Chapter 10

Fair value accounting

©2018 John Wiley & Sons Australia Ltd

 Learning objectives

After studying this presentation, you should be able

to:
10.1 reflect on the role of fair value in accounting
10.2 critically evaluate the traditional definition of fair
value
10.3 communicate the key aspects of the new
definition of fair value
10.4 reflect on and justify how fair value should be
determined for assets and liabilities
 Learning objectives

10.5 critically evaluate the three valuation techniques

and the importance of the input hierarchy
10.6 apply the general disclosure requirements for
items measured at fair value
10.7 reflect on issues that arise from the fair value
standard.
Presentation overview
 The role of fair value in accounting

• Fair value used in accounting is ubiquitous,

appearing in many standards including:
– AASB 3/IFRS 3 Business Combinations
– AASB 7/IFRS 7 Financial Instruments: Disclosures
– AASB 102/IAS 2 Inventories
– AASB 116/IAS 16 Property, Plant and Equipment
– AASB 118/IAS 18 Revenue
– AASB 119/IAS 19 Employee Benefits
– IAS 26 Accounting and Reporting by Retirement
Benefit Plans
 The role of fair value in accounting

• Fair value used in accounting is ubiquitous,

appearing in many standards including:
– AASB 133/IAS 33 Earnings per Share
– AASB 134/IAS 34 Interim Financial Reporting
– AASB 136/IAS 36 Impairment of Assets
– AASB 138/IAS 38 Intangible Assets
– AASB 139/IAS 39 Financial Instruments:
Recognition and Measurement
– AASB 140/IAS 40 Investment Property, AASB
141/IAS 41 Agriculture
 The role of fair value in accounting

• The usefulness of fair value as an economic

measure and its relationship to the fundamental
assumptions:
– Conceptual Framework:
• Asset definition:
– Future economic benefit.
• Liability definition:
– Future economic sacrifice.
• Fair value attempts to capture this inherent
value.
 The traditional definition

• ‘The amount for which an asset could be exchanged,

or a liability settled between knowledgeable, willing
parties in an arms-length transaction.’
IFRS 3/AASB 13
 The traditional definition

• Shortcomings:
– Does not specify if the entity is buying or selling
– What does “settling” a liability mean?
• Does not refer to a ‘creditor’
– At what stage of the hypothetical transaction is
fair value measured
– What does willing mean?
• Could one party be desperate?
 AASB 13/IFRS 13 Fair Value Measurement

• Objectives:
(a) to establish a single source of guidance for all
fair value measurements required or permitted
by IFRSs to reduce complexity and improve
consistency in their application;
(b) to clarify the definition of fair value and related
guidance in order to communicate the
measurement objective more clearly; and
 AASB 13/IFRS 13 Fair Value Measurement

• Objectives:
(c) to enhance disclosures about fair value to
enable users of financial statements to assess
the extent to which fair value is used and to
inform them about the inputs used to derive
those fair values.
 AASB 13/IFRS 13 Fair Value Measurement

• Scope:
– When another IFRS requires or permits fair value
measurements or disclosures about fair value
measurements.
• Excluded from the scope:
– Share-based payments.
– Leasing transactions.
– Measurements that may appear similar to fair
value but are not termed as such.
 AASB 13/IFRS 13 Fair Value Measurement

• Fair value defined:

– 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.
(IFRS 13/AASB 13, Para. 9)
 AASB 13/IFRS 13 Fair Value Measurement

• Fair value defined:

– Would:
• Transaction may be hypothetical.
• Even when there is no observable market to
provide pricing information about the sale of an
asset or the transfer of a liability at the
measurement date, a fair value measurement
shall assume that a transaction takes place at
that date.
(IFRS 13/AASB 13, Para. 21)
 AASB 13/IFRS 13 Fair Value Measurement

• The focus on an exit price – why?

– An ‘exit price’ embodies expectations about the
future cash inflows and outflows associated with
the asset or liability from the perspective of
market participants at the measurement date.
• Offers a number of advantages.
 AASB 13/IFRS 13 Fair Value Measurement

• The focus on an exit price – why?

– Advantages:
• It is current:
– It allows users to focus on a value today, not a
historical price that may or may not be
relevant under today’s conditions.
• It is specific:
– It focuses on the asset or liability at hand,
rather than the price to purchase a generic
equivalent item.
 AASB 13/IFRS 13 Fair Value Measurement

• The focus on an exit price – why?

– Advantages:
• It has a level of independence by introducing, if
only hypothetically, an external party into the
transaction.
 AASB 13/IFRS 13 Fair Value Measurement

• The importance of the concept of a market:

– A transaction that assumes exposure to the
market for a period before the measurement date
to allow for marketing activities that are usual and
customary for transactions involving such assets
or liabilities; it is not a forced transaction (e.g. a
forced liquidation or distress sale).
 AASB 13/IFRS 13 Fair Value Measurement

• What are the characteristics of the market:

– An inactive market would be characterised by:
a) Few recent transactions.
b) Price quotations are not developed using
current information.
c) Price quotations vary substantially.
d) Indices that previously were highly correlated
with the fair values of the asset or liability are
demonstrably uncorrelated.
 AASB 13/IFRS 13 Fair Value Measurement

• What are the characteristics of the market:

– An inactive market would be characterised by:
e) The market has gone toxic.
f) There is a wide bid-ask spread.
g) There is a significant decline in the activity.
h) Little information is publicly available.
 AASB 13/IFRS 13 Fair Value Measurement

• What are the characteristics of the market:

– Is it really inactive?
• Assume a market is active, burden of proof on
the accountant to show it is inactive.
– If it is inactive:
• Make adjustments (possibly substantial).
• Use an alternative valuation technique.
 AASB 13/IFRS 13 Fair Value Measurement

• A fair value measurement assumes that the

transaction to sell the asset or transfer the liability
takes place either:
(a) in the principal market for the asset or liability; or
(b) in the absence of a principal market, in the most
advantageous market for the asset or liability.
• But the entity must have access to the market.
 AASB 13/IFRS 13 Fair Value Measurement

• Market participants:
– The fair value of the asset or liability shall be
measured using the assumptions that market
participants would use in pricing the asset or
liability. In developing those assumptions, an
entity need not identify specific market
participants.
Fair values are specific, what factors should
be considered?

• A fair value measurement is for a particular asset or

liability. Therefore, when measuring fair value an
entity shall take into account the characteristics of
the asset or liability if market participants would
take those characteristics into account when pricing
the asset or liability at the measurement date. Such
characteristics include, for example, the following:
– the condition and location of the asset; and
– restrictions, if any, on the sale or use of the asset.
(IFRS 13/AASB 13, Para. 11)
Fair values are specific, what factors should
be considered?

• Discussion of the highest and best use for non-

financial assets:
– A fair value measurement of a non-financial asset
takes into account a market participant’s ability to
generate economic benefits by using the asset in
its highest and best use or by selling it to another
market participant that would use the asset in its
highest and best use.
(IFRS 13/AASB 13, Para. 27)
Fair values are specific, what factors should
be considered?

• Discussion of the highest and best use for non-

financial assets:
– Paragraph 28 of AASB 13/IFRS 13 imposes three
limitations, as determined by the market:
• Physically possible e.g. the location or condition
of the asset.
• Legally permissible e.g. zoning regulations.
– Financially feasible e.g. fiscally sensible to put
the asset to the nominated best use.
Fair values are specific, what factors should
be considered?

• Application to liabilities and equity: general

principles:
– Fair value measurement assumes that a financial
or non-financial liability or an entity’s own equity
instrument (e.g. equity interests issued as
consideration in a business combination) is
transferred to a market participant at the
measurement date.
• (IFRS 13/AASB 13, Para. 31)
Fair values are specific, what factors should
be considered?

• Application to liabilities and equity: general

principles:
– Liabilities can be valued based on the
corresponding asset:
• When public prices aren’t available for the debt
or equity the entity should, where possible,
‘measure the fair value of the liability or equity
instrument from the perspective of a market
participant that holds the identical item as an
asset at the measurement date’.
Fair values are specific, what factors should
be considered?

• Application to liabilities and equity: general

principles:
– If no corresponding asset exists:
• When using a present value technique to measure the fair value of a
liability that is not held by another party as an asset (e.g. a
decommissioning liability), an entity shall, among other things,
estimate the future cash outflows that market participants would
expect to incur in fulfilling the obligation. Those future cash outflows
shall include market participants’ expectations about the costs of
fulfilling the obligation and the compensation that a market
participant would require for taking on the obligation.
(IFRS 13/AASB 13, Appendix B, Para. 31)
 Fair value techniques

• Acceptable valuation techniques:

1. Market approach:
• Comparable transactions.
2. Income approach:
• Present value, option pricing and binomial.
3. Cost approach:
• Current replacement cost.
 Fair value techniques

• Inputs into valuation:

– Observable inputs:
• are those values that can be obtained
independently from available market data,
possibly with some adjustment for the specific
asset, which would be used by market
participants when valuing an asset or liability.
 Fair value techniques

• Inputs into valuation:

– Unobservable inputs:
• are based on information that is not available
to the market but must be inferred or
estimated based on the best information
available.
 Fair value techniques

• The fair value hierarchy:

– Level 1 inputs:
• Quoted prices (unadjusted) in active markets for
identical assets or liabilities.
– Level 2 inputs:
• Inputs other than quoted prices included within
Level 1 that are observable.
– Level 3 inputs:
• Inputs that are not based on observable market
data (unobservable inputs).
 Disclosures

• An entity shall disclose information that helps users

of its financial statements assess both of the
following:
a) For assets and liabilities that are measured at fair
value on a recurring or non-recurring basis in the
statement of financial position after initial
recognition, the valuation techniques and inputs
used to develop those measurements.
(IFRS 13/AASB 13, Para. 91)
 Disclosures

• An entity shall disclose information that helps users

of its financial statements assess both of the
following:
b) For recurring fair value measurements using
significant unobservable inputs (Level 3), the
effect of the measurements on profit or loss or
other comprehensive income for the period.
(IFRS 13/AASB 13, Para. 91)
 Specific issues

• How to deal with transaction costs:

– The transaction costs are considered in
determining which market valuation to use.
– The reason for this is that transaction costs are not
an inherent quality of the item being valued —
they are an artefact of the market.
 Specific issues

• How blocks of assets are dealt with:

– Could be an entity holding a high number of
relatively rare assets e.g. shares and commodities.
– If the entity were to ‘flood’ the market with all its
holdings at one time the expected market
response would be to drop the per unit price.
 Specific issues

• How blocks of assets are dealt with:

– But, AASB 13/IFRS 13, paragraph 69:
• Blockage factor is not permitted in a fair value
measurement.
• The fair value is determined for each asset
individually.
 Specific issues

• Fair value at initial recognitions different to cost:

– Remember we’re using an exit price model.
– Assume entry = exit unless:
• related party transaction
• duress
• complex transaction
• different markets (retail vs. wholesale).
– If different gain or loss TPL:
• unless another standard doesn’t allow.
 Specific issues

• The role for third party valuations:

– Standard does not preclude their use.
– Important to evaluate:
• The issuer of the quote.
• The nature of the quote.
– Is the information current?
– Are any assumptions valid?
– Will have implications for auditors.
 Summary

• The role of fair value in accounting.

• The traditional definition of fair value.
• The key aspects of the new definition of fair value.
• Fair value for assets and liabilities.
• The three valuation techniques and the importance
of the input hierarchy.
• The general disclosure requirements for items
measured at fair value.
• Issues that arise from the fair value standard.