AF301 ACCOUNTING THEORY AND APPLICATIONS

Topic : Fair Value Measurement

You will have learned from an earlier session in this course that the IASB is currently working on a project to develop a new Conceptual Framework to employ as a frame of reference in construction entities’ external financial reports. One of the issues that the IASB is still working on is the principle of measurement. The following bases for measurement are currently under consideration,-

(a) Historical cost

(b) Modified historical cost (for depreciation and impairment,- that is a downward adjustment to a carrying amount where it is necessary to ensure that no asset is reported at an amount that exceeds that obtainable from using or selling it.)

(c) Current entry price (the cost to replace an item)

(d) Current exit price (the sum obtainable if an asset is sold, or the sum paid out if a liability is discharged)

(e) Fair value as defined in IFRS 13.

(f) Present value

(g) Value to the entity (the lower of replacement cost as compared with the higher of present value and net realizable value)

The IASB’s current thinking is that each of these bases may be the most appropriate form of measurement to employ for at least one line item typically found reported in an entity’s statement of financial position. Application of fair value accounting in financial reporting is therefore likely to be selective.

In times past the IASB and its forerunner the IASC have used the term ‘fair value’ rather loosely. Where accounting standards have used the term ‘fair value’ the standard setter has intended it to mean different things in different standards, so at one time or another items (c),(d).(f) and (g) have all been understood as fair values. In 2010 the IASB issued ‘IFRS 13 Fair Value Measurement’. The IASB required adoption of IFRS 13 for reporting periods beginning on or after 1st January 2013. From that date preparers of financial reports are to understand the term ‘fair value’ and determine fair value measures and make disclosures as required IFRS 13 in almost all cases where the term is used in the IASB’s suite of accounting standards. The IASB’s objectives in developing IFRS 13 are as follows,-

a) To define fair value measurement

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b) To establish a framework for measuring fair value that is to be applied (with some minor exceptions) in all contexts.

c) To establish disclosure requirements in relation to fair value.

IFRS 13 does not specify that any asset or liability must be measured at fair value. It specifies how fair value is to be measured where such a valuation may be, or must be, reported to comply with any other Standard.

Fair Value Defined:-

IFRS 13 “Fair Value Management” 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.”

This will impact on the reporting required under the following statements for reporting periods commencing on or after 1st January 2013, where the term ‘fair value’ has been used but defined differently.

IAS 16: Property Plant and EquipmentIAS 32: Financial Instruments PresentationIAS 38: Intangible AssetsIAS 39: Financial Instruments : Recognition and MeasurementIAS 40: Investment PropertyIFRS 4: Insurance ContractsIFRS 5: Non-current assets held for sale and discontinued operations.

The following standards make reference to market based valuations in financial reporting, without offering a definition of ‘fair value’.

IAS36 Impairment of AssetsIAS41 AgricultureIFRS6 Exploration for the Evaluation of Mineral ResourcesIFRS7 Financial Instrument DisclosuresIFRS9 Financial Instruments

The IFRS 13 definition will apply to all these Standards.

However the definition does not apply in the following cases,-

IAS17 Leases IAS19 Employee Benefits IAS26 Accounting for Reporting by Retirement Benefit Plans IFRS2 Share Based Payments

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Measurement of ‘net realiasable value’ (IAS2) and ‘value in use’ (IAS36) are not affected.

How does application of fair value accounting impact on equity?

IFRS 13 does not in itself require any account to be reported at fair value. In some of the standards listed above reporting fair values is required, in other it is an option. However use of fair values in financial reporting raises the issue as to how the value changes from the original costs recorded in the ledger system will impact on how equity is reported in the financial statements. Should any value change be considered part of the operating profit measure, a part of the ‘other comprehensive income’ measure, or should it be taken to the statement of changes in equity? While IFRS 13 has provided a rationalisation of our understanding of fair value, it has not rationalised how we report the impact of reported value changes on equity. For example IFRS 9 ‘Financial Instruments’ requires the following,-

Such assets held solely in order to collect contractual cash flows, - report at amortised cost.. Such assets held in order to collect contractual cash and possibly to sell at some unspecified

future date,- report at ‘fair value through other comprehensive income’ All other financial assets are to be reported at ‘fair value through profit or loss’.

How do we find the fair value for any asset or liability?

As fair value is a market based measurement it is necessary to consider which market an entity should refer to in taking a measurement. The appropriate market is deemed to be the principal market the entity operates in, and if there is no principal market, the market that is the most advantageous for the entity to operate in. Note that an entity, which is more likely to buy than to sell in the market seeks the market it is best to make purchases in, but will report the net selling price in that market. In making a decision as to which market is most advantageous to operate in, both transaction costs and transportation costs are obviously relevant. Consider the following example,-

Example 1

Asset XYZ is sold in two different active markets.

In market A, the price that would be received is $27; transaction costs are $4 and the costs to transport Asset XYZ to Market A are $2In market B, the price that would be received is $26; transaction costs are $1 and the costs to transport Asset XYZ to Market B are $3

Required:(a) Which is the most advantageous market?(b) What will the reported fair value be for asset XYZ?

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Acknowledgement: Adapted from IASB (2013) IFRS 13 Fair Value Measurement, Illustrative Examples

But, suppose there is only an imperfect market for an asset.

Example 2

When you start work you may decide that you want to get your own car. Few of us can afford to buy a brand new vehicle. How will you determine the fair value for a second hand car? (IAS 16 allows but does not require non current assets to be reported at fair value).

Or suppose that there is no market for an asset at all.

Example 3

How would you determine the fair value of shares in the following companies operating in Fiji?

Fijian Holdings Limited Kontiki Growth Fund Asian Paints Ltd Basic Industries New World Ltd

(IFRS 9 requires investments, other than investments in subsidiary and associate companies to be reported at fair value)

It is worth noting that George Benson an American academic has estimated, in the context of the American economy, that only 1% of fair values that could be determined purely on quoted prices.

Now consider example 4

Example 4

Twinkle Toes Ltd conducts a business that makes women’s shoes. It operates a factory in a suburb of Nadi. The company owns both the factory and the land on which the factory stands. The land was acquired in 2001 for $200000 and the factory was built in that year at a cost of $520000. Both assets are recorded at a cost, with the factory having a carrying amount at 31 st

December 2012 of $260000.

In recent years there has been a property boom on the outskirts of Nadi, with residential house prices doubling such that the average price of a house is approximately $500000. A recent valuation of the land on which the factory stands as performed by a property valuation group and based on recent sales of land in the area has the land at a value of $1000000. The land is now considered prime residential property given its closeness to Denarau and its suitability for

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building executive apartments. It would cost $100000 to demolish the factory to make way for these apartments to be built. The directors of Twinkle Toes Ltd want to report both the factory and the land at fair value.

How would you go about determining the fair values?

Acknowledgement: This example has been adapted from material appearing in Leo K., J. Hoggett and J. Sweeting (2012) ‘Company Accounting’ 9th edition. Wiley.

And finally consider example 5

Example 5

On 1st January 2013 Swift Expansion Ltd issues a fixed interest security at a unit par value of $1000, raising $2 million, with a coupon rate of 6%, maturing on 31st December 2022.. Fiji Finance Ltd purchased 200 units at issue date. On 31st December 2013 Swift Expansion Ltd is considering issuing another fixed interest security that will also mature on 31 st December 2022. Examining conditions prevailing in the market, it concludes that it will have to offer a coupon rate of 8% per annum if it is to attract investors to purchase units of the security at its par value.

Required:

(a) Determine the fair value of the securities issued by Swift Expansion Ltd as at 31st

December 2013 applying the provisions of IFRS 13.(b) Construct the journal entries Swift Expansion Ltd and Fiji Finance Ltd will have made on

1st January and at 31st December 2013 in relation to the sale and purchase of this security.

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Appendix: Illustrative Example of Disclosure Required by IFRS 13

Table 1: Disclosure requirements complying with paragraphs 93(a) and (b) of IFRS 13

Fair value measurements at the end of the

reporting period using

Quoted prices

in active Significant

markets for other Significant

identical observable unobservable Total

assets inputs inputs gains

Description 31/12/X9 (Level 1) (Level 2) (Level 3) (losses)

Recurring fair value $000 $000 $000 $000

measurements

Trading equity securities

Real estate industry 93 70 23

Oil gas industry 45 45

Other 15 15

Total trading equity securities 153 130 23

Other equity securities

Financial services industry 150 150

Healthcare industry 163 110 53

Energy industry 32 32

Private equity fund investments 25 25

Other equity securities 15 15

Total other equity securities 385 275 110

Non-recurring fair value

measurements

Assets held for sale 26 (15)

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Table 2: Disclosure requirements complying with paragraph 93(d) of IFRS 13

Quantitative information about fair value measurements using

significant unobservable inputs (Level 3)

Fair value at Valuation Unobservable

Range (weighted

Description 31/12/X9 technique(s) input average)Other equity securities: $000

Healthcare industry 530Discounted cash flow weighted average cost of capital

7%-16% (12.1%)

long-term revenue growth rate 2%-5% (4.2%)long-term pre-tax operating margin

3%-20% (10.3%)

discount for lack of marketability 5%-20% (17%)

control premium10%-30% (20%)

Market comparable companies EBITDA multiple 10-13 (11.3)

revenue multiple 1.5-2.0 (1.7)

discount for lack of marketability 5%-20% (17%)

control premium10%-30% (20%)

Equity securities Debt securitiesResidential mortgage

Private equity fund backed securities TotalOpening balance 20 105 125 Transfers into Level 3 60(a)(b) 60 Transfers out of Level 3 (5)(b)(c) (5)Total gains or losses for the period Included in profit or loss 5 (23) (18) Included in other comprehensive

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incomePurchases, issues, sales andsettlements Purchases Issues Sales (12) (12) SettlementsClosing balance 25 125 150

Change in unrealised gains or lossesfor the period included in profitor loss for assets held at the end ofthe reporting period 5 (23) (18)

Table 3; Fair value measurements using significant unobservable inputs (Level 3) complying with paragraph 93 (e) of IFRS 13 in $millions

a) Transferred from Level 2 to Level 3 because of lack of observable market data, resulting from a decrease in market activity for the securities.

b) The entity’s policy is to recognize transfers into and transfers out of Level 3 as of the date of the event or change in circumstances that caused the transfer.

c) Transferred from Level 3 to Level 2 because observable market data became available for the securities.

Acknowledgement: These illustrative disclosures have been adapted from IASB (2013) IFRS 13 Fair Value Measurement: Illustrative Examples

Reading:

International Accounting Standards Board (2012) ‘IFRS 13 Fair Value Measurement (available on the IASB’s website)

Leo K, J Hoggett and J Sweeting (2012) ‘Company Accounting’ 9th edition. Chapter 5. Wiley

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