Fair value measurement Chapter 5 Fair value measurement Prepared by Mark Vallely

Learning objectives Explain the need for an accounting standard on fair value measurement (p. 198) Discuss the key characteristics of the term ‘fair value’ (p. 199) Explain the steps in determining the fair value of non-financial assets (p. 204) Describe how to measure the fair value of liabilities (p. 214) Explain how to measure the fair value of an entity’s own equity instruments (p. 218) Discuss issues relating to the measurement of the fair value of financial instruments (p. 218) Prepare the disclosures required by AASB 13 Fair Value Measurement (p. 219) Discuss the issues associated with the measurement and use of fair values (p. 224)

A standard on fair value measurement In September 2011 AASB 13 Fair Value Measurement was issued AASB 13 is a new standard which provides a consistent definition of fair value to be applied across all other accounting standards Prior to the introduction of AASB 13 different standards had their own definition of fair value The main objectives of AASB 13 are: To define fair value To establish a framework for measuring fair value To require disclosures about fair value measurement LO1: Explain the need for an accounting standard on fair value measurement (p. 198)

Definition of fair value Prior to the release of AASB 13 the OLD definition of fair value was: “...the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.” The NEW definition of fair value in AASB 13 is as follows: “...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.” LO2: Discuss the key characteristics of the term ‘fair value’ (p. 199)

Elements of the definition Current exit price The exit price is defined as: “...The price that would be received to sell an asset or paid to transfer a liability” The exit price is based on the perspective of the holder The exit price is based on expectations about future cash flows generated by the asset subsequent to its sale These cash flows may be generated from use of the asset by the acquiring entity or its sale by the acquiring entity Similarly, an entity might intend to hold a liability until settlement – its fair value is based on expected cash outflows by the entity Even when an entity intends to hold an asset, its FV is measured as an exit price by reference to a hypothetical sale of the asset to a market participant who will use it or sell it Why no entry price?

Elements of the definition Orderly transactions Excludes sales made under liquidation or “fire sale” conditions Orderly implies a ‘period for marketing’ that is customary for such an asset prior to the transaction date Excludes non-arms length sales Market participants Must be independent from each other (not related parties) Must be knowledgeable about the asset or liability Must have the ability to enter into the transaction Must be willing to transact and not be forced or compelled Similar to the previous ‘knowledgeable, willing parties in an arm’s length…

Elements of the definition Transaction and transport costs Transaction costs are incremental direct costs that would not have been incurred had the decisions to sell the asset/transfer the liability not been made. Lower transaction costs usually indicate a more advantageous market Transport costs are the costs incurred to transport an asset from its current location to its principal market. Both costs affect the determination of fair value Both costs are used to determine the principal market However, the price used to measure FV is NOT adjusted for transaction costs Transport costs are deducted to calculate the fair value

Elements of the definition – Example 5.1 An entity sells asset XYZ in markets, including Market B In Market B Price = $26 Transaction Costs = $2 Transport costs = $1 How do we determine the principal (ie the most advantageous) market? What is the Fair Value? IF we sold the asset, net proceeds would be $23 Compare this amount to other markets If $23 is the highest amount, Market B is the principal market (you must consider both costs) Fair value is $25 FV is adjusted for transport costs only Is principal market is the same as most advantageous market?

Application of AASB 13 AASB 13 applies to: Non-financial assets; and Liabilities and equity Four step process to make a fair value measurement: Step 1 - Determine the asset or liability that is the subject of the measurement Step 2 - Determine the valuation premise that is appropriate * Step 3 - Determine the principal or most advantageous market Step 4 - Determine the appropriate valuation technique * Relevant for non-financial assets only LO3: Explain the steps in determining the fair value of non-financial assets (p. 204)

Step 1: Determine the asset or liability that is the subject of the measurement This step involves considering characteristics that market participants would take into account when pricing an asset or liability. Relevant questions to consider include: What is the location of the asset? What is the condition of the asset? Are there any restrictions on sale or use of the asset? Is the asset or liability a stand-alone asset or it is a group of assets?

Step 2: Determine the valuation premise that is appropriate Fair value is measured by considering the highest and best use of an asset. “...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.” These uses must be physically possible, legally permissible and financially feasible. The highest and best use is not based on how the entity is currently using it (or not using it) It is based on the perspective of the market participant E.g. land on which a factory currently stands could be used for residential housing development. You could discuss an example of when an entity acquires an asset and does not use it (e.g. to remove competition to its own products)

Step 2: Determine the valuation premise that is appropriate In combination valuation premise FV is determined under this premise when market participants would obtain maximum benefit principally through using the asset in combination with other assets and liabilities as a group. The asset will be sold as an individual asset, not as a group, but the asset will be used by the market participant in conjunction with other assets. Stand-alone valuation premise FV is determined under this premise when market participants would obtain maximum benefit principally through using the asset on a stand-alone basis. Refer example 5.2 & 5.3 of text for application of “highest and best use” concept

Step 3: Determine the principal or most advantageous market FV measurement assumes that the transaction takes place in either: the principal market or the most advantageous market Principal market The market with the greatest volume and level of activity Most advantageous market The market that would maximise the amount received/paid after deducting transaction and transport costs An entity need not make an exhaustive search. In fact the market it usually sells in is presumed to be the principal market unless contrary evidence exists

Elements of the definition – Example 5.4 Asset XYZ in sold in two markets In Market A Price = $27 Transaction Costs = $2 Transport costs = $3 In Market B Price = $26 Transport costs = $1 Market A – net proceeds would be $22 Market B – net proceeds would be $23 Market B @ $23 is the most advantageous market Fair value is $25 FV is adjusted for transport costs only

Step 4: Determine the appropriate valuation technique Valuation techniques The objective of the valuation technique selected is to estimate the price at which an orderly transactions would take place between market participants under current market conditions. Three possible valuation techniques exist: Market approach – uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities or groups of assets and liabilities (e.g. a business) Cost approach – often referred to as current replacement cost – it reflects the amount currently required to replace the service capacity of the asset Income approach – converts future amounts (e.g. cash flows or income and expenses) to a single current (e.g. discounted) amount. FV measurement is based on values indicated by current market expectations about those future amounts

Step 4: Determine the appropriate valuation technique Choice of technique A hierarchy of techniques is not proposed in AASB 13 Judgement is required to select the most appropriate technique for the situation Appropriate to the circumstances Sufficient data to apply technique Technique must maximise use of observable inputs and minimise use of unobservable inputs Sometimes use multiple techniques, with results weighed and evaluated Technique must be consistently applied Refer to Example 5.5

Step 4: Determine the appropriate valuation technique Inputs Defined as: Assumptions market participants use when pricing an asset or liability… such as the risk inherent in a valuation technique (e.g. pricing model) and the risks inherent in the inputs to the valuation technique Inputs are classified into: Observable inputs – are developed using market data, such as publicly available information about actual events or transactions, and reflect the assumptions that market participants would use Unobservable inputs – are those where market data is not available and are developed using the best information available about the assumptions that market participants would use To achieve consistency and comparability AASB 13 provides a hierarchy of inputs.

Fair value hierarchy Prioritising inputs Inputs are prioritised into three levels (Level 1, Level 2…) Highest priority is given to quoted market prices in active markets – lowest priority is given to unobservable inputs When using observable inputs, they must be relevant observable inputs Availability / subjectivity of inputs could affect choice of technique BUT the FV hierarchy prioritises inputs not the technique itself Once determined, a FV measure is categorised according to the lowest level input to the technique Lowest level>> Level 1 next slide

Fair value hierarchy Level 1 inputs Defined as: “...quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date.” Commonly used for assets such as motor vehicles, plant & equipment, publicly traded shares A market is not active if there are few recent transactions or price quotes vary substantially over time. Level 1 inputs must be for identical items – for buildings, items may be similar, but will not be identical

Fair value hierarchy Level 2 inputs Defined as: “...inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.” Included within this definition are: Quoted prices for similar assets in active markets Quoted prices for identical items in inactive markets Inputs other than quoted prices that are observable – e.g. interest rates, credit risks, rental price per square metre Inputs that are derived from or corroborated by observable market data by correlation or other means

Fair value hierarchy Level 3 inputs Defined as: “...unobservable inputs for the asset or liability.” In this case the data may be that of the entity itself, that may be adjusted for factors that market participants might consider Examples of where level 3 inputs would be used include when valuing: Cash generating units Trademarks Accounts receivable A cash-generating unit is the smallest group of assets that independently generates cash flow and whose cash flow is largely independent of the cash flows generated by other assets. The concept is used by the international financial reporting standards in the determination of asset impairment. Without the cash-generating unit concept, it would be excessively difficult to determine the cash flows associated with individual assets for an impairment analysis. Refer to Example 5.6

Application to liabilities Traditionally the measurement of a liability was commonly based on the amount required to settle the present obligation. In AASB 13, fair value is the amount paid to transfer a liability. The fair value measurement thus assumes that The liability is transferred to another market participant at the measurement date. The market participant transferee would be required to fulfil the obligation The IASB argues that the fair value of a liability from the perspective of market participants who owe the liability is the same regardless of whether it is settled or transferred. Both the entity and market participant face the same risks LO4: Describe how to measure the fair value of liabilities (p. 214)

Application to liabilities Many of the principles just discussed for non-financial assets also apply to measuring the FV of liabilities Only 3 steps (identify liability, principal or most advantageous market, appropriate valuation technique) Note the highest and best use principle does not apply to liabilities For some financial liabilities there is an observable market and a quoted price may be obtained to measure the FV of the liability. In most cases, a liability for one entity represents an asset for the other entity (e.g. a bank loan) AASB 13 requires that measurement of the financial liability be calculated from the perspective of the market participant that holds the corresponding asset

Application to liabilities Corresponding asset Measurement should be in the following order: the quoted price of the asset in an active market the quoted price for the asset in an inactive market a valuation under a technique such as the income approach (e.g. a PV technique) or the market approach Example 5.7 demonstrates a situation where an entity uses a market approach valuation technique for a liability.

Application to liabilities No corresponding asset Example: an entity that must decommission an oil platform when drilling ceases Measurement must be done by applying a valuation technique from the perspective of a market participant that owes the liability. A present value technique could be applied. Example 5.8 shows an example of the use of the present value technique for a simple debt obligation Example 5.9 shows an example for a non-financial liability such as a decommissioning liability

Application to liabilities Non performance risk The fair value of a liability will reflect the effect of non-performance risk. Defined as: “...the risk that an entity will not fulfil an obligation. Non-performance risk includes, but may not be limited to, the entity’s own credit risk.” Example 5.10 demonstrates the valuation of liabilities with a consideration of non-performance risk.

Application to equity instruments Measurement of equity instruments is needed where an entity issues its own equity instruments in exchange for a business as part of a business combination The principles in relation to liabilities also apply to equity instruments. The FV measure assumes the entity’s equity instruments are transferred to a market participant at measurement date The company must measure the fair value of the equity instrument from the perspective of a market participant who holds the instrument as an asset. LO5: Explain how to measure the fair value of an entity’s own equity instruments (p. 218)

Issues in measuring financial instruments Inputs based on bid and ask prices Some inputs are based on market prices that include: bid prices — the price a dealer is willing to pay; and ask prices — the price a dealer is willing to sell. E.g. - a foreign exchange dealer who is exchanging Australian dollars for Japanese yen. In such cases the price within a bid–ask spread that is most representative of fair value should be used to measure fair value. A mid-market price may be used as a practical expedient. LO6: Discuss issues relating to the measurement of the fair value of financial instruments (p. 218)

Issues in measuring financial instruments Offsetting positions Entities may hold both financial assets and financial liabilities, and as such is exposed to both market risk and credit risk. Sometimes such assets and liabilities are managed as a group to achieve a net exposure AASB 13 treats this as an exception, whereby an entity can measure the net financial asset or net financial liability This exception may be only be applied where an entity manages the group of financial assets and liabilities on a net exposure basis as a part of its documented risk management strategy.

Disclosure AASB 13 requires an entity to disclose information that enables users to assess both of the following: 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. 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. Detailed disclosures contained in section 5.7 of text LO7: Prepare the disclosures required by AASB 13 Fair Value Measurement (p. 219)

Questions about fair value measurement How reliable are the FV numbers? Consider unobservable data Does past experience warn us against the extensive use of FV? Consider Enron Are the FV measure not based on directly observable market prices costly to determine? Expensive exercise for management Should measure based on unobservable inputs be called FV? Highly subjective. How relevant and reliable are they? Can FV be prescribed before the finalisation of the Conceptual Framework? LO8: Discuss the issues associated with the measurement and use of fair values (p. 224).