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Are you ready for IFRS 13?

By David Raggay and Sunil Kansal

IFRS 13 was published by the International Accounting Standards Board (IASB) in May 2011.  It is effective for financial periods beginning on or after January 1, 2013 and has the following key characteristics

            • It defines fair value
            • It establishes a framework for fair value measurement in a single IFRS
            • It requires extensive disclosures about fair value

Background

The concept of fair value measurement and related disclosures has existed for many years in International Financial Reporting Standards (IFRS). Until recently, however there were several concerns about its application:

  • There was limited guidance in IFRS for the application of fair value accounting. In some cases, the guidance was contradictory.
  • One of the recommendations of the G20 on accounting standards was to "achieve clarity and consistency in the application of valuation standards internationally". This in turn prompted further efforts at convergence with US GAAP.

The foregoing was addressed by the Board as part of a wider issue which included off balance sheet financing. Consequently, the following standards were also addressed:

  • IFRS 7 Financial instruments: Disclosures was amended in 2010
  • IFRS 10 Consolidated financial statements was published in May 2011
  • IFRS 11 Joint arrangements, was published in May 2011
  • IFRS 12 Disclosure of interests in other entities was published in May 2011

NEW DEFINITION

Prior to the issue of IFRS 13, Fair Value was defined in IAS 32 Financial Instruments: Presentation as: "the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction"

IFRS 13 defines Fair Value 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". A key focus of the revised definition is the fact that FV is market-based (as opposed to entity-based) and the need to include in the measurement of FV all assumptions which would be considered by market participants.


FAIR VALUE HIERARCHY

The Fair Value Hierarchy was introduced for financial periods beginning on or after January 1, 2009 as an amendment to IFRS 7-Financial Instrument Disclosures. As the foregoing suggests, the impact related only to the disclosures on issues pertaining to financial instruments.

The salient features of the hierarchy are as follows:

  • Level 1 inputs: Quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.
  • Level 2 inputs: Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.
  • Level 3 inputs: Unobservable inputs for the asset or liability.

Under IFRS 13, the hierarchy is applied not just to financial instruments, but to all assets, liabilities and equity. The standard, while not changing the timing for the determination of fair values, provides increased guidance on how to measure fair value when such measurements or disclosures, or those based on fair value, are required or permitted by IFRS.


CAUTION

In addition to the normal scope exclusions relating to standards which specifically address certain issues, (IFRS 2 Share-based Payment & IAS 17 Leases), IFRS 13 does not apply to measurements which are similar to, but not fair value. Such measurements include "net realizable value" and "value in use".

In addition to the foregoing, there are several complexities involved in the standard, including the following:

  • Portfolio Exception -the ability to measure fair value of a group of financial assets and liabilities based on price that would be received to sell a net long position or to transfer a net short position for a particular risk exposure. Certain criteria need to be met to use this exception and there are advantages as well as disadvantages of doing so.
  • Nonperformance risk- the fair value of a liability reflects the effect of non-performance risk. Non-performance risk includes, but may not be limited to, an entity's own credit risk (as defined in IFRS 7 Financial Instruments: Disclosures). Non-performance risk is assumed to be the same before and after the transfer of the liability.
  • Blockage factors- these should not be included in FV measurement
  • Restricted assets & equity instruments- one needs to determine whether the restriction would be taken into account by market participants when pricing the asset.

KEY CONCEPTS

Active market

A market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis

Exit price

The price that would be received to sell an asset or paid to transfer a liability

Highest and best use

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

Most advantageous market

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

Observable inputs

Inputs  that  are  developed  using  market  data,  such  as  publicly

available information about actual events or transactions, and that

reflect  the  assumptions  that  market  participants  would  use  when

pricing the asset or liability.

Principal market

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


In general, the market in which the entity transacts more frequently is also the market with the greatest volume and deepest liquidity. In these instances, the principal market would likely be the same as the most advantageous market (this would be the case with most of the financial instruments), however, when this is not the case, applying IFRS 13 would change the current practice.

For example, those markets might be different if the entity is a swap dealer that enters into transactions with customers in the retail market, but the principal (or most advantageous) market for the exit transaction is with other dealers in the dealer market.

As another example, if an entity previously measured the FV of agriculture produced based on its local market but there is a more deeper and liquid market for the same agriculture produced (for which transport costs are not prohibitive), the latter market would be deemed the principal market and would be used to determine the FV.

Example:

Market A

Market B

Market C

Trade Volume (Units)

60,000

31000

8000

Market Price (per unit)

41

40

46

Transport cost (TC)

-6

-5

-7

Price after TC

35

35

39

Transaction Costs

-3

-4

-6

Net proceeds

32

31

33


Market A is the Principal market because it has the highest volume, however, the most advantageous market is Market C since it has the highest net proceeds. Therefore, quote from the principal market should be used.

The price used to measure fair value should not be adjusted for transaction costs, because such costs are incremental costs of the transaction and thus do not constitute an attribute of the asset or liability itself. However, if the location of the asset or liability is deemed an attribute of the asset or liability (e.g., for a commodity), the price used to determine fair value should be adjusted for any costs necessary to transport it to (or from) its principal or most advantageous market.



CONSIDERATIONS IN THE MEASUREMENT OF FAIR VALUE

The guidance in the standard requires that, inter alia, the following be contemplated:

  • The asset or liability being measured, including its condition, location and any restrictions on sale
  • The principal (or most advantageous) market in which an orderly transaction would take place for the asset or liability
  • For a non-financial asset, the highest and best use of the asset and whether the asset is used in combination with other assets or on a stand-alone basis
  • The assumptions that market participants would use when pricing the asset or liability.
  • The valuation technique(s) appropriate for the measurement, considering the availability of 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 fair value hierarchy within which the inputs are categorised.
  • Transaction costs are not include in fair value, though transportation costs may be under certain circumstances

IFRS 13 specifies how an entity  should  measure  fair  value  and  disclose  information  about  fair  value measurements.    It does not specify when the related financial statement items should be measured at fair value.



WHAT WILL CHANGE?

  • The measurement of the fair value of certain items may change. This could occur for example due to the need to exclude transaction costs or the requirement to apply the "highest and best use" criteria to non-financial assets
  • The principles in the standard also apply to FV disclosures and those based on FV
  • Additional extensive disclosures are required in many areas. The extent of disclosure also increases as the FV inputs fall significantly within levels 2 & 3 of the FV hierarchy.

David Raggay B.Sc., M.Sc., CA is Managing Principal of IFRS Consultants. Sunil Kansal is Head of Global IFRS Desk.

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