1. Chapter 10 Fair Value Accounting PowerPoint Presentation by Matthew Tilling ©2012 John Wiley & Sons Australia Ltd

2. THE ROLE OF FAIR VALUE IN ACCOUNTING Fair value used in accounting is ubiquitous, appearing in many standards including AASB 3/IFRS 3AASB 118/IAS 18AASB 136/IAS 36AASB 141/IAS 41 AASB 7/IFRS 7AASB 119/IAS 19AASB 138/IAS 38 AASB 102/IAS 2AASB 133/IAS 134AASB 139/IAS 39 AASB 116/IAS 16AASB 134/IAS 34AASB 140/IAS 40

3. The Usefulness of Fair Value as an Economic Measure Conceptual Framework Asset Definition – Future Economic Benefit Liability Definition – Future Economic Sacrifice Fair value attempts to capture this inherent value

4. 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

5. Shortcomings of the Traditional Definition A.Does not specify if the entity is buying or selling B.What does “settling” a liability mean? – Does not refer to a ‘creditor’ C.At what stage of the hypothetical transaction is fair value measured D.What does willing mean? – Could one party be desperate?

6. IFRS 13/AASB 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 (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.

7. IFRS 13/AASB 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.

8. 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)

9. 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)

10. 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. It is current It is specific

11. The Importance of the Concept of a Market/ Orderly Transaction Orderly Transaction: 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).

12. The Importance of the Concept of a 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. 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.

13. The Importance of the Concept of a 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

14. The Importance of the Concept of a Market 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

15. The Importance of the Concept of a Market/Market Participants 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.

16. The Importance of the Concept of a Market/Market Participants Market Participant Characteristics: a)They are Independent of each other, i.e. they are not related party b)They are knowledgeable, having reasonable understanding about the asset or liability and the transaction using all available information c)They are able to enter into a transaction for the asset or liability d)They are willing to enter into a transaction for the asset or Liability

17. Application to non financial Assets There are four steps a n entity needs to undertake to make fair value measurement. The entity has to determine: a)The particular asset or Liability that is the subject of the measurement b)For non-financial assets, the valuation premise that is appropriate for the measurement c)The principal or most advantageous market for the asset or liability. d)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 in pricing and the level of the fair value of the fair value hierarchy within which the inputs are categorized.

18. What is the particular asset that is the subject of the measurement? 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)

19. What is the particular asset that is the subject of the measurement? Some of the questions that need to be asked when determining the asset to be measured are: What is the location of the asset? What is the condition of the asset? Are there any restriction on the sale or use of the asset? Is the asset a stand-alone asset or is it agroup of assets?

20. 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) As determined by the market – Physically Possible – Legally Permissible – Financially Feasible

21. What is the principal or most advantageous market for the asset A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place either: a)In the principal market b)In the absence of the principal market, in the most advantageous market The principal market is the market with the greatest volume and level of activity for the asset or liability The company do not need to make exhaustive search for the principal market. It is assumed that the principal market is the market the company usually enters unless evidence to the contrary exist.

22. What is the principal or most advantageous market for the asset The most advantageous market is the market that maximizes the amount that would be received to sell the asset or transfer the liability after considering transaction cost and transport cost

23. Example to determine the most advantageous market and fair value ِ Asset XYZ is sold in two different active markets. In market A, the price that would be received is $27; transaction costs are $2and the costs to transport the asset to Market A are $3. In market B, the price that would be received is $26;transaction costs are $2 and the costs to transport the asset to market B are $1. Find the fair value of asset XYZ.

24. Solution The fair value of the asset is measured using the price in the most advantageous market. The most advantageous market is the one that maximizes the amount that would be received to sell the asset after considering transaction cost and transport cost. In market A, the net amount received by the entity is $22, that is 27-2-3 In market B, the net amount received by the entity is $23, that is 26-2-1 Market B is the most advantageous market. The fair value of the asset is $25, being the amount received net of transport cost. Although transaction costs are used to determine the most advantageous market, they are not used in the calculation of fair value.

25. What is the valuation techniques appropriate for measurement? Acceptable valuation techniques – Market Approach A valuation technique that uses prices and other relevant information generated by market transactions involving identical or similar assets or liabilities. – Income Approach valuation technique the converts future amounts to a single present (discounted ) amount. e.g. Present value. Option Pricing; Binomial – Cost Approach A valuation technique that reflects the amount that would be required currently to replace the service capacity of an asset (Current Replacement Cost) Choice of technique IFRS does not propose a hierarchy of valuation technique. Some valuation techniques are better in some circumstances than others. Judgment is required in selecting the appropriate technique.

26. Inputs to 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. 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.

27. 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 2 include: – Quoted prices for similar assets or liabilities in active markets – Quoted prices for identical or similar assets or liabilities in markets that are not active – Inputs other than market prices that are observable such as interest rates and credit risks Level 3 Inputs – Inputs that are not based on observable market data (unobservable inputs).

28. 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)

29. 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”

30. 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)

31. 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. 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)

32. SPECIFIC ISSUES How to deal with transaction costs – Although transaction costs are considered when determining the most advantageous market, the price used to measure the fair value of the asset or liability shall not be adjusted for those costs. – Transaction costs do not include the costs that would be incurred to transport an asset to or from its most advantageous market.

33. How Blocks of Assets are Dealt With Should an entity impound a lower per unit price for large holdings? No – Remember Fair Values are specific – Assume no need to sell in one go – Unless you would

34. Fair Value at Initial Recognition 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

35. Fair Value after Revaluation There is an interesting potential tension between the impairment standard and the fair value standard. FVLCTS ≠ FV

36. The Role for Third Party Valuations Standard does not preclude their use Evaluate issuer of quote Evaluate the nature of the quote – Information Current – Validity of Assumptions

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