Fair value

Fair value

IFRS 13 / ASC 820 summarized and in order :

1.A Quoted market prices

1. Market approach

The following list is ordinal.

Thus, the market approach should be applied first.

If it is not feasible to apply the market approach, the cost approach should be applied second.

If it is not feasible to apply the cost approach, the income approach should be used last.

Similarly, quoted prices should be used before observed prices, an active market before a non-active market and so on.

1.A.i Active market

1.A.ii Non-active market

1.A.i.a Identical items

Financial instruments, industrial or agricultural commodities traded on active markets.

1.A.i.b Similar items

I.e. loan portfolios

1.A.ii.a Identical items

I.e. raw material, merchandise

1.A.ii.b Similar items

I.e. finished goods, land, buildings, machinery, equipment

Level one inputs

IFRS 13.76 | ASC 820-10-35-40: Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.

Level two inputs

IFRS 13..81 | ASC 820-10-35-47: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

IFRS 13..82 | ASC 820-10-35-48: Level 2 inputs include the following: ... (b) quoted prices for identical or similar assets or liabilities in markets that are not active.

1.B Observed market prices

1.B.i Interest rates, yield curves

I.e. interest rate swaps

1.B.ii Implied volatilities

I.e. market traded options

1.B.iii Credit spreads

I.e. commercial loan to rated entity

1.C Market corroborated prices

I.e. licensing arrangement, rental agreement

Level two inputs

IFRS 13.81 | ASC 820-10-35-47: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

IFRS 13.82 | ASC 820-10-35-48: Level 2 inputs include the following: ... (c) inputs other than quoted prices that are observable for the asset or liability, for example:

(i) interest rates and yield curves observable at commonly quoted intervals;

(ii) implied volatilities; and

(iii) credit spreads.

Level two inputs

IFRS 13.81 | ASC 820-10-35-47: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

IFRS 13.82 | ASC 820-10-35-48: Level 2 inputs include the following: ... (d) market-corroborated inputs.

market-corroborated os defined as "Inputs that are derived principally from or corroborated by observable market data by correlation or other means."

For example, IFRS 9.B35 (c) | ASC 820-10-55.21.c: Receive-fixed, pay-variable interest rate swap based on a specific bank’s prime rate. A Level 2 input would be the bank’s prime rate derived through extrapolation if the extrapolated values are corroborated by observable market data, for example, by correlation with an interest rate that is observable over substantially the full term of the swap.


2. Cost approach

2.A Historical cost

2.B Replacement cost

2.C Reproduction cost

The price paid/received to buy/sell an item in a past market transaction.

Since it involves past events, historical cost is not, generally, a fair value issue.

Fair value is defined 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."

In contrast, historical cost is the price was received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Thus, since it relates to transactions that have not yet occurred, fair value generally needs to be estimated.

When fair value is derived from a price on an active market, no estimate is necessary.

In contrast, since it relates to transactions that have already occurred, historical cost does not generally need estimation.

Although there are exceptions. For example, in non-monetary transactions such as barter sales or exchanges for a financial instrument, the fair value of the items exchanged does need to be determined.

Nevertheless, it is included in this list because it is by far the most common way to value most items.

The cost to replicate the functionality of asset using current (modern) materials, designs, technologies and production techniques.

The cost to replicate the asset using past (historical) materials, designs, technologies and production techniques.

Level one or two inputs

Level two or three inputs

If the item had been acquired on an active market, its cost would be consistent with a level one input.

IFRS 13.76 | ASC 820-10-35-40: Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.

If the item had not been acquired on an active market, its cost would be consistent with a level two input.

IFRS 13..81 | ASC 820-10-35-47: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

IFRS 13..82 | ASC 820-10-35-48: Level 2 inputs include the following: ... (b) quoted prices for identical or similar assets or liabilities in markets that are not active.

Replacement or reproduction cost can be determine using level two inputs, if comparable assets are sold on the market, or level three inputs, if it built, manufactured or otherwise replicate the asset. These costs can be both eternal (quoted by subcontractors) or internal (estimates of own materials, wages, overhead, etc.).

IFRS 13..81 | ASC 820-10-35-47: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

IFRS 13.82 | ASC 820-10-35-48: Level 2 inputs include the following: ... (b) quoted prices for identical or similar assets or liabilities in markets that are not active.

IFRS 13.86 | ASC 820-10-35-52: Level 3 inputs are unobservable inputs for the asset or liability.

IFRS 13.87 | ASC 820-10-35-52: Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. ...

IFRS 13.89 | ASC 820-10-35-54A: An entity shall develop unobservable inputs using the best information available in the circumstances, which might include the entity’s own data. ...

IFRS 13.87 | ASC 820-10-35-52: ... However, the fair value measurement objective remains the same, ie an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. ...


3. Income approach

3.A Pricing models

3.B Present value techniques

3.C Multi-period excess earnings

IFRS 9.B11.b | ASC 920-10-55-3G.b mention: option pricing models, such as the Black-Scholes-Merton formula or a binomial model (ie a lattice model), that incorporate present value techniques and reflect both the time value and the intrinsic value of an option.

Also known as discounted cash flow methods, while both generally accepted methods require future cash flows to be estimated and discounted to present value, first method can be applied to a wide range of items, while the second is suitable primarily for financial assets with fixed or predictable cash flows such as bonds, notes, loans and receivables.

Expected present value

Also known as the risk adjusted cash flow method, "the expected present value technique uses as a starting point a set of cash flows that represents the probability-weighted average of all possible future cash flows ... IFRS 9.B23-30 | ASC 820-10-55-13 to 20 provide a discussion of how the method should be applied.

Discount rate adjustment

Also known as the risk adjusted discount rate method, "the discount rate adjustment technique uses a single set of cash flows from the range of possible estimated amounts ... The discount rate used in the discount rate adjustment technique is derived from observed rates of return for comparable assets or liabilities that are traded in the market." IFRS 9.B18-22 | ASC 820-10-55-10 to 12 provide a discussion of how the method should be applied.

Excess earnings attributable to asset after deducting earnings attributable to contributory assets.

While mentioned by IFRS and US GAAP, neither provide an in depth by discussion of this method.

IFRS 13.B11 | ASC 820-10-55-3G merely mention: ... valuation techniques include, for example ... (c) the multi-period excess earnings method, which is used to measure the fair value of some intangible assets.

While IFRS 13.B3.d | ASC 820-10-55-3.d merely note: an asset’s use in combination with other assets or with other assets and liabilities might be incorporated into the valuation technique used to measure the fair value of the asset. That might be the case when using the multi-period excess earnings method to measure the fair value of an intangible asset because that valuation technique specifically takes into account the contribution of any complementary assets and the associated liabilities in the group in which such an intangible asset would be used.

Level two inputs

Level three inputs

IFRS 13.81 | ASC 820-10-35-47: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

IFRS 13.82 | ASC 820-10-35-48: Level 2 inputs include the following: ... (c) inputs other than quoted prices that are observable for the asset or liability, for example:

(i) interest rates and yield curves observable at commonly quoted intervals;

(ii) implied volatilities; and

(iii) credit spreads.

IFRS 13.86 | ASC 820-10-35-52: Level 3 inputs are unobservable inputs for the asset or liability.

IFRS 13.87 | ASC 820-10-35-52: Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. ...

IFRS 13.89 | ASC 820-10-35-54A: An entity shall develop unobservable inputs using the best information available in the circumstances, which might include the entity’s own data. ...

IFRS 13.87 | ASC 820-10-35-52: ... However, the fair value measurement objective remains the same, ie an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. ...


Rated note

1/1/X1, XYZ acquired a five-year, zero coupon note with a nominal value of 10,000 from a BB rated company for 7,971. The same day, the yield on 3-year, AAA-rated government debt was 1.33% and the BB spread was 3.31% confirming that the note had been acquired at fair value.

Dr/Cr

7,971 = 10,000 ÷ (1+ 4.64%)5.

1/1/X1 | 1.1.X1

 

 

Note

10,000

 

 

Cash

 

7,971

 

Discount

 

2,029


12/31/X1, XYZ determined that the AAA rate and BB spread were 1.06% and 2.72% respectively, implying a fair value of 8,621.

IFRS 13.B18 | ASC 820-10-55-10: The discount rate adjustment technique uses a single set of cash flows from the range of possible estimated amounts, whether contractual or promised (as is the case for a bond) or most likely cash flows. In all cases, those cash flows are conditional upon the occurrence of specified events (for example, contractual or promised cash flows for a bond are conditional on the event of no default by the debtor). The discount rate used in the discount rate adjustment technique is derived from observed rates of return for comparable assets or liabilities that are traded in the market. Accordingly, the contractual, promised, or most likely cash flows are discounted at an observed or estimated market rate for such conditional cash flows (that is, a market rate of return).

8,621 = 10,000 ÷ (1+ 3.78%)4

12/31/X1 | 31.12.X1

 

 

Discount

370

 

 

Interest income

 

370

Discount

280

 

 

Gain

 

280



P

Amortized cost

Discount rate

Amortization

A = A(A-1) + C

B

C = A x B

1

7,971

4.64%

370

2

8,341

4.64%

387

3

8,72

4.64%

405

4

9,133

4.64%

424

5

9,557

4.64%

443

 

10,000

 

 

 

 

 

 


280 = 8,621 - 8,341

12/31/X2 | 31.12.X2

 

 

Discount

326

 

 

Interest income

 

326



P

Amortized cost

Discount rate

Amortization

A = A(A-1) + C

B

C = A x B

1

8,621

3.78%

326

2

8,947

3.78%

338

3

9,285

3.78%

351

4

9,636

3.78%

364

 

10,000

 

 

 

 

 

 


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