Remi Forgeas
Remi Forgeas

Differences in the Definition of Fair Value and the Related Disclosures

IFRS closes the gap with FASB on fair value to provide a single definition of fair value in IFRS.

October 06, 2011
by Remi Forgeas, CPA

Despite the convergence project between Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) and the growing importance of fair value in accounting standards, there were significant differences in the definition of fair value and the related disclosures. With the adoption of IFRS 13, Fair Value Measurement last May, these differences disappeared almost entirely.

IFRS 13 aims to provide a single definition of fair value in IFRS. It also brings together all the guidance in determining fair value that could be found in various IFRS statements. Not surprisingly, these objectives are similar to those FASB followed when FAS 157 — Fair Value Measurements, now Topic ASC820, was issued.

IFRS 13 should be applied for annual periods beginning on or after 1 January 2013.

Who Is Impacted?

YES, YES and YES. All companies are impacted by this standard.

Example: The standard on business combination (IFRS 3) requires the acquirer to measure all the assets and liabilities acquired at fair value. This measurement will be carried out according to IFRS 13.

Despite the fact that a lot of standards require some kind of fair value determination, until the adoption of IFRS 13, there was no consistency in fair value determination.

The following list is a sample of standards requiring some sort of fair value determination:

  • IAS 16 allows fair value measurement of tangible fixed assets;
  • IAS 39 and IFRS 9 make extensive use of fair value to measure financial instruments;
  • IAS 41 uses the concept of fair value in measuring biological assets and agricultural products;
  • IFRS 3 requires the acquired assets and liabilities to be measured at fair value.

It should be noted that IFRS 13 does not apply to fair value measurement for the purposes of IAS 17 Leases and IFRS 2 Share-based payments. IAS 36 defines the recoverable value of an asset as the higher of its fair value, fewer costs to sell and its value in use.

IFRS 13 Covers Only the ‘How’, Not the ‘When’

This standard provides guidance on how to determine fair value, but does not change the scope of fair value application, which other standards still provide.

This segregation between the “when” and the “how” led many commentators to express their concern over the definition of the “fair value” as a general concept not attached to specific transactions or assets/liabilities.

The IFRS Fair Value Is Now Aligned With U.S. GAAP

Fair value used to be defined as the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm's-length transaction.

Under IFRS 13, 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.

This definition introduces three important concepts:

  • Fair value is based on an exit price;
  • Value of a liability can be defined using the notion of transferability;
  • Fair value is a market value and cannot be an entity-specific value.

An Exit Price at the Time of Initial Recognition

On the surface, the exit price for one participant is the entry price for another entity. This fact is not very obvious.

There could be a difference between the entry price and the exit price of an asset if, for example, the asset is acquired in a primary market and is sold only in a secondary market.

Also, there can be no explicit entry price provided the asset is acquired as part of a business combination as an ancillary item.

Fair Value Is a Market Value

Where there is no market, many assets and liabilities measured at fair value are not traded on active or non-active markets.

Standard setters have acknowledged this fact and thus the standard requires preparers to determine the fair value as though an active market existed. A number of assumptions accompany this “theoretical” valuation.

When the asset can be traded on various markets, preparers should apply the price to the principal market. The principal market is the market in which the largest volumes are traded. Otherwise, the most advantageous market should be used. Note: The entity must have access to the market.

The Highest and Best Use of a Non-Financial Asset

Fair value is the value at which an entity can sell the asset to a market participant in the principal market. This market participant is assumed to offer a price that reflects the highest and best use for the participant. This notion of best use viewed from the market participant standpoint, and not from the company, has complex practical impacts.

Real life Example: Through the acquisition of a business, an entity acquires a brand. For strategic reasons, it does not intend to use it or to sell it. From the acquirer’s point of view, this brand has no value.

Prior to the adoption of IFRS 13, at the time of the purchase price allocation, no value would have been allocated to this asset.

Under IFRS 13, the fair value of this brand will be estimated from a market participant standpoint, i.e., a competitor. Consequently, the fair value assessed may be high. Hence, there will be a shift from goodwill to an identified intangible asset that the company does not intend to use or sell.

The standard requires extensive disclosures with regards to the reasons why the asset is not used optimally.

A Three-Level Approach Based on Inputs

The three-level fair value hierarchy was already in IFRS 7 — Financial Instruments: Disclosures. IFRS 13 adopts this principle, but relies more on the quality of the inputs than on the valuation methodology.

It is the weakest inputs that determine the fair value measurement level of the instrument. For example, a fair value mainly based on Level 1 inputs, but that includes Level 3 elements can also be classified as Level 3.

Three-Level Fair Value Hierarchy Definition

Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities that the 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.

Level 3: Unobservable inputs for the asset or liability.

The entity cannot choose its measurement method. It must apply the method which optimizes the fair value measurement level of the instrument.

The main impact of the fair value classification is the size of the related disclosures (limited to Level 1 inputs, extensive with Level 3 inputs).

Several Proposed Valuation Techniques

The standard focuses on inputs; however it still requires the use of one of the three following valuation techniques:

  • The “market” approach, which is based on public and available information.
  • The “income” approach, which is similar to discounted cash-flow approach.
  • The “cost” approach, which focuses on the replacement cost.

Priority must always be given to the valuation technique that results in the better quality fair value (i.e. the set up of an active market may lead to establishing a Level 1 fair value instead of a Level 3 fair value).

Fair Value of Liabilities

The standard develops the principle of a “transfer” price for liabilities, not just a value for its settlement.

IFRS 13 proposes that asset valuation techniques may be used for any liability for which a transfer price cannot be determined. Where applicable, price adjustments may be necessary to reflect the fact that this is a valuation from the point of view of of the market participant. See, for example, IAS 13 paragraphs 37 and 40.

Finally, IFRS 13 explicitly states that the fair value of a liability must consider the risk of non-performance.

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Remi Forgeas, CPA, is an audit and assurance partner for WeiserMazars LLP US and provides his views on international convergence of GAAP and whether progress is really being made in light of recent developments. For U.K. IFRS, you can contact, Steven Brice who is a technical partner in the financial reporting advisory group for WeiserMazars LLP UK and provides his views on international convergence of GAAP and whether progress is really being made in light of recent developments.

* The views expressed in this article are the author’s own and do not necessarily reflect the views of the AICPA or AICPA CPA Insider.