Doctorate of Business Administration

Fair Value Measurement

By: Associate Professor Dr. GholamReza Zandi

zandi@segi.edu.my

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Definition

• 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 price at which an asset or liability could be exchanged in a current transaction between knowledgable, unrelated willing parties (FASB).

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IFRS 13

• Do not apply to:– Share based payment transaction (IFRS 2 or

MFRS 2)– Leasing transaction (IAS 17 or MFRS 117)– Measurements that have some similarities to

FV but are not fair value, i.e. net realizable value in IAS 2 Inventories (MFRS 102) , or IAS 36 Impairment of Assets (MFRS 136).

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IFRS 13

• Disclosure of IFRS 13 are not required for the following:– Plan assets measured at FV in accordance

with IAS 19 Employee benefits (MFRS 119)– Retirement benefit plan investments

measured at fair value less costs of disposal in accordance with IAS 26 (MFRS 126)

– Assets for which recoverable amount is FV less costs of disposal in accordance with IAS 36.

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Objective of Fair Value Measurement

• To estimate an exchange price in the absence of an actual transaction, the FASB grappled with the reliability of fair value measures, the reliability of these measures compared with the reliability of other measures based on judgments and estimates, and the causes of unreliable measures.

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Implementing FV Measurement

• It requires the preparer of financial statements to estimate an exchange price.

• What is the ‘estimate’ price?• Who determines this price?• Highest priority to market inputs that reflect

quoted prices in active markets and lowest priority to inputs based on a firm’s own estimates and assumptions using valuation technique consistent with the market approach, income approach, and cost approach.

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Revaluation

• The revaluation or FV system of accounting differs from historical cost method in that fair value assigns some form of current value to assets instead of historical, reliable cost data.

• FV approach claims that it is more relevant in that it provides current measures.

• Revaluations can alter a firm’s financial ratios and provide more relevant picture of the company’s current financial position.

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The Approaches

• Market approach - Uses prices generated by actual transactions involving identical or similar assets or liabilities

• Income approach – techniques that discount future expected cash flows or earnings

• Cost approach – consider amount required to replace an asset’s service capacity.

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Market Approach

• Uses prices and other relevant information generated by market transactions involving identical or comparable/similar assets, liabilities or group of assets and liabilities.

• Whereby the rational investor would pay no more for an asset than the price at which comparable assets could be acquired in the market.

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Market Approach - Issues

• All valuations involve judgment– Judgment cannot be audited

• With regard to exotic financial derivatives there recently has been either NO market or the quoted prices were so far off of previous experience that they were called into question as to whether they truly reflected the FV?

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Cost Approach

• Reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost).

• Price that would be received for the asset is based on the cost to a market participant buyer to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence.

• A rational investor would not pay more for an existing asset that it would cost today to buy or make the asset.

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Cost Approach

• Only utilised in the allocation of purchase price, ie, take over of another company/subsidiary.

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Income Approach

• Converts future amounts (cash flows or income and expenses) to a single current (discounted) amount.

• When income approach is used, the FV measurement reflects current market expectations about future amounts.– Present value techniques– Option pricing models (incorporate PV techniques and

reflect time value and intrinsic value of an option)– Multi-period excess earnings method (for FV of some

intangibles)

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Income Approach

• One determines the value of an asset on basis of what income it can or will produce.

• The projected income stream from asset is then discounted back to today by use of ‘appropriate rate that reflects the risk’.

• In practice, determining the future cash flows associated with a security, a project or a business enterprise involves a lot of judgment.

• Most commonly used to value business enterprise and intangible assets.

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Income Approach - Issues

• Every cash flow projection involves assumptions about the future, while past results provide no assurance as to the future. Analysing income approach starts from the past.

• How realistic are the future sales, expenses etc.

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Arguments

• Accountants have long questioned the reliability of implementing fair value measures because estimating a firm’s future cash flow is subjective.

• Values not based on actual market prices have potential to be manipulated, which some believe increases uncertainty and added risk.

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Issues

• Accounting depreciation does not reflect actual diminution in value of PPE. Many fully depreciated assets are still in use and require no cash outlay.

• Accountants deal with accounting depreciation, while businessmen use economic depreciation in their decisions.

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Issues

• Productivity improvements mean that virtually no assets are ever replaced on a like-for-like basis. E.g. today’s car is better than ten year old car. There are no known indexes that capture technological improvements.

• In real business world, there are virtually no like-for-like replacements.

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Issues

• Newly acquired PPE and real estate, have substantially lower operating costs. Offset by higher depreciation.

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Prior Studies

• FV measurement is an endogenous consequence of the strategic interaction between firms.

• Implementing the FV rule in an imperfect and incomplete market requires preparers of financial statements to understand the multistage game between rivals in the product market so as to estimate market clearing prices.

• When policymakers require implementation of the Fv rule, they must assume that preparers of financial statement have this capability.

The End