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Fair value measurement of financial instruments – 6

IFRS Watch - Issue 32

Changes in valuation techniques

Various valuation techniques are used to estimate fair value. Each has its own merits and suitability to the instrument being valued in the given circumstances. In practice, different valuation techniques can give rise to different estimates of fair value and, therefore, it is important to select the most appropriate methodology for the given circumstances.

Once a valuation technique has been selected, it should be applied consistently. However, a change in a valuation technique or its application (e.g. a change in its weighting when multiple valuation techniques are used or a change in an adjustment applied to a valuation technique) is appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances. That might be the case if, for example, any of the following events take place:

  • new markets develop;
  • new information becomes available;
  • information previously used is no longer available;
  • valuation techniques improve; or
  • market conditions change.

If there is a change in the valuation technique used or its application, any resulting difference should be accounted for as a change in accounting estimate in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors; in such circumstances, the disclosures in IAS 8 for a change in accounting estimate are not required. [IFRS 13:66]

Inputs to valuation techniques

Inputs are defined as “the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk, such as the following:

(a) the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model); and

(b) the risk inherent in the inputs to the valuation technique.”

The reliability of a fair value measurement derived from a valuation technique is dependent on both the reliability of the valuation technique as well as the reliability of the inputs that
go into the model. Consequently, when selecting a valuation technique it will be important to consider the availability of reliable inputs for that valuation.

Valuation inputs that are observable are more reliable than those that are unobservable (sometimes referred to as 'entity-specific' because these inputs are derived by an entity rather than by the 'market'). Therefore, valuation techniques used to measure fair value should maximise the use of relevant observable inputs and minimise the use of unobservable inputs.

Various factors may influence the fair value of a financial instrument. Below is a non-exhaustive list of factors that may be relevant in valuing non-derivative and derivative financial instruments:

  • time value of money (i.e. interest at the risk-free rate);
  • credit risk (both counter-party credit risk for a financial asset and own credit risk for a financial liability)
  • liquidity risk;
  • foreign currency exchange rates;
  • commodity prices;equity prices;
  • volatility;
  • prepayment or surrender risk; and
  • servicing costs.

The following additional guidance is provided regarding inputs used for valuation techniques:

An entity should select inputs that are consistent with the characteristics of the asset or liability that market participants would take into account in a transaction for the asset or liability.

In some cases, those characteristics result in the application of an adjustment, such as a premium or discount (e.g. a control premium or non-controlling interest discount). However, a fair value measurement should not incorporate a premium or discount that is inconsistent with the unit of account in the IFRS that requires or permits the fair value measurement.

Premiums or discounts that reflect size as a characteristic of the entity's holding are not permitted in a fair value measurement. For example, an investor holding one share that is quoted in an active market may receive a different amount of consideration per share compared to an investor that sells 20% of the total equity shares. The difference between the two holdings is simply the size of the investor's holding, which IFRS 13 states is not a characteristic of the financial asset and thus cannot be considered in the fair value measurement. For both investors the fair value measurement of the shares is the price for disposing of a single share multiplied by the quantity held.

In contrast, when measuring the fair value of a controlling interest, it is appropriate to incorporate a control premium because IFRS 13 regards the control premium as a characteristic of the asset or liability.

In all cases, if there is a quoted market price in an active market for an asset or a liability, the entity should use that price without adjustment when measuring fair value, except as specified in IFRS 13:79.

Observable inputs

Examples of markets in which inputs might be observable for some assets and liabilities include the following.

Exchange markets - In an exchange market, closing prices are both readily available and generally representative of fair value (e.g. the Nigeria Stock Exchange).

Dealer markets - In a dealer market, dealers stand ready to trade (either buy or sell for their own account),  thereby providing liquidity by using their capital to hold an inventory of
the items for which they make a market. Typically, bid and ask prices (representing the price at which the dealer is willing to buy and the price at which the dealer is willing to sell, respectively) are more readily available than closing prices. Over-the-counter markets (for which prices are publicly reported) are dealer markets. Dealer markets also exist for some other assets and liabilities, including some financial instruments, commodities and physical assets (e.g. used equipment).

Brokered markets - In a brokered market, brokers attempt to match buyers with sellers but do not stand ready to trade for their own account. Brokers do not use their own capital to hold an inventory of the items for which they make a market. The broker knows the prices bid and asked by the respective parties, but each party is typically unaware of another party's price requirements. Prices of completed transactions are sometimes available. Brokered markets include electronic communication networks, in which buy and sell orders are matched, and commercial and residential real estate markets.

Principal-to-principal markets - In a principal-to-principal market, transactions, both originations and re-sales, are negotiated independently with no intermediary. Little information about those transactions may be made available publicly.

Quoted prices provided by third parties

IFRS 13 does not preclude the use of quoted prices provided by third parties, such as pricing services or brokers, if it is determined that the quoted prices provided by those parties are developed in accordance with IFRS 13.

However, if there has been a significant decrease in the volume or level of activity for the asset or liability, an entity is required to evaluate whether the quoted prices provided by third parties are developed using current information that reflects orderly transactions or a valuation technique that reflects market participant assumptions (including assumptions about risk). In weighting a quoted price as an input to a fair value measurement, an entity should place less weight (when compared with other indications of fair value that reflect the results of transactions) on quotes that do not reflect the result of transactions.

Furthermore, the nature of a quote (e.g. whether the quote is an indicative price or a binding offer) should be taken into account when weighting the available evidence, with more weight given to quotes provided by third parties that represent binding offers.

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