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ONE-STOP SHOPPING FOR FAIR VALUE MEASUREMENT (WHAT IS FAIR VALUE AND HOW IS IT CALCULATED)IFRS 13: FAIR VALUE MEASUREMENT

Why Does IFRS 13 Matter to Me?• IFRS 13 Fair Value Measurement is now the single source of IFRS guidance on fair

value measurements.

• IFRS 13 establishes new requirements for the measurement of fair value. The methods of determining fair value you applied in the past may no longer be acceptable.

— You will not need to measure more items at fair value than you currently do because of IFRS 13. Other IFRSs tell you when to measure fair value. IFRS 13 tells you how.

• Changes to the way you measure fair value and enhanced disclosures may initially mean more work.

ISSUE 004 | JUNE 2012

Reporting AlertIFRS

This publication was originally published by The Canadian Institute of Chartered Accountants in 2012. It has been reissued by Chartered Professional Accountants of Canada.

2 Reporting Alert Issue 004 | June 2012

When Is IFRS 13 Effective?• For annual periods beginning on or after January 1, 2013. Earlier application is permitted.

Method of adoption: Prospectively as of the beginning of the annual period in which it is initially applied. IFRS 13 does not require adjusting fair values that were determined in earlier periods in accordance with the standards at that time. As well, the disclosure requirements of IFRS 13 need not be applied to comparative information presented in the period in which the standard is first applied.

What Are the Basics of IFRS 13?

What is IFRS 13?• Defines fair value• Establishes a framework for measuring fair value that applies whenever another IFRS requires or

permits such a measurement (with limited defined exceptions)• Sets disclosure requirements about fair value measurements

Keep in mind that IFRS 13 does not apply to share-based payment transactions accounted for in accor-dance with IFRS 2 Share-based Payment, and leasing transactions within the scope of IAS 17 Leases.

How does IFRS 13 define “fair value”?It 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.” This is also referred to as an exit price. Fair value is a market-based, rather than an entity-specific, measurement. Therefore, the intentions of an entity regarding an asset or liability it currently holds are not relevant.

What are some key concepts to consider in the determination of fair value?The following key concepts may appear straightforward; however, they cause a subtle but significant change in how fair value was previously determined.

Principal or Most Advantageous Market• In determining fair value, assume the asset is sold or the liability is transferred in the principal

market for that item. The principal market is the one with the greatest volume and level of activity for the asset or liability. It is presumed to be the market in which an entity normally enters into transactions for the asset or liability unless there is evidence that another market has greater volume and level of activity.

• If there is no principal market, the most advantageous market should be used (i.e., the market that maximizes the amount to sell the asset or minimizes the amount to transfer the liability).

• Fair value is measured at the price in the principal (or most advantageous) market, even when that price is not directly observable, or estimated using another valuation technique from the perspective of a market participant.

Issue 004 | June 2012 Reporting Alert 3

Application to non-financial assets: highest and best use• Measurement is determined based on a market participant’s ability to generate economic benefits

by using a non-financial asset in its highest and best use. — The highest and best use of a non-financial asset:

» considers the use of the asset that is physically possible, legally permissible and financially feasible

» might provide maximum value to market participants on a stand-alone basis, or through its use in combination with other assets as a group or in combination with other assets and liabilities

— However, an entity’s current use of a non-financial asset is presumed to be its highest and best use so an exhaustive search for other potential uses of an asset besides its current use is not required unless there is evidence to suggest that a different use by market participants would maximize the value of the asset.

Application to liabilities and an entity’s own equity instruments• When a quoted price is not available and the identical item is held as an asset by another entity,

the fair value of the liability or equity instrument is the fair value of the corresponding asset.• The fair value of a liability reflects non-performance risk, including an entity’s own credit risk.

Valuation methodsA number of valuation techniques are available to measure fair value such as:• Market approach — use of market information involving similar or identical assets, liabilities

or groups thereof.• Income approach — present value of future cash flows on the measurement date• Cost approach — current replacement cost

The valuation technique(s) chosen should maximize the use of relevant observable inputs and minimize unobservable inputs.

Fair Value HierarchyFair valuation measurements are categorized based on the type of inputs provided for the valuation. This hierarchy builds on the one previously contained in IFRS 7 Financial Instruments: Disclosures.

However, it now applies to all fair value measurements.• Level 1 — inputs that are quoted prices in active markets for the identical item

at the measurement date.• Level 2 — other observable inputs such as quotes for similar items in an active market,

interest rates or credit rates.• Level 3 — unobservable inputs, including the entity’s own data.


What are the disclosure requirements?The fair value disclosures in IFRS 7 have been relocated to IFRS 13 and now apply to all assets and liabilities, not just financial assets and liabilities. This could mean significantly more disclosure work for some companies.

The requirements are intended to help financial statement users assess the valuation techniques and inputs used to measure fair value, as well as the effect on comprehensive income of recurring measure-ments based on unobservable inputs. The following are the minimum disclosures required for each class of assets and liabilities to meet this objective. Companies should consider whether others are necessary to help users understand their fair value measurements:• fair value at the end of the reporting period• level of the hierarchy under which the valuation falls• amounts of any transfers between Levels 1 and 2 of the hierarchy• techniques and inputs to fair value measurements and any changes in valuation methods• detailed Level 3 measurement disclosures, including processes used

What Are the Key Changes?

What has changed from the previous standards?• Definition of fair value as exit price: There is now an explicit reference to exit price in the

definition of fair value.

• Description of market participants and principal (or most advantageous) market: The standard clarifies who “knowledgeable and willing participants in arms-length transactions” are, and explicitly requires use of available prices in the principal (or most advantageous) market.

• Highest and best use: The standard introduces the concept of highest and best use for measuring non-financial assets at fair value.

• Bid-ask spread: Changes to the guidance in this area introduce an element of judgment in that an entity must determine which price is most representative of fair value.

• Distinguishes transaction costs from transport costs: Transaction costs are expensed.

• Three-level fair value hierarchy: Amendments to the three-level hierarchy align some treatments that were previously quite different. The hierarchy now provides a clear approach to inputs to fair value measurement.


• Disclosures: The guidance on disclosures is more detailed than before, but it does build on previous disclosure requirements. The primary change is around the use of Level 3 measurements. More information is required for those measurements, including a description of the valuation process in place, and discussion of the sensitivity of the fair value measurement to changes in significant unob-servable inputs and any interrelationships between those inputs that might magnify or mitigate the effect on the measurement. These disclosures help increase transparency when models are used to measure fair value (particularly when users need more information about measurement uncertainty, such as when the market for an asset or a liability has become less active).

How Does This Impact My Business – What Are the Key Areas to Consider?• Does this impact current valuation techniques used?

— For many entities, the greatest impact will be on the valuation techniques to measure unquoted investments or other financial instruments for which no active market exists.

• Does this impact key performance metrics? — Certainly, for some entities, the potential impact depends on the extent to which your

key performance indicators are based on financial statement components involving fair value measurements.

• What is the impact on the financial statements? — For many entities, the volume of disclosures will be greater. Disclosures are especially

extensive for fair value measurements categorized within Level 3 of the fair value hierarchy and for transfers between levels.

• What is the impact on contractual arrangements? — In general, IFRS 13 shouldn’t affect the validity of contractual arrangements, because

it doesn’t change the core requirements of existing standards. However, it may change the practical effect of certain contracts. For example, bonus calculations and bonus amounts could be affected if they are based in part on fair value measurements in the financial statements.

• What is the impact on systems and operations? — Some entities may need to develop processes for:

» categorizing fair value measurements within the fair value hierarchy » developing assumptions that market participants would use when pricing an asset

or liability » determining the principal (or most advantageous) market for an asset or liability


• What are the tax implications? — In some cases, depending on the tax requirements, the difference in the fair value measure-

ment may flow directly into the computation of taxable income; in other cases, it may change the amounts of the temporary differences between accounting and tax amounts.

• Are there any regulatory or legal implications? — As with any change in accounting requirements, IFRS 13 may prompt changes in controls

and thus require revisions in the existing certification process. However, the existence of one framework for all fair value measurements may simplify this process.

What’s My Action Plan? Key Milestones and ConsiderationsBelow are some key steps to consider for your action plan to implement IFRS 13:

• Identify the population of financial statement items measured at fair value and identify any new disclosures needed under IFRS 13.

— Note that the level at which an asset or a liability is aggregated or disaggregated for recognition purposes is determined in accordance with the requirements in other IFRSs.

• Review the processes that generate fair value measurements and assess these against the revised definition and guidance in IFRS 13.

— This may involve inquiries of others. For instance, IFRS 13 doesn’t preclude using quoted prices provided by pricing services or brokers, but you must determine that the prices provided have been developed in accordance with the standard.

— IFRS 13 states that an entity need not undertake an exhaustive search of all possible markets to identify the principal market but should take into account all information that is reasonably available. An entity must decide what is “reasonably available” and how much effort should be put into looking for such information.

— IFRS 13 states that an entity’s current use of a non-financial asset is presumed to be its highest and best use unless market or other factors suggest that a different use by market participants would maximize the value of the asset. An entity must set up a process for identifying when such factors suggest a different use by market participants; it must also decide how much effort should be put into looking for such information.

— The valuation of liabilities requires the determination of own credit risk, which could be a challenge and could present concerns about the release of proprietary information.

• The fact that a “market price” is available for a particular item doesn’t automatically mean the price provides an appropriate measurement under IFRS 13. For instance:

— There may have been a significant decrease in the volume or level of activity, so the most recent prices don’t reflect the risk premium that market participants would demand as com-pensation for the inherent uncertainty.

— The most recent prices may reflect forced transactions or distress sales.


• IFRS 13 doesn’t attempt to analyze every possible situation and doesn’t prescribe a methodology for making significant adjustments to transactions or quoted prices; therefore, significant judgment may be required.

• In broad terms, valuation techniques are classified into market, income and cost approaches. These techniques won’t all be equally appropriate in different circumstances.

• A valuation technique must be applied in a way that maximizes market data and minimizes data developed using other means. The technique must be applied consistently (except where it changes to reflect changing circumstances).

• Review required changes to disclosures: — Many entities will identify additional disclosures — The disclosure requirements extend into other areas as well. For example:

» For your non-financial assets measured at fair value, if the” highest and best use” of a non-financial asset differs from its current use, you must disclose that fact and address why the non-financial asset is being used in a manner differing from its highest and best use.

» For Level 3 measurements of financial assets and financial liabilities, the work to disclose the effect of changing (one or more) unobservable inputs to reflect reasonably possible alter-native assumptions may involve the preparation of a complex and time-consuming matrix.

• Identify the additional data, valuation techniques or other information required to implement these requirements; assess their availability, and the corresponding implications for controls and procedures.

• Assess the impact on mergers and acquisitions. IFRS 13 is applicable to fair value measurements required in accounting for business combinations. This includes measuring the purchase consideration (including contingent consideration, recognized in the purchase equation at its acquisition-date fair value) as well as the fair values of the net assets acquired.

• Consider MD&A disclosures needed to explain the impact of fair value on financial performance.

• Consider the education and training available on this topic.

ResourcesNeed more information? CICA has compiled some external resources to help you understand and apply IFRS 13.


Appendix A: Key Impacts for Smaller Entities

OverviewThe following discussion provides high-level commentary on the aspects of IFRS 13 most likely to apply to smaller entities. The information is intended for general guidance only and does not substitute for directly consulting the Standard and accompanying materials.

Resources for Topic 820, Fair Value Measurement, in U.S. GAAP may also be helpful since the IASB and FASB worked together to ensure that IFRS 13 and Topic 820 are identical (except for minor differences in style).

Note that IFRS 13 continues to use the previously established fair value hierarchy, categorizing into three levels the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs).

Accounts Receivable

Accounts receivable are typically measured at amortized cost, not at fair value. A provision may be recognized if their collectability is impaired, but this is not an attempt to measure them at fair value. It does not, for example, take into account the risk premium that would be charged by other market participants to acquire the receivables. IFRS 13 will not typically affect how receivables are measured. However, IFRS 13 also applies to the note disclosures about the fair values of financial assets carried at amortized cost, and may change both how those disclosed amounts are calculated and the volume of information to be provided about them.

Inventory

Inventory is measured at the lower of cost or net realizable value. The concept of net realizable value has some similarity to fair value, but is nevertheless different; as above, it does not, for example, take into account the risk premium that would be charged by other market participants to acquire the inventory. IFRS 13 specifically does not apply to this and other similar measurements, and will not typically affect the ongoing measurement of inventories (however, IFRS 13 would apply to inventories measured at fair value in accordance with the practice in some industries).

Property, Plant and Equipment; Intangible Assets; Investment Property

IFRSs allow various options for measuring these assets at fair value; the details differ in each case. Smaller entities rarely choose to apply these measurement options, applying the cost model instead. However, if smaller entities do apply a fair value measurement model, then IFRS 13 applies to those fair value measurements. In these rare cases, applying IFRS 13 may generate a difference in the resulting values; in particular, it requires measuring a non-financial asset on the basis of its “highest and best” use by a market participant, even if this doesn’t reflect the asset’s actual current use.


Quoted Securities

IFRS 13 states that a quoted price in an active market provides the most reliable evidence of fair value and is used without adjustment to measure fair value whenever available. If the item being measured has a bid price and an ask price, the price within the bid-ask spread that is most representative of fair value in the circumstances is used to measure fair value. The use of bid prices for asset positions is permitted, but is not required. Furthermore, IFRS 13 does not preclude the use of mid-market pricing or other pricing conventions that are used by market participants as a practical expedient for fair value measurements within a bid-ask spread.

Smaller entities with holdings of quoted securities measured at the bid price may or may not need to amend their current measurement practices following an assessment of whether the bid price is most representative of fair value. Entities should consider whether:• the market is the principal market for the asset (or, if there is no principal market, the most

advantageous market for the asset);• whether the quoted prices are from an active market for the identical asset; and• whether the value of the asset selected represents the price that would be received to sell

the asset in an orderly transaction between market participants at the measurement date.

This may not hold in all situations. For example, IFRS 13 notes that a quoted price in an active market may not represent fair value at the measurement date if significant events (such as transactions in a principal- to-principal market, trades in a brokered market or announcements) take place after the close of a market but before the measurement date. It requires that an entity establish and consistently apply a policy for identifying events that might affect fair value measurements.

The fact that some kind of “market price” is available for a particular item does not automatically mean the price provides an appropriate measurement under IFRS 13. For example, there may have been a significant decrease in the volume or level of activity, so that most recent prices do not reflect the risk premium that market participants would demand as compensation for the inherent uncertainty. Alternatively, the most recent prices may reflect forced transactions or distress sales (i.e., transactions that are not orderly). While IFRS 13 provides factors to assist in the determination of whether there has been a significant decrease in volume or level of activity, or a transaction is orderly or not, it does not attempt to analyze every possible situation and does not prescribe a methodology for making significant adjustments to transactions or quoted prices; therefore, significant judgment may be required.


Unquoted Securities

Smaller companies may hold interests in other non-publicly traded entities, either in their common shares or in other equity instruments such as share purchase warrants. IAS 39 requires measuring these at fair value in most cases (although it states an entity is precluded from measuring such instruments at fair value if the range of reasonable fair value estimates is significant and the probabilities of the various estimates cannot be assessed) and provides guidance on inputs to valuation techniques. However, the measurement of all these assets needs to be revisited to ensure it reflects the principles of IFRS 13.

For example, it isn’t sufficient to rationalize that fair value likely wouldn’t have changed materially since the date the instruments were purchased, or to rely solely on the most recent reported transaction. The fair value calculation needs to respond specifically to conditions at the measurement date and to incorporate an appropriate estimate of the risk premium that would be demanded by market participants, and any other risk adjustments.

Using a technique such as the Black-Scholes-Merton formula or other binomial model does not in itself ensure generating an appropriate measurement in accordance with IFRS 13. The entity must consider whether the theoretical value generated by the model accurately reflects an amount that market participants would pay to acquire the instruments in question, based again on taking all conditions into account and considering appropriate risk adjustments.

Assets Subject to Restrictions

Small companies may hold assets, within the categories described above or elsewhere, which are subject to restrictions of some kind on their use or sale. For example, they may be subject to statutory escrow requirements or to other limitations imposed by contracts. If the restriction is attached to the instrument, then market participants would demand a risk premium, reflecting their inability to access a public market for the instrument for the specified period of time. The fair value that would otherwise be calculated for the item is reduced to reflect this risk premium.

IFRS 13 does not provide detailed guidance on measuring the impact of the restriction, but comments that it would reflect the restriction’s nature and duration, the extent to which buyers are limited by it (for example, the restriction may or may not limit the number of potential buyers) and other qualitative/quantitative factors specific to both the instrument and the issuer.

Asset Retirement/Decommissioning Obligations and Other Provisions

IAS 37 requires measuring a provision, including asset retirement obligations and similar items, at the best estimate of the expenditure required to settle the present obligation at the end of the reporting period and clarifies that this is the amount an entity would rationally pay to settle the obligation or to transfer it to a third party at that time. This is not strictly the same as measuring the provision at its fair value; however, the material in IFRS 13 is often helpful in developing a process for measuring provisions. In particular, Example 11 of the Illustrative Examples accompanying IFRS 13 provides an illustration of measuring a decommissioning liability acquired in a business combination (which does require fair value measurement — see below); this may be a useful reference point in assessing the completeness of the inputs and methodology applied to measure such a provision on an ongoing basis.


Accounts Payable and Other Liabilities Measured at Amortized Cost

IFRS 13 does not affect how financial liabilities carried at amortized cost are measured. However, similar to the comments made above under Accounts Receivable, IFRS 13 applies to disclosures about the fair value of financial liabilities carried at amortized cost, and may affect both how those disclosed amounts are calculated and the volume of information required.

Debt Instruments and Other Liabilities Measured at Fair Value

Smaller companies occasionally hold financial liabilities measured at fair value under IFRSs, such as foreign currency warrants or embedded derivatives contained within convertible or other instruments. Consistent with current practice, entities will value these liabilities using an appropriate valuation technique; but, as already noted, using an established methodology such as the Black-Scholes model does not in itself ensure generating an appropriate measurement in accordance with IFRS 13. The entity must consider whether the theoretical value generated by the model accurately reflects an amount that market participants would pay to acquire the instruments in question, based again on taking all conditions into account and on considering appro-priate risk adjustments.

Stock Options and Other Share-Based Compensation

IFRS 13 specifically does not apply to these items; they continue to be valued using the requirements of IFRS 2 Share-based Payment.

Leases

IFRS 13 specifically does not apply to leasing transactions, which continue to be valued using the requirements of IAS 17 Leases.

Business Combinations

IFRS 13 applies to fair value measurements used in accounting for business combinations under IFRS 3. This includes measuring the purchase consideration – including contingent consideration, recognized in the purchase equation at its acquisition-date fair value – as well as the fair values of the net assets acquired.

For example, property, plant and equipment acquired in a business combination is measured on the basis of its “highest and best” use by a market participant even if this doesn’t reflect the asset’s actual current use. Intangible assets are also measured on the basis of their highest and best use by market participants. Example 3 of the Illustrative Examples accompanying IFRS 13 provides an illustration of a research and development project acquired in a business combination, describing how its highest and best use might be, depending on the circumstances, to continue development, to discontinue development and to sell the project in a locked-up state (to market participants with competing technologies, for its defensive value), or to discontinue development altogether with no prospects of a sale (in which case its fair value might be zero).

Liabilities acquired in a business combination are also measured at their acquisition-date fair value, even if measured at amortized cost subsequently. For example, privately held debt of the acquiree is not necessarily measured in the acquisition equation at its carrying value in the acquiree’s financial statements: the value is adjusted to reflect changes in market conditions and/or in the acquiree’s credit spread, to reflect changes in its risk of non-performance.


DisclaimerCICA Reporting Alerts provide an orientation to matters in an accounting standard or securities regulation, focused on the needs of smaller public company CFOs and audit committee chairs. Reporting Alerts are prepared by the Guidance and Support group at The Canadian Institute of Chartered Accountants (CICA) in consultation with CICA’s Small Company Advisory Group. They have not been approved by any Board or Committee of the CICA and neither CICA nor the authors accept any responsibility or liability that might occur directly or indirectly as a consequence of the use, application or reliance on this material.

copyrightCopyright © 2012 The Canadian Institute of Chartered Accountants

Disclosures

The disclosures required by IFRS 13 will be largely consistent with current requirements. However, in any case where an item is measured at its fair value – whether on a recurring basis, or on a non- recurring basis (such as the one-off fair value measurement applied in accounting for a business combination) – IFRS 13 will gener-ally increase the volume of disclosure. It requires presenting the required quantitative disclosures in a tabular format unless another format would be more appropriate.

The disclosures are especially extensive for fair value measurements categorized within Level 3 of the fair value hierarchy and for transfers between Levels. Some common considerations include:• For recurring and non-recurring fair value measurements categorized within Level 2 and Level 3 of the

fair value hierarchy, describe the valuation technique(s) and the inputs used in the fair value measure-ment. If the valuation technique has changed (e.g., from a market approach to an income approach, or to use an additional valuation technique), disclose that change and the reason(s) for making it.

• For fair value measurements categorized within Level 3 of the fair value hierarchy, provide: — quantitative information about the significant unobservable inputs used in the fair value measurement — a description of the valuation processes (including, for example, how the valuation policies and

procedures are selected and how changes in fair value measurements are analyzed from period to period)

— (for recurring measurements only) a reconciliation from the opening balances to the closing bal-ances, showing separately such items as total gains or losses recognized in profit or loss and/or other comprehensive income, purchases, sales, issuances, settlements, and transfers between levels

• For recurring and non-recurring fair value measurements, if the highest and best use of a non-financial asset differs from its current use, disclose that fact and why the non-financial asset is being used in a manner differing from its highest and best use.

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