Fair Value Measurement – A Step Forward on Valuations
INTRODUCTION
On June 2011, the Hong Kong Institute of Certified Public Accountants issued a new accounting standard - Hong Kong Financial Reporting Standard 13 Fair Value Measurement (HKFRS 13). This new accounting standard:
(a) Defines fair value;
(b) Sets out in a single HKFRS a framework for measuring fair value; and
(c) Requires disclosures about fair value measurements.
It applies to other HKFRSs that require or permit fair value measurements or disclosures about fair value measurements such as fair value less costs to sell. The HKFRS 13 is to be applied for annual periods beginning on or after 1 January 2013. Earlier application is permitted.
SCOPE
The HKFRS 13 applies when another HKFRS requires or permits fair value measurements or disclosures about fair value measurements. However, the measurement and disclosure requirements of the HKFRS 13 do not apply to:
(a) Share-based payment transactions within the scope of HKFRS 2 Share-based Payment;
(b) Leasing transactions within the scope of Hong Kong Accounting Standards (HKAS) 17 Leases; and
(c) Measurements that have some similarities to fair value but are not fair value, such as net realizable value in HKAS 2 Inventories or value in use in HKAS 36 Impairment of Assets.
MAIN FEATURES
The HKFRS 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 (i.e. an exit price). This definition of fair value emphasizes that fair value is a market-based measurement, not an entity-specific measurement. When measuring fair value, an entity uses the same assumptions that market participants would use when pricing the asset or liability under current market conditions, including assumptions about risk. As a result, an entity’s intention to hold an asset or to settle, or otherwise fulfill a liability is not relevant when measuring fair value.
FAIR VALUE MEASUREMENT APPROACH
The HKFRS 13 explains that a fair value measurement requires an entity to determine:
(a) The particular asset or liability being measured;
(b) For a non-financial asset, the highest and best use of the asset and whether the asset is used in combination with other assets or on a stand-alone basis;
(c) The principal or most advantageous market for the asset or liability; and
(d) The appropriate valuation technique(s) to use when measuring fair value. The valuation technique(s) used should maximize the use of relevant observable inputs and minimize unobservable inputs. Those inputs should be consistent with the inputs a market participant would use when pricing the asset or liability.
The Asset or Liability
When measuring fair value an entity shall take into account the characteristics of the asset or liability if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. Such characteristics can include the following:
(a) The condition and location of the asset; and
(b) Restrictions, if any, on the sale or use of the asset
The effect on the measurement arising from a particular characteristic will differ depending on how that characteristic would be taken into account by market participants.
Market
A fair value measurement assumes 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 principal market, in the most advantageous market for the asset or liability.
An entity need not undertake an exhaustive search of all possible markets to identify the principal market or most advantageous market, but it shall take into account all information that is reasonably available. In the absence of evidence to the contrary, the market in which the entity would normally enter into a transaction to sell the asset or to transfer the liability is presumed to be the principal market or the most advantageous market.
Assumptions Used
An entity shall measure the fair value of an asset or liability using the same assumptions that market participants would use when pricing the asset or liability, assuming that market participants act in their economic best interest.
Price
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (i.e. an exit price) regardless of whether that price is directly observable or estimated using another valuation technique. [para.24]
Price Adjustment
The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs, however, if location is a characteristic of the asset, the price in the principal (or most advantageous) market shall be adjusted for the costs that would be incurred to transport the asset from its current location to that market. [para.25, 26]
Application to Non-financial Assets
In the fair value measurement of a non-financial asset, one should take into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use. [para.27] The highest and best use of a non-financial asset takes into account the use of the asset that is physically possible, legally permissible and financially feasible, as follows: [para.28]
(a) A use that is physically possible takes into account the physical characteristics of the asset that market participants would also take into account when pricing the asset (e.g. the location or size of a property).
(b) A use that is legally permissible takes into account any legal restrictions on the use of the asset that market participants would also take into account when pricing the asset (e.g. the zoning regulations applicable to a property).
(c) A use that is financially feasible takes into account whether the use of the asset that is physically possible and legally permissible generates adequate income or cash flows (considering the costs of converting the asset to that use) to produce an investment return that market participants would require from an investment in that asset put to that use.
An entity’s current use of a non-financial asset is presumed to be its highest and best use unless market or other factors suggest that a different use by market participants would maximise the value of the asset. [para.29]
Valuation Technique
An entity shall use valuation techniques that are appropriate in the circumstances and for which sufficient data is available to measure fair value, maximising the use of relevant observable inputs and minimising the use of unobservable inputs. [para.61] The objective of using a valuation technique is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants, at the measurement date, under current market conditions. Three widely used valuation techniques are: [para.62]
(a) market approach,
(b) cost approach; and
(c) income approach.
An entity shall use valuation techniques consistent with one or more of those approaches to measure fair value.
In some cases a single valuation technique will be appropriate (e.g. when valuing an asset or a liability using quoted prices in an active market for identical assets or liabilities). In other cases, multiple valuation techniques will be appropriate (e.g. this may be the case when valuing a cash-generating unit). If multiple valuation techniques are used to measure fair value, the results (i.e. respective indications of fair value) shall be evaluated considering the reasonableness of the range of values indicated by those results. A fair value measurement is the point within that range that is most representative of fair value in the circumstances. [para.63]
Inputs to valuation techniques
The general principles in using valuation techniques to measure fair value are to maximise the use of relevant observable inputs and minimise the use of unobservable inputs. [para.67] Examples of markets in which inputs might be observable for some assets and liabilities (e.g. financial instruments) include: [para.68]
(a) exchange markets,
(b) dealer markets,
(c) brokered markets; and
(d) principal-to-principal markets.
If an asset or a liability measured at fair value has a bid price and an ask price (e.g. an input from a dealer market), the price within the bid-ask spread that is most representative of fair value in the circumstances shall be used to measure fair value. [para.70] The use of bid prices for bid prices for asset positions and ask prices for liability positions is permitted, but is not required. Furthermore, the HKFRS 13 does not preclude the use of mid-market pricing or other pricing conventions that are used by market participants as a practical expedient for fair value measurements within a bid-ask spread. [para.71]
Fair Value Hierarchy
To increase consistency and comparability in fair value measurements and related disclosures, the HKFRS 13 establishes a fair value hierarchy that categorizes the inputs to valuation techniques into three levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs). [para.72]
(a) Level 1 inputs are quoted prices (unadjusted) in active markets (i.e. principal market, most advantageous market or recent entity’s transaction) for identical assets or liabilities that the entity can access at the measurement date. [para.76] A quote price in an active market provides the most reliable evidence of fair value and shall be used without adjustment to measure fair value whenever available except when: [para.77]
• An entity holds a large number of similar assets or liabilities for which quoted price in active markets are available but not readily accessible for each of those assets or liabilities individually. The entity may therefore measure fair value by using an alternative pricing method that does not rely exclusively on quoted prices, for instance matrix pricing, but the resulting fair value measurement will be categorized within a lower level of fair value hierarchy.
• The quoted price in an active market does not represent fair value at the measurement date, e.g. significant events after the close of a market but before the measurement date. An entity shall establish and consistently apply a policy for identifying those events that might affect fair value measurements. However, if the quoted price is adjusted for new information, the resulting fair value measurement will be classified in a lower level of the fair value hierarchy. [para.79]
(b) Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. [para.79] Level 2 inputs include the following:
i. Quoted prices for similar assets or liabilities in active markets.
ii. Quoted prices for identical or similar assets or liabilities in markets that are not active.
iii. Inputs other than quoted prices that are observable for the asset or liability, for example:
• Interest rates and yield curves observable at commonly quoted intervals;
• Implied volatilities; and
• Credit spreads.
iv. Market-corroborated inputs.
Remarks for Level 2
If adjustment to Level 2 inputs is required, it will vary depending on factors specific to the asset or liabilities, which include:
1) The condition or location of the asset;
2) The extent to which inputs relate to items that are comparable to the asset or liability (including those factors described in paragraph 39); and
3) The volume or level of activity in the markets within which the inputs are observed.
An adjustment to a Level 2 input that is significant to the entire measurement might result in a fair value measurement categorized within Level 3 of the fair value hierarchy if the adjustment uses significant unobservable inputs.
Here are some examples for Level 2 inputs:
1) Receive-fixed, pay-variable interest rate swap based on the London Interbank Offered Rate (LIBOR) swap rate;
2) Receive-fixed, pay-variable interest rate swap based on a yield curve denominated in a foreign currency;
3) Receive-fixed, pay-variable interest rate swap based on a specific bank’s prime rate;
4) Three-year option on exchange-traded shares;
5) Licensing arrangement;
6) Finished goods inventory at a retail outlet;
7) Building held and used; and
8) Cash-generating unit - derived from observable market data, e.g. multiples derived from prices in observed transactions involving comparable (i.e. similar) businesses.
(c) Level 3 inputs are unobservable inputs for the asset or liability. Examples of Level 3 inputs are:
1) Long-dated currency swap;
2) Three-year option on exchange-traded shares;
3) Interest rate swap;
4) Decommissioning liability assumed in a business combination. – current estimate using the entity’s own data about the future cash outflows to be paid to fulfill the obligation; and
5) Cash-generating unit - developed using the entity’s own data.
Disclosure
1) An entity shall disclose information that helps users of its financial statements assess both of the following:
(a) For assets and liabilities measured at fair value on a recurring or non-recurring basis in the statement of financial position after initial recognition, 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.
2) An entity shall follow the following table to determine items that should be disclosed.
CONCLUSION
Many of the HKFRS 13 requirements are consistent with industry practices that already operate today. However, it is the first time the concepts (e.g. highest and best use and principal market) have explicitly been part of HKFRS literature.
HKFRS 13 consolidates all fair value measurement guidance dispersed across different standards into a single standard as a single source of guidance on how fair value is measured. It makes the fair value measurement procedure standardised. The HKFRS 13 has made a clear explanation on the fair value, the market, the valuation technique, the concept of highest and best use and the fair value hierarchy. This has established a framework for the entity and Valuers to follow when determining fair value.
Overall, HKFRS 13 is an important step forward in establishing an objective and consistent fair value measurement in the valuation industry.