Fair Value Text

1. Market approach

As outlined in IFRS 13.B5 to B7 | ASC 820-10-55-3A to 3C, the market approach is based on market transactions involving identical or similar assets or liabilities (groups of).

In its simplest form, the market approach is used to value, for example, stock or bonds traded on an active market.

The market approach also encompasses techniques such matrix pricing which involves valuing “financial instruments, such as debt securities, without relying exclusively on quoted prices for the specific securities, but rather relying on the securities’ relationship to other benchmark quoted securities.”

When available, it is not only the easiest to use method, but also yields the most reliable results.

1.A Quoted market prices

1.A.i Active market

1.A.ii Non-active market

1.A.i.a Identical items

Financial instruments, industrial or agricultural commodities traded on active markets.

1.A.i.b Similar items

I.e. loan portfolios

1.A.ii.a Identical items

I.e. raw material, merchandise

1.A.ii.b Similar items

I.e. finished goods, land, buildings, machinery, equipment

Level one inputs

IFRS 13.76 | ASC 820-10-35-40: Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.

Level two inputs

IFRS 13.81 | ASC 820-10-35-47: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

IFRS 13.82 | ASC 820-10-35-48: Level 2 inputs include the following: ... (b) quoted prices for identical or similar assets or liabilities in markets that are not active.

1.B Observed market prices

1.C Market corroborated prices

I.e. licensing arrangement, rental agreement

Level two inputs

IFRS 13.81 | ASC 820-10-35-47: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

IFRS 13.82 | ASC 820-10-35-48: Level 2 inputs include the following: ... (c) inputs other than quoted prices that are observable for the asset or liability, for example:

(i) interest rates and yield curves observable at commonly quoted intervals;

(ii) implied volatilities; and

(iii) credit spreads.

Level two inputs

IFRS 13.81 | ASC 820-10-35-47: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

IFRS 13.82 | ASC 820-10-35-48: Level 2 inputs include the following: ... (d) market-corroborated inputs.

market-corroborated os defined as "Inputs that are derived principally from or corroborated by observable market data by correlation or other means."

For example, IFRS 9.B35 (c) | ASC 820-10-55.21.c: Receive-fixed, pay-variable interest rate swap based on a specific bank’s prime rate. A Level 2 input would be the bank’s prime rate derived through extrapolation if the extrapolated values are corroborated by observable market data, for example, by correlation with an interest rate that is observable over substantially the full term of the swap.

2. Cost approach

As outlined in IFRS 13.B8 and B9 | ASC 820-10-55-3D and 3E, this is the amount that would be needed to replace (the service capacity of) an asset.

In some instances, it is merely the other side of the market approach coin. For example, if year X, model 123 automobiles are currently being sold for 10,000 (market price), they can also be acquired for 10,000 (replacement cost).

In other instances, it is more involved. For example, if a company acquires a factory in a business combination, and no comparable factories are being sold on the market, it would need to estimate how much it would cost if it were to build a comparable factory for itself.

2.A Historical cost

2.B Replacement cost

2.C Reproduction cost

As it addresses future value, the guidance for fair value does not apply to historical cost.

Historical cost involves past transactions or events.

Fair value, involves to future transactions or events.

Fair vlaue 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 13.9 | ASC 820-10-35-2).

Historical cost is included here for the sake of completeness, as it is the way assets and liabilities are always initially measured.

The cost to replicate the functionality of asset using current (modern) materials, designs, technologies and production techniques.

The cost to replicate the asset using past (historical) materials, designs, technologies and production techniques.

Level one inputs

Level two or three inputs

If an item was acquired in an orderly transaction with a market participant, its value is just as obvious as if it were currently being sold on an active market.

IFRS 13.76 | ASC 820-10-35-40: Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.

IFRS 13..81 | ASC 820-10-35-47: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

IFRS 13..82 | ASC 820-10-35-48: Level 2 inputs include the following: ... (b) quoted prices for identical or similar assets or liabilities in markets that are not active.

Replacement or reproduction cost can be determine using level two inputs, if comparable assets are sold on the market, or level three inputs, if it built, manufactured or otherwise replicate the asset. These costs can be both eternal (quoted by subcontractors) or internal (estimates of own materials, wages, overhead, etc.).

IFRS 13..81 | ASC 820-10-35-47: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

IFRS 13.82 | ASC 820-10-35-48: Level 2 inputs include the following: ... (b) quoted prices for identical or similar assets or liabilities in markets that are not active.

IFRS 13.86 | ASC 820-10-35-52: Level 3 inputs are unobservable inputs for the asset or liability.

IFRS 13.87 | ASC 820-10-35-52: Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. ...

IFRS 13.89 | ASC 820-10-35-54A: An entity shall develop unobservable inputs using the best information available in the circumstances, which might include the entity’s own data. ...

IFRS 13.87 | ASC 820-10-35-52: ... However, the fair value measurement objective remains the same, ie an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. ...

3. Income approach

As outlined in IFRS 13.B10 to B30 | ASC 820-10-55-4 to 20, the income approach converts future cash flows (or income and expense) into a present value.

Not only is it more demanding to apply than either the market or cost approach, it also yields inferior results.

As such, it should be avoided if possible.

Note: of the two present value techniques discussed, the Expected Present Value Technique (a.k.a. risk adjusted cash flow method) yields more reliable results than the Discount Rate Adjustment Technique (a.k.a. risk adjusted discount rate method).

Consequently, not only should the DRAT be avoided if possible, it should not be used to estimate the fair value of anything but financial instruments with fixed (clearly defined) cash flows.

Also note: while EPVT is mathematically identical to value-in-use (IAS 36), EPVT relies on cash flows and discount rates that "reflect assumptions that market participants would use when pricing the asset or liability".

In contrast, VIU is calculated using cash flow projections based on management’s best estimate, financial budgets or forecasts.

In other words, EPVT is calculated using external data (market participant assumptions), while VIU is calculated using internal data (management estimates).

3.A Pricing models

3.B Present value techniques

3.C Multi-period excess earnings

IFRS 9.B11.b | ASC 920-10-55-3G.b mention: option pricing models, such as the Black-Scholes-Merton formula or a binomial model (i.e. a lattice model), that incorporate present value techniques and reflect both the time value and the intrinsic value of an option.

Note: In the guidance, present value techniques are presented before option pricing models.

Also known as discounted cash flow methods, while both generally accepted methods require future cash flows to be estimated and discounted to present value, first method can be applied to a wide range of items, while the second is suitable primarily for financial assets with fixed or predictable cash flows such as bonds, notes, loans and receivables.

Excess earnings attributable to asset after deducting earnings attributable to contributory assets.

While mentioned by IFRS and US GAAP, neither provide an in depthby discussion of this method.

IFRS 13.B11 | ASC 820-10-55-3G merely mention: ... valuation techniques include, for example ... (c) the multi-period excess earnings method, which is used to measure the fair value of some intangible assets.

While IFRS 13.B3.d | ASC 820-10-55-3.d merely note: an asset’s use in combination with other assets or with other assets and liabilities might be incorporated into the valuation technique used to measure the fair value of the asset. That might be the case when using the multi-period excess earnings method to measure the fair value of an intangible asset because that valuation technique specifically takes into account the contribution of any complementary assets and the associated liabilities in the group in which such an intangible asset would be used.

Level two inputs

Level three inputs

IFRS 13.81 | ASC 820-10-35-47: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

IFRS 13.82 | ASC 820-10-35-48: Level 2 inputs include the following: ... (c) inputs other than quoted prices that are observable for the asset or liability, for example:

(i) interest rates and yield curves observable at commonly quoted intervals;

(ii) implied volatilities; and

(iii) credit spreads.

IFRS 13.86 | ASC 820-10-35-52: Level 3 inputs are unobservable inputs for the asset or liability.

IFRS 13.87 | ASC 820-10-35-52: Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. ...

IFRS 13.89 | ASC 820-10-35-54A: An entity shall develop unobservable inputs using the best information available in the circumstances, which might include the entity’s own data. ...

IFRS 13.87 | ASC 820-10-35-52: ... However, the fair value measurement objective remains the same, ie an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. ...