Fair value hierarchy, with inputs prioritised

DOLPHY D'SOUZA | Updated on July 26, 2011


The management must use valuation techniques that are appropriate to the circumstances and for which sufficient data are available.

With the issuance of IFRS 13 Fair Value Measurement and a similar standard under US GAAP, a uniform framework has been created that will reduce complexity in applying the fair value principles and improve consistency across the world.

“Fair value” often means different things to different people. In the context of IFRS, it means 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 (i.e., an exit price).

Fair value is not an entity-specific measurement, but rather is focused on market participant assumptions for a particular asset or liability. For example, an entity may have fair valued land on the assumption that it would build a residential complex. However, if market participants believe that the highest and best use is to build a commercial complex, adopting IFRS 13 could result in a higher fair value than previously determined.

A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place either in the principal market or the most advantageous market. For example, if an entity previously measured the fair value of agricultural produce based on its local market, but there is a deeper and more liquid another market for the same agricultural produce (for which transportation costs are not prohibitive), the latter market would be deemed the principal market and would be used to determine fair value.

IFRS 13 includes a fair value hierarchy which prioritises the inputs in a fair value measurement.

Level 1 applies to assets and liabilities that are quoted in an active market; the quoted prices are used for valuation. In Level 2, inputs (other than quoted prices in Level 1) that are observable for the asset or liabilityare used. Examples are interest rates and yield curves observable at commonly quoted intervals, implied volatilities and credit spreads. In Level 3, unobservable inputs for the asset or liability are used. Example is projected cash flows used to value a business in an entity that is not publicly listed.

IFRS 13 describes three different valuation techniques that may be used to measure fair value :

Market approach uses prices and other relevant information from market transactions involving identical or similar assets or liabilities;

Income approach converts future amounts (e.g., cash flows or income and expenses) to a single current (discounted) amount; and

Cost approach reflects the amount required currently to replace the service capacity of an asset (frequently referred to as current replacement cost, which differs from the cost incurred).

The management must use valuation techniques that are appropriate in the circumstances and for which sufficient data are available. In some cases, this will result in more than one technique being used (for example, using both an income and a market approach to value a business). When measuring fair value, an entity is required to maximise the use of relevant observable inputs and minimise the use of unobservable inputs.

When multiple valuation techniques are appropriate, management evaluates the results and selects the point within any indicated range that is most representative of fair value.

When markets become inactive , the objective of fair value measurement (an exit price in an orderly transaction which is not a distress sale) does not change.

(The author is Partner and National IFRS Leader, Ernst & Young.)

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Published on July 21, 2011

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