Athens, October 2017
Chris Ragkavas, BA, MA, FCCA, CGMA
IFRS technical expert, financial consultant.
Since January 2013, academics and practitioners alike, seek guidance from IFRS 13 when measuring assets and liabilities at fair value. Before its introduction, preparers of financial statements calculated fair value based on various standards permitting or requiring fair value measurement, and this had led to some inconsistencies.
The standard does not address which assets and liabilities are measured at fair value, or when these measurements are to be performed.
The standard however, must be applied when fair value is permitted or required by another standard.
Measurement and disclosure requirements of IFRS 13 do not apply to:
Share based payment transactions within the scope of IFRS 2 Share based payment.
Leasing transactions within the scope of IFRS 16 Leases.
Measurements that have similarities to fair value, but are not fair value as defined by IFRS 13, for example net realizable value as defined by IAS 2 Inventories. Reason being, as we will see later in this article, fair value is not entity specific, but an objective estimation of market participants’ view of the element at stake. Inventories on the contrary, can only be valued as such, as economic benefits will arise from their use or sale, only as inventories, they have no alternative use. For example, a Lenovo computer can only be used as such, so irrespective of the holder (Media Markt, Dixons Carphone, Curry’s) it is, and will only be, usable as a laptop. That is not the case for example, for a property, which may have many alternative uses.
Assets and liabilities that are subject to the standard, are measured based on available information:
Present in the principal or most advantageous market;
By identifying market participants and the assumptions they make in determining fair value;
By selecting an appropriate valuation technique or techniques and related inputs to determine fair value; the acceptable techniques are the ‘market approach’, the ‘income approach’, the ‘cost approach’.
Inputs are obtained according to classifications further explained, as Level 1, 2, 3.
Irrespective of the method applied in order to determine fair value, the result must always be in line with, and representative of, the market participants’ assumptions and expectations. Fair value will never be entity specific.
The use of any input to the valuation process, must relate only to the item at stake, and not to the entity (-ies) from which it is derived.
Assume we fair value an owner occupied building (IAS 16) of a small-sized law firm in the center of Athens. Our approach is based on recent market transactions of identical (Level 1, observable, market inputs), or similar items (Level 2, observable, market inputs) assets. However, all transactions were entered into, by multinational entities, which own much larger and many more offices in the same region, and which have a much stronger negotiation power when compared to the law firm.
The law firm’s office space will be fair valued from the viewpoint of the major market participants and not adjusted for entity specific reasons, i.e. ignoring the small-sized law firm’s negotiation power to sell/use that building.
Unit of account
The asset or liability that is subject to fair value measurement, i.e. the unit of account, is defined by the corresponding standard that requires the application of IFRS 13.
IAS 36 Impairment of assets, states that the reporting entity should measure the fair value less costs of disposal of a cash generating unit, as part of determining the recoverable amount of that cash generating unit. In this context, the cash generating unit is the unit of account.
On the contrary, based on IFRS 9 Financial instruments, the unit of account is the individual financial asset or liability in question, e.g. common shares, debentures.
The entity must consider the highest and best use of the asset from the perspective of market participants, even if the entity intends a different use of that asset.
The highest and best use of a non financial asset, is ‘the use of the asset by market participants that would maximize the value of the asset or group of assets and liabilities (e.g. a cash generating unit or a business) within which, the asset would be used’.
The entity’s current use of the asset may be assumed to be its highest and best use, unless market or other factors suggest that a different use by market participants would maximize the asset’s value.
The highest and best use takes into account the use of the non-financial asset that is:
Physically possible, considering physical characteristics, like size and location. For example, the entity would need to consider physical condition and location of a building when calculating its highest and best use by market participants.
Legally permissible, considering potential legal restrictions on the asset’s use. The use of the asset must not necessarily be legal at the measurement date; it must not be legally prohibited, though.
Financially feasible, considering whether the asset generates an adequate investment return that market participants would require from an investment in that asset put to that use.
The principles outlined for non-financial assets, are not applicable and relevant for financial assets, liabilities or an entity’s own equity instruments. Financial items do not have alternative uses.
Further clarification of legally permissible
An entity uses a ground floor real estate as a bookshop. It wishes to fair value it. It is the only legally permissible use, at its current condition. Market participants when valuing the real estate, see a much greater potential when modified to a brasserie-café-bookstore. Considerable fixtures and fittings must be realized for that purpose. When calculating its fair value, the reporting entity will factor these expectations in (including the costs of restructuring the real estate), as this would maximize its value.
When a change in use is specifically legally prohibited, that exercise would not be performed.
The same principle applies, even when an entity’s usage of an asset is very different to the market participants’, or even when the asset is currently not in use by the entity.
To protect its competitive position, or for other reasons, an entity may intend not to use an acquired non-financial asset actively, or it may intend not to use the asset according to its highest and best use. For example, that might be the case for an acquired intangible asset that the entity plans to use defensively by preventing others from using it. Nevertheless, the entity shall measure the fair value of a non-financial asset assuming its highest and best use by market participants.
Queries, comments, are welcome at [email protected]