Overview IFRS 13 understand inputs to valuation techniques
Level 2 and 3 inputs assessment approach
Step 4: determine level 2 or 3 in the hierarchy of the significant input (or all significant inputs)
Fair value measurements and inactive markets
Overview IFRS 13 understand inputs to valuation techniques
The fair value standards define a principal market as the market with the greatest volume and level of activity for the asset or liability. It further states that market participants are buyers and sellers in this market that are independent of each other, knowledgeable, and willing and able to enter into a transaction for the asset or liability.
The determination of the reporting entity’s principal market is made from the perspective of the reporting entity; the availability of pricing inputs is not part of that assessment. For example, if the reporting entity is a retail customer and does not have access to the wholesale market, the reporting entity’s principal market is the retail market and quoted prices in the wholesale market will not qualify as fair value for that reporting entity.
If a price for the exact unit of account (i.e., a Level 1 input) is not available in the principal market, then valuation techniques will require one or more inputs from the same or other markets to derive fair value. The availability of pricing inputs from other markets may impact the choice of valuation technique. For example, if Level 1 inputs are available in another market for a market approach, that approach may provide more objective evidence of fair value than an income approach using Level 2 inputs from the principal market. However, as the price is not from the reporting entity’s principal market, it is no longer considered a Level 1 input.
By distinguishing between inputs that are observable in the marketplace, and therefore more objective, and those that are unobservable and therefore more subjective, the hierarchy is designed to indicate the relative subjectivity and reliability of the fair value measurements.
Disclosure is required by level; as the objectivity of the inputs decrease, disclosure increases. Certain required disclosures are applicable only to those fair value assets and liabilities characterized as Level 3. IFRS 13 understand inputs to valuation techniques
Fair value hierarchy
The evaluation of the significant inputs determines the asset or liability’s classification within the fair value hierarchy. The key characteristics of each level are as follows:
Quoted prices for identical assets or liabilities in active markets (unadjusted)
Quoted prices for similar items in active markets
Quoted prices for identical/similar items, no active market
Liabilities traded as assets in inactive markets
Unobservable inputs (e.g., a reporting entity’s or other entity’s own data)
Market participant (not entity-specific) perspective is still required
A common misconception is that securities that are “less risky” should be categorized in Level 1. For instance, many might perceive US Treasury securities as essentially risk-free, and, therefore, should be considered Level 1 in the fair value hierarchy. However, certain Treasury securities are more appropriately categorized in Level 2 because they do not trade in an active market.
Level 1 inputs
Level 1 inputs are quoted prices (unadjusted) for identical assets or liabilities in active markets. A quoted price for an identical asset or liability in an active market (e.g., an equity security traded on a major exchange) provides the most reliable fair value measurement and, if available, should be used to measure fair value in that particular market.
In practical terms, the list of instruments that likely qualify as Level 1 fair value measurements is fairly narrow (i.e. assessment of such an input is uncomplicated). It includes the following:
- Listed equity securities traded in active, deep markets (for example, NYSE, NASDAQ, etc.)
- London Metal Exchange futures contract prices IFRS 13 understand inputs to valuation techniques
- On-the-run Treasury bonds1
- Treasury bills (both on- and off-the-run,2 because of the high volume of trades and pricing based on those trades) IFRS 13 understand inputs to valuation techniques
- Exchange-traded futures and options IFRS 13 understand inputs to valuation techniques
- Open-ended mutual funds with published daily NAV at which investors can freely subscribe to or redeem from the fund
- Closed-ended registered mutual funds (for example, exchange-traded funds) traded on active markets IFRS 13 understand inputs to valuation techniques
Certain derivative transactions, such as interest rate and credit default swaps, are executed through clearing houses.
Each day, the clearinghouse provides a “value mark” that dictates the amount owed by/to the counterparty. Because this value mark is not a value at which a reporting entity could open or close the trade at that particular point in time, the value mark is not a Level 1 fair value input.
Level 2 and 3 inputs assessment approach
The following figure illustrates the steps to differentiate Level 2 and Level 3 within the fair value hierarchy of a fair value measurement. Level 1 fair value measurements have been excluded from the framework as they have a Level 1 price for the entire unit of account.
– Restricted assets IFRS 13 understand inputs to valuation techniques
Assess disclosure requirements IFRS 13 understand inputs to valuation techniques
Reassess conclusions at each reporting date => go to step 1 IFRS 13 understand inputs to valuation techniques
Step 1: determine all inputs to valuation techniques
Inputs broadly refer to the information that market participants use to make pricing decisions, including assumptions about risk. Inputs may include price information, revenue growth, changes in profitability, volatility factors, specific and broad credit data, liquidity statistics, and all other factors that have more than an insignificant effect on the fair value measurement.
Reporting entities should use observable inputs when available. IFRS 13 understand inputs to valuation techniques
Step 2: determine which inputs are significant
In some cases, a valuation technique used to measure fair value may include inputs from multiple levels of the fair value hierarchy. IFRS 13 73 indicates that the asset or liability is categorized in its entirety on the lowest level of a significant input. IFRS 13 understand inputs to valuation techniques
One significant unobservable input results in the entire asset or liability being classified in Level 3. Therefore, the reporting entity needs to identify all significant inputs when determining the appropriate classification within the hierarchy.
Assessing the significance of a particular input to the fair value measurement requires judgment, and should consider factors specific to the asset or liability. There are no bright lines for determining significance. A reporting entity should develop and consistently apply a policy for assessing significance.
IFRS 13 B35(b) provides an example of an interest rate swap with a ten-year life that has an observable yield curve for nine years. In that example, provided that the extrapolation of the yield curve to the tenth year is not significant to the fair value measurement of the swap in its entirety, the fair value measurement is considered Level 2. Had the reporting entity judged the final year of the instrument to be a significant input, it would have been a Level 3 measurement.
In assessing the significance of unobservable inputs to an asset or liability’s fair value, a reporting entity should
- consider the sensitivity of the asset or liability’s overall value to changes in the input, and IFRS 13 understand inputs to valuation techniques
- assess the likelihood of variability in the input over the life of the asset or liability. IFRS 13 understand inputs to valuation techniques
An input could be unobservable and have little impact on the valuation at initial recognition, but the same input could have a significant remeasurement impact if markets and related assumptions change.
Additionally, reporting entities should perform the significance assessment on an individual input level as well as on an aggregate input level, considering aggregation of inputs when more than one item of unobservable data (or more than one parameter) is used to measure the fair value of an asset or liability. This assessment will depend on the facts and circumstances specific to a given asset or liability and will require significant professional judgment.
Step 3: determine if significant inputs are observable or unobservable
Observable inputs include both Level 1 and Level 2 inputs. Observable inputs include among others the following.
- Prices or quotes from exchanges or listed markets (e.g., New York Mercantile Exchange, Chicago Board of Trade, London Stock Exchange, Tokyo Stock Exchange, or New York Stock Exchange and Euronext) in which there is sufficient activity IFRS 13 understand inputs to valuation techniques
- Proxy observable market data that is proven to be highly correlated and has a logical, economic relationship with the instrument being valued (e.g., electricity prices in two different locations or “zones” that are highly correlated) IFRS 13 understand inputs to valuation techniques
- Other direct and indirect market inputs that are observable in the marketplace
Determining what constitutes observable inputs will require significant judgment.
Characteristics of observable inputs
The following list of characteristics, if present, would provide evidence that an input is derived from observable market data. However, inputs need not have all of the following characteristics for it to qualify as observable market data. IFRS 13 understand inputs to valuation techniques
□ Supported by market transactions IFRS 13 understand inputs to valuation techniques
Although data need not be traced directly to a “live” or “perfectly offsetting” transaction, there should be strong evidence that:
- the data sources draw their information from actual market transactions between other market participants or
- the information is used by market participants to price actual market transactions.
The reporting entity will normally need to perform a degree of review and/or verification of the data supporting the quote.
□ Not proprietary IFRS 13 understand inputs to valuation techniques
Observable data incorporated into an input of a valuation technique comes from sources other than within the reporting entity that is making the determination. In addition, the data should be distributed broadly, and not limited in its distribution to only the entity making the determination or to a small group of users.
The data should be available to and regularly used by participants in the relevant market/product sector as a basis for pricing transactions or verifying such prices. Even an internally developed assumption may be an observable input if it can be corroborated to an external source.
□ Readily available IFRS 13 understand inputs to valuation techniques
Market participants should be able to obtain access to the data, although the supplier of the information could impose a reasonable fee for access.
□ Regularly distributed IFRS 13 understand inputs to valuation techniques
The term “regular distribution” means that the data is made available in a manner that is timely enough to allow the data to be meaningful in pricing decisions. Further, there should be procedures in place to verify that changes between intervals have not occurred that would render the data meaningless. In addition, the distributed information should indicate its effective date to ensure that data received is not stale.
□ Transparent IFRS 13 understand inputs to valuation techniques
The people/sources providing and/or distributing the data and their role in a particular product/market should be transparent and known to be reliable. In addition, it needs to be clear to the people who provide the data that market participants use this information to price/verify transactions.
□ Verifiable IFRS 13 understand inputs to valuation techniques
The data should be verifiable. Further, there should be evidence that users are, in fact, regularly verifying the data. For example, people who are independent of a particular reporting entity should be able to contact the third-party data provider directly in order to verify the data that is obtained and used. It also should be possible for people to verify the data by comparing it with data that is obtained from other reliable sources.
□ Reliable IFRS 13 understand inputs to valuation techniques
The data should reflect actual market parameters and be subject to certain levels of periodic testing and monitoring. These controls should exist at the entity providing the data, and at the entity using the data. Reporting entities should test and review the reliability of a source’s data on an ongoing basis before actually using that source as a basis for determining or disclosing a fair value measurement and its level within the fair value hierarchy.
□ Based on consensus IFRS 13 understand inputs to valuation techniques
The data or inputs that are provided by multiple sources should be comparable within a reasonably narrow range before a reporting entity can regard the information as demonstrating a market consensus. If particular sources produce price outliers, the reporting entity should understand them and how they impact the data. Due diligence should be performed to confirm that the consensus was derived from different sources.
□ Provided by sources actively involved in the relevant market IFRS 13 understand inputs to valuation techniques
The data should originate from a source that is an active participant with respect to the relevant product and within the relevant market. Further, the reporting entity that is using the data should periodically demonstrate that the source of the data provides reliable information on a consistent basis.
Although there are instances in which market forces could help ensure that a data source provides reliable information, such assurance may need to be supplemented with other evidence, such as the results of back-testing applied to verify the consistency and reliability of a particular source’s data.
Assessing the level of market activity to determine if inputs are observable
The level of activity in the asset or liability’s principal market will contribute to the determination of whether an input is observable or unobservable. Level 1 and Level 2 measurements are based on observable inputs while Level 3 measurements are unobservable. IFRS 13 understand inputs to valuation techniques
The fair value standards define an active market as one in which transactions for the asset or liability being measured take place with sufficient frequency and volume to provide pricing information on an ongoing basis. An observable input that may otherwise be a Level 1 input will be rendered Level 2 if the information relates to a market that is not active. IFRS 13 understand inputs to valuation techniques
For example, in assessing market inputs, consider a security for which aggregate broker data is published on occasion, and for which trading does not occur on a regular basis. In this case, the price is quoted only occasionally and the security is not regularly traded.
To determine the level of the inputs within the hierarchy, the reporting entity should consider recent activity supporting the quote and trading volume trends. While the reporting entity should examine all of the facts and circumstances, the information provided in this example appears to indicate the quote is a Level 2 or Level 3 input.
Although observability could have an indirect relationship with liquidity, only the observability of significant inputs serves to distinguish between Levels 2 and 3. Liquidity is not a differentiating factor. For example, a reporting entity may be able to sell a structured security in one day; however, for valuation purposes, they are only able to obtain indicative broker quotes that cannot be corroborated by market observable inputs. IFRS 13 understand inputs to valuation techniques
Additionally, there can be a wide spectrum of liquidity associated with instruments in Levels 2 and 3. For example, a residential mortgage-backed security is likely significantly more liquid than an abandoned warehouse and land in tertiary markets, while both may accurately be determined to be Level 3 valuations.
In addition, a US dollar fixed-for-floating interest rate swap is likely to be determined to be a Level 2 instrument by most market participants based upon the observability of the market inputs used to value it. However, it is not easy and likely time consuming, to novate an interest rate swap to another party. By definition, this derivative is less “liquid” than many fixed income securities that are determined to be Level 3. This is another example of why Level 2 versus Level 3 is not a representation of liquidity.
IFRS 13 B34 provides examples of markets in which inputs might be observable for some assets and liabilities. Reporting entities should consider the specific facts and circumstances of each input in each market in assessing whether an input in a particular market is observable. IFRS 13 understand inputs to valuation techniques
Excerpt from IFRS 13 B34
Examples of markets in which inputs might be observable for some assets and liabilities (for example, financial instruments) include exchange markets, dealer markets, brokered markets, and principal-to-principal markets. [Emphasis added.]
The following, based on information in IFRS 13 B34, provides additional clarification on each market:
□ Exchange market IFRS 13 understand inputs to valuation techniques
In an active exchange market (e.g., NYSE, London Stock Exchange), closing prices are both readily available and representative of fair value.
□ Dealer market IFRS 13 understand inputs to valuation techniques
In a dealer market, dealers stand ready to trade at an executable bid or ask price for their own account, thereby providing market liquidity by using their capital to hold an inventory of the items for which they make a market. Over-the-counter markets are dealer markets. Assets and liabilities, other than securities, also exist in dealer markets, such as financial instruments, commodities, and physical assets.
□ Brokered market IFRS 13 understand inputs to valuation techniques
In a brokered market, brokers attempt to match buyers with sellers, they do not stand ready to trade (typically providing indicative valuations) for their own account, and do not use their own capital to hold an inventory of the items for which they make a market. For a broker quote to be observable, a reporting entity may not need transparency into the market data used to develop the quote, but would need knowledge of how the quote is created and whether the broker can stand ready to execute.
Broker quotes can be derived from models or based on market observable transactions. In many cases, transparency into the specific technique used is not available. However, a reporting entity may be able to perform analysis to determine the implied inputs used (e.g. discount rate/yield). From this analysis a reporting entity may be able to connect such implied inputs to market observable information (e.g., trade information).
□ Principal-to-principal market IFRS 13 understand inputs to valuation techniques
Principal-to-principal transactions (both originations and re-sales) are negotiated independently, with no intermediary. Often, very little information about these transactions is publicly available, and as such, the markets are generally not considered observable.
Pricing services, broker quotes, and dealer quotes
Ultimately, it is management’s responsibility to determine the appropriateness of its fair value measurements and their classification in the fair value hierarchy, including measurements for which pricing services (such as Bloomberg, Interactive Data Corporation, Thomson Reuters, Markit, Standard and Poor’s), broker pricing information, and similar sources are used. IFRS 13 understand inputs to valuation techniques
IFRS 13 B45 indicates that the use of quoted prices provided by third parties, such as pricing services or brokers, is permitted if the reporting entity has determined that the quoted prices provided by those parties are developed in accordance with the fair value standard. Therefore, reporting entities that use pricing services need to understand how the pricing information is developed and obtain sufficient information to determine where instruments fall within the fair value hierarchy.
For example, a pricing service could provide quoted prices for an actively traded equity security which, if corroborated by the reporting entity, would be considered Level 1 inputs. The same pricing service may also provide a corporate bond price based on matrix pricing, which may constitute a Level 2 or Level 3 input, depending on the information used in the model.
The information provided by these sources could result in a financial instrument falling into any level in the fair value hierarchy, depending on the inputs and methods used for a particular financial instrument. IFRS 13 understand inputs to valuation techniques
Dealer quotes are observable only if the dealer stands ready and willing to transact at that price. Brokers, on the other hand, report what they see in the market but usually are not ready and willing to transact at that price. In order for broker quotes to be observable, they need to be corroborated by other market events or data.
A broker quote may be a Level 2 input if observable market information exists for comparable assets and/or the dealer is willing and able to transact in the security at that price. In many cases, a single broker quote may be indicative of a Level 3 measure if there are no comparables and the quote is provided with no commitment to actually transact at that price. IFRS 13 understand inputs to valuation techniques
A reporting entity should have some higher-level (i.e., observable) data to support classification of an input as Level 2. A broker quote for which the broker does not stand ready to transact cannot be corroborated with an internal model populated with Level 3 information to support a Level 2 classification.
Multiple indicative broker quotes or vendor prices based on Level 3 inputs do not raise the categorization of that instrument to Level 2. However, there may be other instances in which pricing information can be corroborated by market evidence, resulting in a Level 2 input.
In some cases, reporting entities may rely on pricing services or published prices that represent a consensus reporting of multiple brokers or “evaluated prices.” It may not be clear if the reporting entity can transact at the prices provided or if observable market data was used to develop the indicative price.
To support an assertion that a broker quote or information obtained from a pricing service represents a Level 2 input, the reporting entity should perform further review procedures to understand how the price was developed, including understanding the nature and observability of the inputs used to determine that price.
As market activity often ebbs and flows, pricing techniques often do as well. Because of this, reporting entities should perform review procedures on an on-going basis for financial reporting purposes versus at a singular point in time. In the case of consensus pricing services and in other cases, additional corroboration could include the following:
- Use of liquidity or transparency information and metrics provided by the vendor which may include the liquidity score and depth of the quotes informing the price
- Review of vendor valuation methodology documentation IFRS 13 understand inputs to valuation techniques
- Discussions with pricing services, dealers, or other companies to obtain additional prices of identical or similar assets to corroborate the price
- Back-testing of prices to determine historical accuracy against actual transactions. While this analysis provides more evidence on the accuracy/reliability of historical prices provided, it may also provide an initial indication of whether pricing uses observable data inputs. It is likely that additional corroboration would be necessary to determine the use of observable market data. IFRS 13 understand inputs to valuation techniques
- Comparisons to other external or internal valuation model outputs and their corroboration with observable market data
The level of investigation necessary is highly dependent on the facts and circumstances, such as the type and complexity of the asset or liability being measured, and its observability and the level of activity in the marketplace. Generally, the more specialized the asset or liability being measured and the less actively traded it is, the more review procedures will be necessary to corroborate the price in order to support classification as a Level 2 input.
When performing additional procedures, reporting entities should clearly document the assessment and conclusion. Without additional supporting information, in general prices obtained from a single or multiple broker sources or a pricing service are considered indicative values or proxy quotes that generally represent Level 3 inputs.
In another example, a reporting entity may obtain a price from a broker or pricing service for a municipal security. The reporting entity may be fully aware of the depth and activity of the security’s trading in the marketplace based on its historical trading experience. In addition, the pricing methodology for the security may be common and well-understood (e.g., matrix pricing) and the reporting entity may be able to perform less due diligence.
However, this conclusion may not be appropriate for a reporting entity that obtains a price from a broker or pricing service for a collateralized debt obligation that is not frequently traded and may not be as easily subject to common, well-understood pricing methodologies (e.g., matrix pricing). Therefore, the reporting entity may need to perform more due diligence.
Reporting entities commonly use proprietary models to calculate certain fair value measurements (e.g., some long-term derivative contracts, impairments of financial instruments, and illiquid investments such as real estate). However, they determine the level within the fair value hierarchy based on the inputs to the valuation, not on the methodology or complexity of the model. However, certain valuations may require the use of complex models to develop forward curves and other inputs; therefore, the models and inputs are frequently inextricably linked. IFRS 13 understand inputs to valuation techniques
The use of a valuation model does not automatically result in a Level 3 fair value measurement. A standard valuation model that uses all observable inputs may result in a measurement classified as Level 2. For example, consider the measurement of a financial asset that is not actively traded. The reporting entity performs the valuation using a proprietary model incorporating inputs provided by brokers.
However, while the financial asset is not actively traded, assume the broker providing the inputs is standing ready to transact at the quoted price and/or the reporting entity obtains sufficient corroborating data. Provided the model does not include management assumptions used to make adjustments to the data, it may be reasonable to conclude that the inputs are observable, and thus the measurement would be classified as Level 2.
However, if adjustments or interpolations are made to Level 2 inputs in an otherwise standard model, the measurement may fall into Level 3, depending on whether the adjusted inputs are significant to the measurement. Furthermore, if a reporting entity uses a valuation model that is proprietary and relies on unobservable inputs, the resulting fair value measurement will be categorized as Level 3. IFRS 13 understand inputs to valuation techniques
For example, when Level 2 inputs are not available and the reporting entity is required to develop a forward price curve because the duration of the contract exceeds the length of time that observable inputs are available, or is otherwise required to make adjustments to observable data, the valuation is relying on Level 3 inputs and would be classified as a Level 3 fair value measurement if those inputs are significant to the overall fair value measurement.
Step 4: determine level 2 or 3 in the hierarchy of the significant input (or all significant inputs)
Level 2 inputs
The categorization of an asset/liability as Level 1 requires that it is traded in an active market. If an instrument is not traded in an active market, it may fall to Level 2. Level 2 inputs are inputs that are observable, either directly or indirectly, but do not qualify as Level 1.
Examples of Level 2 inputs include: IFRS 13 understand inputs to valuation techniques
- A dealer quote for a non-liquid security, provided the dealer is standing ready and able to transact
- Posted or published clearing prices, if corroborated with market transactions
- Vendor or broker provided indicative prices, if due diligence by the reporting entity indicates such prices were developed using observable market data
Examples of instruments that are typically Level 2 measurements include:
- Most US public debt IFRS 13 understand inputs to valuation techniques
- Short-term cash instruments IFRS 13 understand inputs to valuation techniques
- Certain derivative products IFRS 13 understand inputs to valuation techniques
Adjustments to Level 2 inputs
Adjustments to Level 2 inputs should include factors such as the condition and/or location of the asset/liability on the measurement date. An adjustment that is significant to the fair value measurement may place the measurement in Level 3 in the fair value hierarchy.
Extrapolating and interpolating data
IFRS 13 82 indicate that a Level 2 input needs to be observable for substantially the full term of an asset or liability that has a contractual term. However, certain inputs derived through extrapolation or interpolation may be corroborated by observable market data (e.g., interpolating three-year yields using observable one- and five-year interest rate yields) and would be considered a Level 2 input.
For example, assume that the interest rate yield curve for index A has historically been correlated to the interest rate yield curve for index B, and market participants believe the indexes will continue to be correlated. Also, assume that the interest rate yield curve for index A is observable for three years, but the interest rate yield curve for index B is only observable for two years.
A reporting entity could extrapolate the third year of the interest rate yield curve for index B based on years one and two and the correlation of the third year of interest rate yield curve for index A. In this example, the interest rate yield for index B for year three would be considered a Level 2 input. IFRS 13 understand inputs to valuation techniques
However, extrapolating short-term data to measure longer-term inputs may require assumptions and judgments that cannot be corroborated by observable market data and, therefore, represent a Level 3 input. IFRS 13 understand inputs to valuation techniques
Level 3 inputs
Reporting entities may use unobservable inputs to measure fair value if relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. These unobservable inputs are considered Level 3.
Even when Level 3 inputs are used, the fair value measurement objective remains the same—that is, to reflect an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs should reflect the assumptions that market participants would use when pricing the asset or liability (including assumptions about risk). IFRS 13 understand inputs to valuation techniques
Level 3 inputs may include information derived through extrapolation or interpolation that cannot be directly corroborated by observable market data. In developing Level 3 inputs, a reporting entity need not undertake exhaustive efforts to obtain information about market participant assumptions; however, it should take into account all information that is reasonably available.
Therefore, if a reporting entity uses its own data to develop Level 3 inputs, it should adjust that data if information is reasonably available that indicates market participants would use different assumptions. IFRS 13 understand inputs to valuation techniques
Examples of inputs that are unobservable and considered Level 3 include the following: IFRS 13 understand inputs to valuation techniques
- Inputs obtained from broker quotes that are indicative (i.e., not firm and able to be transacted upon) or not corroborated with market transactions
- Management assumptions that cannot be corroborated with observable market data IFRS 13 understand inputs to valuation techniques
- Vendor-provided prices, not corroborated by market transactions IFRS 13 understand inputs to valuation techniques
Common examples of assets or liabilities typically valued using Level 3 measurements include:
- Complex instruments, such as longer-dated interest rate and currency swaps and structured derivatives IFRS 13 understand inputs to valuation techniques
- Fixed income asset-backed securities, depending on the specific asset owned (i.e., the specific tranche), the nature of the valuation model used, and whether the inputs are observable IFRS 13 understand inputs to valuation techniques
- Impairment testing of goodwill or indefinite-lived intangible assets IFRS 13 understand inputs to valuation techniques
- Contingent consideration IFRS 13 understand inputs to valuation techniques
Fair value measurements and inactive markets
IFRS 13 B37-42 addresses valuations in markets that were previously active, but are inactive in the current reporting period.
The fair value standards provide additional factors to consider in measuring fair value when there has been a significant decrease in market activity for an asset or a liability and quoted prices are associated with transactions that are not orderly. For those measurements, pricing inputs for referenced transactions may be less relevant. A reporting entity should determine if a pricing input for an inactive security was “orderly” and representative of fair value by assessing if it has the information to determine that the transaction is not forced or distressed. If it cannot make that determination, the input needs to be considered; however, the input may be less relevant to the measurement than other transactions which are known to be orderly.
Evaluating whether there has been a significant decrease in volume or level of activity
IFRS 13 B37 provide a list of factors to consider in determining whether there has been a significant decrease in the volume or level of activity in relation to normal market activity. The factors that an entity should evaluate include (but are not limited to):
- There is a significant decline in the activity of, or there is an absence of a market for new issues (that is, a primary market) for that asset or liability or similar assets or liabilities IFRS 13 understand inputs to valuation techniques
- There are few recent transactions IFRS 13 understand inputs to valuation techniques
- Price quotations are not developed using current information IFRS 13 understand inputs to valuation techniques
- Price quotations vary substantially either over time or among market makers (for example, some brokered markets)
- Indices that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability IFRS 13 understand inputs to valuation techniques
- There is a significant increase in implied liquidity risk premiums, yields, or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the reporting entity’s estimate of expected cash flows, taking into account all available market data about credit and other non-performance risk for the asset or liability IFRS 13 understand inputs to valuation techniques
- There is a wide bid-ask spread or significant increases in the bid-ask spread IFRS 13 understand inputs to valuation techniques
- Little information is publicly available (for example, a principal-to-principal market) IFRS 13 understand inputs to valuation techniques
If a reporting entity concludes that there has been a significant decrease in the volume or level of activity in the market for an asset or liability, the reporting entity should perform further analysis of the transactions or quoted prices observed in that market. A significant decrease in activity on its own is not indicative that the market is not orderly. Further analysis is required because the transactions or quoted prices may not be determinative of fair value and significant adjustments may be necessary when using the information in estimating fair value.
Adjusting observable inputs
The fair value standards do not prescribe a methodology for making significant adjustments to transactions or quoted prices when estimating fair value. Instead of applying a prescriptive approach, reporting entities should weight indications of fair value. IFRS 13 understand inputs to valuation techniques
If there has been a significant decrease in the volume and level of activity for the asset or liability, it may be appropriate for the reporting entity to change its valuation technique or to apply multiple valuation techniques. For example, a reporting entity may use indications of fair value developed from both a market approach and a present value technique in its estimate of fair value. When using multiple indications of fair value, the reporting entity should consider the reasonableness of the range of fair value indications. The objective is to determine the point within that range that is most representative of fair value under current market conditions.
One approach to selecting a point within a range of indications of fair value would be to weight the multiple indications. Reporting entities are required to consider the reasonableness of the range, as noted in IFRS 13 B40. A wide range of fair value measurements might indicate that further analysis is required in order to achieve the fair value measurement objective. Importantly, the fair value measurement objective remains the same regardless of the valuation techniques used, even when circumstances indicate that there has been a significant decrease in the volume and level of activity for the asset or liability.
When there has been a significant decrease in the volume or level of activity for the asset or liability, a reporting entity will need to perform additional work to evaluate observable inputs, such as quoted prices or broker quotes, to determine whether observable inputs reflect orderly transactions or whether a valuation technique reflects market participant assumptions.
A reporting entity must consider price quotes when markets are not active, including those obtained from pricing services and broker quotes, provided it determines that those prices reflect orderly transactions. Further, a reporting entity is not precluded from concluding that the inputs are Level 2 in the fair value hierarchy even though a market is not active. IFRS 13 understand inputs to valuation techniques
The reporting entity’s intention to hold an asset is not relevant in estimating fair value at the measurement date. Rather, the fair value measurement should be based on a hypothetical transaction to sell the asset or transfer the liability at the measurement date, considered from the perspective of willing market participants.
Reporting entities may make adjustments to observed prices to address the decrease in activity. It may be challenging to develop appropriate inputs to be used in the valuation techniques and to reconcile fair value measures when a significant difference exists between the use of a valuation technique and an observable price.
Identifying transactions that are not orderly
IFRS 13 B43 states that even when an entity determines that there has been a significant decrease in the volume and level of activity for an asset or liability in relation to normal market activity for the asset or liability (or similar assets or liabilities), it is not appropriate to conclude that all transactions in the market for the asset or liability are not orderly.
Rather, a determination as to whether a transaction is orderly, and thus a relevant input into the valuation, requires analysis and often a high degree of judgment. See ‘Significant decrease in volume or level of activity‘, below for further details. The fair value standards provide a list of circumstances that may indicate that a transaction is not orderly, including (but not limited to):
- There was not adequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such an asset or liability. IFRS 13 understand inputs to valuation techniques
- There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant.
- The seller is in or near bankruptcy or receivership (i.e., distressed) or the seller was required to sell to meet regulatory or legal requirements (i.e., if the seller was forced). Though, not all requirements to divest result in a forced sale, as many requirements to divest are made in circumstances which allow sufficient time and marketing effort to result in an orderly disposal. IFRS 13 understand inputs to valuation techniques
- The transaction price is an outlier when compared with other recent transactions for the same (or a similar) asset or liability.
The determination of whether transactions are orderly should be based on the weight of the available evidence.
Evaluating observable transaction prices
The determination of whether a transaction is (or is not) orderly is more difficult if there has been a significant decrease in the volume and level of activity for the asset or liability. However, the fair value standards provide guidance once the determination has been made. Specifically, IFRS 13 B44 provides guidance to be considered in evaluating observable transaction prices under different circumstances:
- Transaction is not orderly—If the evidence indicates the transaction is not orderly, a reporting entity is required to place little, if any, weight (compared with other indications of fair value) on that observable transaction price when estimating fair value. IFRS 13 understand inputs to valuation techniques
- Transaction is orderly—If the evidence indicates the transaction is orderly, a reporting entity is required to consider that transaction price when estimating fair value. The amount of weight placed on that transaction price (when compared with other indications of fair value) will depend on the facts and circumstances of the transactions and the nature and quality of other available inputs. IFRS 13 understand inputs to valuation techniques
If a reporting entity does not have sufficient information to conclude whether an observed transaction is orderly (or is not orderly), it is required to consider that transaction price when estimating fair value or implied market risk premiums. In those circumstances, that transaction price may not be determinative (i.e., the sole or primary basis) for estimating fair value.
Less weight should be placed on transactions in which a reporting entity has insufficient information to conclude whether the transaction is orderly when compared with other transactions that are known to be orderly.
Premiums and discounts
The fair value standards include restrictions on the application of premiums and discounts related to the size of a position of financial instruments held when measuring fair value. The fair value standards distinguish between premiums or discounts related to the size of the reporting entity’s holding (such as a blockage factor for an equity investment classified as available for sale), which are prohibited, as opposed to those related to a characteristic of the asset or liability (for example, a control premium on a subsidiary), which is permitted under certain circumstances. IFRS 13 understand inputs to valuation techniques
Level 1 measurements
The fair value standards state that there should be no adjustment to Level 1 inputs. In accordance with IFRS 13 80, the fair value of a position for an investment in a financial instrument in an active market should be calculated as the product of the quoted price for the individual instrument times the quantity held (commonly referred to as “P times Q”). Here is guidance on the fair value hierarchy. IFRS 13 understand inputs to valuation techniques
Excerpt from IFRS 13 69
In all cases, if there is a quoted price in an active market (that is, a Level 1 input) for an asset or liability, a reporting entity shall use that quoted price without adjustment when measuring fair value…
IFRS 13.76-80 discusses other considerations when using Level 1 inputs. IFRS 13 understand inputs to valuation techniques
A blockage factor is a discount applied to reflect the inability to trade a block of the security because the market for the security, although an active one, cannot absorb the entire block at one time without adversely affecting the quoted market price. When measuring the fair value of a financial instrument that trades in an active market, the fair value standards prohibit the use of a blockage factor. IFRS 13 understand inputs to valuation techniques
A control premium is an amount a buyer is willing to pay over the current market price of a publicly traded company to acquire a controlling interest in that company. IFRS 13 69 indicates that control premiums are also not permitted as adjustments to Level 1 measurements. IFRS 13 understand inputs to valuation techniques
Level 2 and Level 3 measurements
Certain premiums or discounts are permitted for instruments that are not classified as Level 1. When determining whether it is appropriate to include a premium or discount in a Level 2 or Level 3 fair value measurement, reporting entities should consider the following:
- Market participant assumptions IFRS 13 understand inputs to valuation techniques
- The unit of account as defined by other guidance for the asset or liability being measured
- The unit of measurement IFRS 13 understand inputs to valuation techniques
- Whether the premium or discount is related to the size of the entity’s holding of the asset or liability or reflective of a characteristic of the asset or liability itself
- Whether the impact of the premium or discount is already contemplated in the valuation
While the determination of fair value, including the application of premiums and discounts, is rooted in market participant assumptions, such application cannot contradict the unit of account prescribed in other guidance for the asset or liability being measured.
If a reporting entity holds an asset that has restrictions on its sale or transferability (i.e., a restricted asset), the fair value measurement should be adjusted to reflect the discount, if any, a market participant would require as a result of the restriction. The impact of a restriction on the sale or use of an asset depends on whether the restriction would be considered by market participants in pricing the asset.
Example 8: Restriction on the sale of an equity instrument of IFRS 13 (IFRS 13 IE28) illustrates a situation in which a reporting entity holds an equity instrument (a financial asset) for which sale is legally or contractually restricted for a specified period. For example, such a restriction could limit sale to only qualifying investors. The restriction is a characteristic of the instrument and, therefore, would be transferred to market participants.
In that case, the fair value of the instrument would be measured on the basis of the quoted price for an otherwise identical unrestricted equity instrument of the same issuer that trades in a public market, adjusted to reflect the effect of the restriction. The adjustment would reflect the amount market participants would demand because of the risk relating to the inability to access a public market for the instrument for the specified period. The adjustment will vary depending on all of the following: IFRS 13 understand inputs to valuation techniques
- the nature and duration of the restriction; IFRS 13 understand inputs to valuation techniques
- the extent to which buyers are limited by the restriction (for example, there might be a large number of qualifying investors); and
- qualitative and quantitative factors specific to both the instrument and the issuer. IFRS 13 understand inputs to valuation techniques
Example 9: Restrictions on the use of an asset of IFRS 13 (IFRS 13 IE29) illustrates the impact of a contractual restriction on the use of donated land to a not-for-profit organization. In those examples, the not-for-profit organization is perpetually restricted in its use of the property. However, it determines that the contractual restriction exists through an agreement (donor agreement) that is separate and distinct from the asset itself.
The restriction would not legally be transferred to market participants if the land were to be sold as it is not part of the deed or legal description of the property. Therefore, this asset restriction is specific to the not-for-profit organization and another owner could use the land for other purposes based on zoning where it is located. In this case, the restriction is not considered in the valuation of the land since the restriction is not an attribute of the asset itself and thus not a relevant input for market participants when determining the fair value of the land.
See also: The IFRS Foundation