Disclosures required in connection with market risk are:

(a) Sensitivity analysis, showing the effects on profit or loss of changes in each market risk
(b) If the sensitivity analysis reflects interdependencies between risk variables, such as interest rates
and exchange rates the method, assumptions and limitations must be disclosed.

7.5 Capital disclosures

Certain disclosures about capital are required. An entity's capital does not relate solely to financial
instruments, but has more general relevance. Accordingly, those disclosures are included in IAS 1, rather
than in IFRS 7.

8 Fair value measurement 6/12

FAST FORWARD
IFRS 13 Fair value measurement gives extensive guidance on how the fair value of assets and liabilities
should be established.

In May 2011 the IASB published IFRS 13 Fair value measurement. The project arose as a result of the
Memorandum of Understanding between the IASB and FASB (2006) reaffirming their commitment to the
convergence of IFRSs and US GAAP. With the publication of IFRS 13, IFRS and US GAAP now have the
same definition of fair value and the measurement and disclosure requirements are now aligned

8.1 Objective
IFRS 13 sets out to:
(a) Define fair value
(b) Set out in a single IFRS a framework for measuring fair value
(c) Require disclosure about fair value measurements

8.2 Definitions
IFRS 13 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'.
The previous definition used in IFRS 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 price which would be received to sell the asset or paid to transfer (not settle) the liability is described
as the 'exit price' and this is the definition used in US GAAP. Although the concept of the 'arm's length
transaction' has now gone, the market-based current exit price retains the notion of an exchange between
unrelated, knowledgeable and willing parties.

8.3 Scope
IFRS 13 applies when another IFRS requires or permits fair value measurements or disclosures. The
measurement and disclosure requirements do not apply in the case of:
(a) Share-based payment transactions within the scope of IFRS 2 Share-based payment
(b) Leasing transactions within the scope of IAS 17 Leases; and
(c) Net realisable value as in IAS 2 Inventories or value in use as in IAS 36 Impairment of assets.
Disclosures are not required for:
(a) Plan assets measured at fair value in accordance with IAS 19 Employee benefits
(b) Plan investments measured at fair value in accordance with IAS 26 Accounting and reporting by
retirement benefit plans; and

Part B Accounting standards 7: Financial instruments 217

 (c) Assets for which the recoverable amount is fair value less disposal costs under IAS 36
Impairment of assets

8.4 Measurement
Fair value is a market-based measurement, not an entity-specific measurement. It focuses on assets and
liabilities and on exit (selling) prices. It also takes into account market conditions at the measurement
date. In other words, it looks at the amount for which the holder of an asset could sell it and the amount
which the holder of a liability would have to pay to transfer it. It can also be used to value an entity's own
equity instruments.
Because it is a market-based measurement, fair value is measured using the assumptions that market
participants would use when pricing the asset, taking into account any relevant characteristics of the
asset.
It is assumed 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 principle market, in the most advantageous market for the asset or liability.
The principal market is the market which is the most liquid (has the greatest volume and level of activity)
for that asset or liability. In most cases the principal market and the most advantageous market will be the
same.
IFRS 13 acknowledges that when market activity declines an entity must use a valuation technique to
measure fair value. In this case the emphasis must be on whether a transaction price is based on an
orderly transaction, rather than a forced sale.
Fair value is not adjusted for transaction costs. Under IFRS 13, these are not a feature of the asset or
liability, but may be taken into account when determining the most advantageous market.
Fair value measurements are based on an asset or a liability's unit of account, which is specified by each
IFRS where a fair value measurement is required. For most assets and liabilities, the unit of account is the
individual asset or liability, but in some instances may be a group of assets or liabilities.

8.4.1 Example: unit of account

A premium or discount on a large holding of the same shares (because the market's normal daily trading
volume is not sufficient to absorb the quantity held by the entity) is not considered when measuring fair
value: the quoted price per share in an active market is used.
However, a control premium is considered when measuring the fair value of a controlling interest, because
the unit of account is the controlling interest. Similarly, any non-controlling interest discount is
considered where measuring a non-controlling interest.

8.4.2 Example: principal or most advantageous market

An asset is sold in two active markets, Market X and Market Y, at $58 and $57, respectively. Valor Co does
business in both markets and can access the price in those markets for the asset at the measurement date
as follows.

Market X Market Y
$ $
Price 58 57
Transaction costs (4) (3)
Transport costs (to transport the asset to that market) (4) (2)
50 52

Remember that fair value is not adjusted for transaction costs. Under IFRS 13, these are not a feature of
the asset or liability, but may be taken into account when determining the most advantageous market.

218 7: Financial instruments Part B Accounting standards

If Market X is the principal market for the asset (ie the market with the greatest volume and level of activity
for the asset), the fair value of the asset would be $54, measured as the price that would be received in
that market ($58) less transport costs ($4) and ignoring transaction costs.

If neither Market X nor Market Y is the principal market for the asset, Valor must measure the fair value of
the asset using the price in the most advantageous market. The most advantageous market is the market
that maximises the amount that would be received to sell the asset, after taking into account both
transaction costs and transport costs (ie the net amount that would be received in the respective markets).

The maximum net amount (after deducting both transaction and transport costs) is obtainable in Market Y
($52, as opposed to $50). But this is not the fair value of the asset. The fair value of the asset is obtained
by deducting transport costs but not transaction costs from the price received for the asset in Market Y:
$57 less $2 = $55.

8.4.3 Non-financial assets

For non-financial assets the fair value measurement looks at the use to which the asset can be put. It
takes into account the ability of a market participant to generate economic benefits by using the asset in
its highest and best use.

8.5 Valuation techniques

IFRS 13 states that valuation techniques must be those which are appropriate and for which sufficient data
are available. Entities should maximise the use of relevant observable inputs and minimise the use of
unobservable inputs.
The standard establishes a three-level hierarchy for the inputs that valuation techniques use to measure
fair value:
Level 1 Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting
entity can access at the measurement date
Level 2 Inputs other than quoted prices included within Level 1 that are observable for the asset or
liability, either directly or indirectly, eg quoted prices for similar assets in active markets or for
identical or similar assets in non active markets or use of quoted interest rates for valuation
purposes
Level 3 Unobservable inputs for the asset or liability, ie using the entity's own assumptions about
market exit value.

8.5.1 Valuation approaches

The IFRS identifies three valuation approaches.

(a) Income approach. Valuation techniques that convert future amounts (eg cash flows or income
and expenses) to a single current (ie discounted) amount. The fair value measurement is
determined on the basis of the value indicated by current market expectations about those future
amounts.
(b) Market approach. A valuation technique that uses prices and other relevant information
generated by market transactions involving identical or comparable (ie similar) assets, liabilities
or a group of assets and liabilities, such as a business.
(c) Cost approach. A valuation technique that reflects the amount that would be required currently
to replace the service capacity of an asset (often referred to as current replacement cost).

Entities may use more than one valuation technique to measure fair value in a given situation. A change of
valuation technique is considered to be a change of accounting estimate in accordance with IAS 8, and
must be disclosed in the financial statements.

Part B Accounting standards 7: Financial instruments 219

 8.5.2 Examples of inputs used to measure fair value
Asset or liability
Level 1 Equity shares in a listed company
Level 2 Licencing arrangement arising
from a business combination
Cash generating unit
Finished goods inventory at a
retail outlet
Building held and used
Level 3 Cash generating unit
Three-year option on exchange-
traded shares
8.6 Measuring liabilities
Fair value measurement of a liability assumes that that liability is transferred at the measurement date to a
market participant, who is then obliged to fulfill the obligation. The obligation is not settled or otherwise
extinguished on the measurement date.
8.6.1 Entity’s own credit risk
The fair value of a liability reflects the effect of non-performance risk, which includes but is not limited to
the entity’s own credit risk. This may be different for different types of liabilities.
220 7: Financial instruments Part B Accounting standards
Input
Unadjusted quoted prices in an
active market
Royalty rate in the contract with
the unrelated party at inception of
the arrangement
Valuation multiple (eg a multiple
of earnings or revenue or a
similar performance measure)
derived from observable market
data, eg from prices in observed
transactions involving
comparable businesses
Price to customers adjusted for
differences between the condition
and location of the inventory item
and the comparable (ie similar)
inventory items
Price per square metre for the
derived from observable market
data, eg prices in observed
transactions involving
comparable buildings in similar
locations
Financial forecast (eg of cash
flows or profit or loss) developed
using the entity’s own data
Historical volatility, ie the
volatility for the shares derived
from the shares’ historical prices
Adjustment to a mid-market
consensus (non-binding) price
for the swap developed using
data not directly observable or
otherwise corroborated by
observable market data
8.6.2 Example: Entity’s own credit risk
Black Co and Blue Co both enter into a legal obligation to pay $20,000 cash to Green Go in seven years.
Black Co has a top credit rating and can borrow at 4%. Blue Co’s credit rating is lower and it can borrow at
8%.
Black Co will receive approximately $15,200 in exchange for its promise. This is the present value of
$20,000 in seven years at 4%.
Blue Co will receive approximately $11,660in exchange for its promise. This is the present value of
$20,000 in seven years at 8%.

8.7 IFRS 13 and business combinations

Fair value generally applies on a business combination. This topic is covered in Chapter 12, together with
some further examples.

8.8 Disclosure
An entity must 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, 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. Disclosure
requirements will include:
(i) Reconciliation from opening to closing balances
(ii) Quantitative information regarding the inputs used
(iii) Valuation processes used by the entity
(iv) Sensitivity to changes in inputs

8.9 Was the project necessary?

The IASB is already considering the matter of the measurement basis for assets and liabilities in financial
reporting as part of its Conceptual Framework project. It could therefore be argued that it was not
necessary to have a separate project on fair value. The Conceptual Framework might have been the more
appropriate forum for discussing when fair value should be used as well as how to define and measure
it.
However, it has been argued that a concise definition and clear measurement framework is needed
because there is so much inconsistency in this area, and this may form the basis for discussions in the
Conceptual Framework project.
The IASB has also pointed out that the global financial crisis has highlighted the need for:
Clarifying how to measure fair value when the market for an asset becomes less active; and
Improving the transparency of fair value measurements through disclosures about measurement
uncertainty.

Part B Accounting standards 7: Financial instruments 221

 8.9.1 Advantages and disadvantages of fair value (v historical cost)

Fair value

Advantages
Relevant to users' decisions
Consistency between companies
Predicts future cash flows
Disadvantages
Subjective (not reliable)
Hard to calculate if no active market
Time and cost
Lack of practical experience/familiarity
Less useful for ratio analysis (bias)
Misleading in a volatile market

Historical cost

Advantages Disadvantages
Reliable Less relevant to users' decisions
Less open to manipulation Need for additional measure of recoverable
Quick and easy to ascertain amounts (impairment test)

Matching (cost and revenue) Does not predict future cash flows

Practical experience & familiarity

222 7: Financial instruments Part B Accounting standards

4 (a) The International Accounting Standards Board has recently completed a joint project with the Financial
Accounting Standards Board (FASB) on fair value measurement by issuing IFRS 13 Fair Value Measurement.
IFRS 13 defines fair value, establishes a framework for measuring fair value and requires significant disclosures
relating to fair value measurement.
The IASB wanted to enhance the guidance available for assessing fair value in order that users could better gauge
the valuation techniques and inputs used to measure fair value. There are no new requirements as to when fair
value accounting is required, but the IFRS gives guidance regarding fair value measurements in existing
standards. Fair value measurements are categorised into a three-level hierarchy, based on the type of inputs to
the valuation techniques used. However, the guidance in IFRS 13 does not apply to transactions dealt with by
certain specific standards.

Required:
(i) Discuss the main principles of fair value measurement as set out in IFRS 13. (7 marks)
(ii) Describe the three-level hierarchy for fair value measurements used in IFRS 13. (6 marks)

(b) Jayach, a public limited company, is reviewing the fair valuation of certain assets and liabilities in light of the
introduction of IFRS 13.
It carries an asset that is traded in different markets and is uncertain as to which valuation to use. The asset has
to be valued at fair value under International Financial Reporting Standards. Jayach currently only buys and sells
the asset in the Australasian market. The data relating to the asset are set out below:
Year to 30 November 2012 Asian European Australasian
Market Market Market
Volume of market – units 4 million 2 million 1 million
Price $19 $16 $22
Costs of entering the market $2 $2 $3
Transaction costs $1 $2 $2
Additionally, Jayach had acquired an entity on 30 November 2012 and is required to fair value a
decommissioning liability. The entity has to decommission a mine at the end of its useful life, which is in three
years’ time. Jayach has determined that it will use a valuation technique to measure the fair value of the liability.
If Jayach were allowed to transfer the liability to another market participant, then the following data would be
used.
Input Amount
Labour and material cost $2 million
Overhead 30% of labour and material cost
Third party mark-up – industry average 20%
Annual inflation rate 5%
Risk adjustment – uncertainty relating to cash flows 6%
Risk-free rate of government bonds 4%
Entity’s non-performance risk 2%
Jayach needs advice on how to fair value the liability.

Required:
Discuss, with relevant computations, how Jayach should fair value the above asset and liability under
IFRS 13. (10 marks)
Professional marks will be awarded in question 4 for the clarity and quality of the presentation and discussion.
(2 marks)

(25 marks)

End of Question Paper

7
4 (a) (i) Fair value has had a different meaning depending on the context and usage. The IASB’s definition 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. Basically it is an exit price. Fair value is focused on the assumptions of the market place and is not
entity specific. It therefore takes into account any assumptions about risk. Fair value is measured using the same
assumptions and taking into account the same characteristics of the asset or liability as market participants would. Such
conditions would include the condition and location of the asset and any restrictions on its sale or use. Further, it is not
relevant if the entity insists that prices are too low relative to its own valuation of the asset and that it would be unwilling
to sell at low prices. Prices to be used are those in ‘an orderly transaction’. An orderly transaction is one that assumes
exposure to the market for a period before the date of measurement to allow for normal marketing activities and to ensure
that it is not a forced transaction. If the transaction is not ‘orderly’, then there will not have been enough time to create
competition and potential buyers may reduce the price that they are willing to pay. Similarly, if a seller is forced to accept
a price in a short period of time, the price may not be representative. It does not follow that a market in which there are
few transactions is not orderly. If there has been competitive tension, sufficient time and information about the asset,
then this may result in a fair value for the asset.
IFRS 13 does not specify the unit of account for measuring fair value. This means that it is left to the individual standard
to determine the unit of account for fair value measurement. A unit of account is the single asset or liability or group of
assets or liabilities. The characteristic of an asset or liability must be distinguished from a characteristic arising from the
holding of an asset or liability by an entity. An example of this is that if an entity sold a large block of shares, it may
have to do so at a discount to the market price. This is a characteristic of holding the asset rather than of the asset itself
and should not be taken into account when fair valuing the asset.
Fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place in the principal
market for the asset or liability or, in the absence of a principal market, in the most advantageous market for the asset
or liability. The principal market is the one with the greatest volume and level of activity for the asset or liability that can
be accessed by the entity.
The most advantageous market is the one which maximises the amount that would be received for the asset or
minimises the amount that would be paid to transfer the liability after transport and transaction costs.
An entity does not have to carry out an exhaustive search to identify either market but should take into account all
available information. Although transaction costs are taken into account when identifying the most advantageous market,
the fair value is not after adjustment for transaction costs because these costs are characteristics of the transaction and
not the asset or liability. If location is a factor, then the market price is adjusted for the costs incurred to transport the
asset to that market. Market participants must be independent of each other and knowledgeable, and able and willing
to enter into transactions.
IFRS 13 sets out a valuation approach, which refers to a broad range of techniques, which can be used. These
techniques are threefold. The market, income and cost approaches.
(ii) When measuring fair value, the entity is required to maximise the use of observable inputs and minimise the use of
unobservable inputs. To this end, the standard introduces a fair value hierarchy, which prioritises the inputs into the fair
value measurement process.
Level 1 inputs are quoted prices (unadjusted) in active markets for items identical to the asset or liability being
measured. As with current IFRS, if there is a quoted price in an active market, an entity uses that price without
adjustment when measuring fair value. An example of this would be prices quoted on a stock exchange. The entity needs
to be able to access the market at the measurement date. Active markets are ones where transactions take place with
sufficient frequency and volume for pricing information to be provided. An alternative method may be used where it is
expedient. The standard sets out certain criteria where this may be applicable. For example, where the price quoted in
an active market does not represent fair value at the measurement date. An example of this may be where a significant
event takes place after the close of the market such as a business reorganisation or combination.
The determination of whether a fair value measurement is level 2 or level 3 inputs depends on whether the inputs are
observable inputs or unobservable inputs and their significance.
Level 2 inputs are inputs other than the quoted prices in level 1 that are directly or indirectly observable for that asset
or liability. They are quoted assets or liabilities for similar items in active markets or supported by market data. For
example, interest rates, credit spreads or yield curves. Adjustments may be needed to level 2 inputs and if this
adjustment is significant, then it may require the fair value to be classified as level 3.
Level 3 inputs are unobservable inputs. The use of these inputs should be kept to a minimum. However, situations may
occur where relevant inputs are not observable and therefore these inputs must be developed to reflect the assumptions
that market participants would use when determining an appropriate price for the asset or liability. The entity should
maximise the use of relevant observable inputs and minimise the use of unobservable inputs. The general principle of
using an exit price remains and IFRS 13 does not preclude an entity from using its own data. For example, cash flow
forecasts may be used to value an entity that is not listed. Each fair value measurement is categorised based on the
lowest level input that is significant to it.

18
(b) Year to 31 December 2012 Asian Market European Market Australasian Market
Volume of market – units 4 million 2 million 1 million
Price $19 $16 $22
Costs of entering the market ($2) ($2) (n/a) see note
Potential fair value $17 $14 $22
Transaction costs ($1) ($2) ($2)
Net profit $16 $12 $20
Note: As Jayach buys and sells in Australasia, the costs of entering the market are not relevant as these would not be incurred.
Further transaction costs are not considered as these are not included as part of the valuation.
The principal market for the asset is the Asian market because of the fact that it has the highest level of activity due to the
highest volume of units sold. The most advantageous market is the Australasian market because it returns the best profit per
unit. If the information about the markets is reasonably available, then Jayach should base its fair value on prices in the Asian
market due to it being the principal market, assuming that Jayach can access the market. The pricing is taken from this
market even though the entity does not currently transact in the market and is not the most advantageous. The fair value
would be $17, as transport costs would be taken into account but not transaction costs.
If the entity cannot access the Asian or European market, or reliable information about the markets is not available, Jayach
would use the data from the Australasian market and the fair value would be $22. The principal market is not always the
market in which the entity transacts. Market participants must be independent of each other and knowledgeable, and able
and willing to enter into transactions.
Input Amount ($ 000)
Labour and material cost 2,000
Overhead (30%) 600
Third party mark-up – industry average (20% of 2,600) 520
––––––
Total 3,120
Annual inflation rate (3,120 x 5% compounded for three years) 492
––––––
Total 3,612
Risk adjustment – 6% 217
––––––
Total 3,829
––––––
Discounted at risk free rate of government bonds plus entity’s non-performance risk – 6% 3,215
The fair value of a liability assumes that it is transferred to a market participant at the measurement date. In many cases there
is no observable market to provide pricing information. In this case, the fair value is based on the perspective of a market
participant who holds the identical instrument as an asset. If there is no corresponding asset, then a valuation technique is
used. This would be the case with the decommissioning activity. The fair value of a liability reflects any compensation for risk
and profit margin that a market participant might require to undertake the activity plus the non-performance risk based on
the entity’s own credit standing. Thus the fair value of the decommissioning liability would be $3,215,000.

19