market data for identical or comparable assets and liabilities. For example, quoted prices in active markets provide reliable evidence of fair value. Other market data like interest rates and yield curves can also be used.
Some key aspects of the market approach under IFRS 13:
- It prioritizes quoted prices in active markets for identical assets or liabilities
- Adjustments may be needed for factors like condition, location, restrictions on sale etc.
- Multiple valuation techniques can be applied within the market approach
Using the market approach requires an active market with available quoted prices and market data. If such data is unavailable, the income or cost approach may be more suitable.
Income Approach: Estimating Future Cash Flows
The income approach converts future cash flows into a single discounted present value to reflect current market expectations. For example, a discounted cash flow model or earnings multiple technique.
Key aspects include:
- Projecting future cash inflows and outflows
- Applying assumptions around growth rates, margins, capex etc.
- Determining an appropriate discount rate
- Converting the future amounts into a net present value
The income approach is useful when an asset generates cash flows largely independent of other assets. Unobservable inputs are often required so income approach valuations may fall under Level 3 of the fair value hierarchy.
Cost Approach: Replacement and Reproduction Costs
The cost approach measures fair value based on the cost to replace an asset's service capacity. This approach is likely to be most appropriate for:
- Specialized assets
- Early stage companies
- Assets with negligible external transactions
- Where income and market approaches cannot be applied
It focuses on current replacement or reproduction costs rather than historical amounts. Key aspects include:
- Identifying replacement asset with substantially the same service potential
- Estimating all necessary costs to construct this replacement asset
- Determining appropriate adjustments for physical deterioration and obsolescence
- Calculating final adjusted current replacement cost
The cost approach relies more on entity-specific inputs rather than observable market data. Therefore these valuations often use Level 3 inputs.
Detailed Breakdown of the Fair Value Hierarchy
IFRS 13 ranks inputs used to measure fair value into 3 levels, with Level 1 representing the most reliable evidence of fair value.
Level 1 Fair Value Hierarchy: Quoted Market Prices
Level 1 inputs are quoted prices in active markets for identical assets and liabilities that the company has access to at the measurement date. For example, quoted prices for stocks listed on the New York Stock Exchange would qualify as Level 1 inputs. These represent the most reliable and observable inputs for determining fair value.
Some examples of Level 1 inputs include:
- Quoted prices for identical assets or liabilities in active markets the company has access to
- Treasury securities and listed equities with quoted market prices
- Exchange-traded derivatives with quoted prices
Level 1 inputs provide the most reliable evidence of fair value and should be used to measure fair value whenever available.
Level 2 Fair Value Hierarchy: Observable Market Data
Level 2 inputs are observable prices and market data, other than quoted Level 1 inputs, for similar assets and liabilities. For example, Treasury yields would qualify as Level 2 inputs for valuing corporate bonds.
Some examples of Level 2 inputs include:
- Quoted prices for similar assets or liabilities in active markets
- Quoted prices for identical assets or liabilities in inactive markets
- Observable inputs other than quoted prices (e.g. interest rates, yield curves, etc.)
- Inputs derived from observable market data
Level 2 inputs are less reliable than Level 1 but still provide significant observable data for determining fair value. Common valuation techniques include matrix pricing, discounted cash flow models, and market multiple approaches.
Level 3 Fair Value Hierarchy: Unobservable Inputs
Level 3 inputs are unobservable data points that market participants would use to value the asset or liability, including internal models and assumptions. For example, future cash flow projections would qualify as Level 3 inputs.
Some examples of Level 3 inputs include:
- Unobservable inputs for the asset or liability
- Internal assumptions and projections
- Discounted cash flow analysis using internal projections
- Investments in private companies
Since Level 3 inputs are unobservable and may be based on internal estimations, they represent the least reliable level of inputs for fair value measurement under IFRS 13.
IFRS 13 Fair Value Measurement Illustrative Examples
This section provides real-world cases showing how fair value is estimated for various assets and liabilities under IFRS 13.
Examples of Level 1 Fair Value Hierarchy: Active Market Valuations
The Level 1 fair value hierarchy utilizes quoted prices in active markets to determine the fair value of assets and liabilities. For example:
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Publicly traded stocks: The fair value would be the quoted market price on the reporting date. No adjustments are required.
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Standardized derivatives contracts: Exchange-traded futures or options contacts have readily observable market prices, requiring no adjustments to estimate fair value.
Examples of Level 2 Fair Value Hierarchy: Adjusted Market Data
The Level 2 hierarchy involves using market data that requires some adjustments to determine fair value. For instance:
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Valuing a bond by using quoted prices for similar instruments and adjusting for differences in credit risk, maturity dates, etc.
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Estimating the fair value of an over-the-counter swap contract by adjusting model inputs like interest rates, volatility, for which market data is observable.
Valuing Complex Financial Instruments Using Level 3 Inputs
Level 3 valuations depend heavily on unobservable inputs due to the complex or unique nature of certain financial assets and liabilities. For example:
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The fair value of distressed debt or private equity investments may require using proprietary valuation models with inputs that reflect management's assumptions and expert judgement.
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Complex derivatives without market data may need to be valued using models that extrapolate inputs based on historical data, requiring significant adjustments and calibration.
In these cases, multiple valuation techniques may be applied to estimate a reasonable fair value range. The inputs and assumptions behind Level 3 fair value estimates should be clearly documented.
Key Takeaways
In summary, fair value aims to provide consistent measurement based on market participant views, using various valuation methods and a standardized hierarchy of inputs.
Core Objective of Fair Value Measurement
The core objective of fair value measurement under IFRS 13 is determining an 'exit price' from the perspective of market participants. This represents the price that would be received when selling an asset or paid to transfer a liability in an orderly transaction between hypothetical market participants at the measurement date.
Key points:
- Fair value aims to measure assets and liabilities from the viewpoint of market participants, not the reporting entity's specific situation
- It seeks to determine an exit price i.e. the price that would be received or paid in an orderly transaction on the measurement date
- This provides consistency in valuation and comparability between entities
Key Valuation Approaches Recap
Companies often use a combination of valuation techniques - including the market, income, and cost approaches - based on the asset or liability being measured.
- Market approach: Uses prices and other relevant information from market transactions involving identical or comparable assets or liabilities
- Income approach: Converts future cash flows to a single present value using discount rates reflecting current market expectations and risks
- Cost approach: Reflects the amount required to replace an asset's service capacity based on current replacement costs
The approach that maximizes observable inputs and market data is preferred.
Understanding the Importance of the Input Hierarchy
The 3-level input hierarchy classifies fair value inputs based on observability, with Level 1 representing quoted prices in active markets.
- Level 1: Quoted prices in active markets for identical assets or liabilities
- Level 2: Inputs other than quoted prices included in Level 1 that are observable directly or indirectly
- Level 3: Unobservable inputs where market data is unavailable
The level of input has a direct impact on the degree of measurement uncertainty. Hence it is critical to understand the input level hierarchy when assessing fair value measurement.
