2.1.1 Fair value disclosures

The scope of IFRS 13 includes disclosures of fair value. This refers to situations where an entity is permitted, or may be required, by a standard or interpretation to disclose the fair value of an item whose carrying amount in the financial statements is not fair value. Examples include:

• IAS 40, which requires the fair value to be disclosed for investment properties measured using the cost model; [IAS 40.79(e)] and
• IFRS 7 – Financial Instruments: Disclosures, which requires the fair value of financial instruments that are subsequently measured at amortised cost in accordance with IFRS 9 to be disclosed. [IFRS 7.25].

In such situations, the disclosed fair value must be measured in accordance with IFRS 13 and an entity would also need to make certain disclosures about that fair value measurement in accordance with IFRS 13 (see 20 below).

In certain circumstances, IFRS 7 provides relief from the requirement to disclose the fair value of a financial instrument that is not measured subsequently at fair value. An example is when the carrying amount is considered a reasonable approximation of fair value. [IFRS 7.29]. In these situations, an entity would not need to measure the fair value of the financial asset or financial liability for disclosure purposes. However, it would need to consider the requirements of IFRS 13 in order to determine whether the carrying amount is a reasonable approximation of fair value.

2.1.2 Measurements based on fair value

The measurement of amounts (whether recognised or only disclosed) that are based on fair value, such as fair value less costs to sell, are within the scope of IFRS 13. This includes the following:

• a non-current asset (or disposal group) held for sale measured at fair value less costs to sell in accordance with IFRS 5 – Non-current Assets Held for Sale and Discontinued Operations – where the fair value less costs to sell is lower than its carrying amount (see Chapter 4);
• commodity inventories that are held by commodity broker-traders and measured at fair value less costs to sell, as discussed in IAS 2 (see Chapter 22);
• where the recoverable amount for an asset or cash-generating unit(s), determined in accordance with IAS 36, is its fair value less costs of disposal. This includes impairment testing of investments in associates accounted for in accordance with IAS 28 – Investments in Associates and Joint Ventures – where that standard requires the test to be performed in accordance with IAS 36 (see Chapter 20); and
• biological assets (including produce growing on a bearer plant), agricultural produce measured at fair value less costs to sell in accordance with IAS 41 – Agriculture (see Chapter 42).

In each of these situations, the fair value component is measured in accordance with IFRS 13. Costs to sell or costs of disposal are determined in accordance with the applicable standard, for example, IFRS 5.

2.1.3 Short-term receivables and payables

Prior to the issuance of IFRS 13, paragraph B5.4.12 of the then extant IFRS 9 allowed entities to measure short-term receivables and payables with no stated interest rate at invoice amounts without discounting, when the effect of not discounting was immaterial. [IFRS 9 (2012).B5.2.12]. That paragraph was deleted as a consequence of the IASB issuing IFRS 13.

In the absence of that paragraph, some questioned whether discounting would be required for such short-term receivables and payables. The IASB amended IFRS 13, as part of its 2010‑2012 cycle of Improvements to IFRSs, to clarify that, when making those amendments to IFRS 9, it did not intend to remove the ability to measure such short-term receivables and payables at their invoice amount. The Board also noted that, when the effects of applying them are immaterial, paragraph 8 of IAS 8 – Accounting Policies, Changes in Accounting Estimates and Errors – permits entities not to apply accounting policies set out in IFRSs. [IFRS 13.BC138A, IAS 8.8].

2.2.1 Share-based payments

IFRS 2 requires certain share-based payments to be measured at grant date fair value (see Chapter 34). However, the objective of an IFRS 2 fair value measurement is not entirely consistent with IFRS 13. Rather than trying to distinguish between these two measures, the IASB decided to exclude share-based payment transactions that are accounted for in accordance with IFRS 2 from the scope of IFRS 13. The grant date fair value of such share-based payments is, therefore, measured and disclosed in accordance with IFRS 2, not IFRS 13. [IFRS 13.BC21].

2.2.2 Lease transactions

As noted at 2 above, the standard does not apply to any leasing transactions accounted for in accordance with IFRS 16. The fair value measurement and disclosures requirements in IFRS 16 apply instead (see Chapter 23 for further discussion on IFRS 16). This scope exception does not extend to lease assets acquired or liabilities assumed in a business combination in accordance with IFRS 3. IFRS 13 would apply to that measurement of fair value. In addition, after adoption of IFRS 16, an entity may need to apply IFRS 13 to sale and leaseback transactions.

At the time of issuing IFRS 13, the IASB noted that applying IFRS 13's requirements might have significantly changed the classification of leases and the timing of recognising gains or losses for sale and leaseback transactions. In addition, at the time that the IASB was undertaking its leases project (which resulted in the issuance of IFRS 16) and the IASB was concerned that such a requirement may have required entities to make potentially burdensome significant changes to their accounting systems for IFRS 13 and the new leases standard. [IFRS 13.BC22].

While it is clear that leasing transactions that were within the scope of IFRS 16 are excluded from IFRS 13, lease liabilities (for lessees) and finance lease receivables (for lessors) are financial instruments, per paragraph AG9 of IAS 32 – Financial Instruments: Presentation, and are, therefore, within the scope of IFRS 7. [IFRS 7.3, IAS 32.AG9]. As discussed at 2.1.1 above, paragraph 25 of IFRS 7 requires an entity to disclose, for each class of financial asset and financial liability, a comparison of fair value to carrying amount (except where the carrying amount is a reasonable approximation of fair value). [IFRS 7.25, 29(a)]. Lease liabilities are explicitly excluded from this disclosure requirements. [IFRS 7.29(d)]. However, finance lease receivables are not. Therefore, since IFRS 7 is not excluded from the scope of IFRS 13, lessors will need to measure the fair value of finance lease receivables in accordance with IFRS 13, in order to provide that IFRS 7 disclosure (unless the carrying amount is a reasonable approximation for fair value).

2.2.3 Measurements similar to fair value

Some IFRSs permit or require measurements that are similar to fair value, but are not fair value. These measures are excluded from the scope of IFRS 13. Such measures may be derived using techniques that are similar to those permitted in IFRS 13. IAS 36, for example, requires value in use to be determined using discounted cash flows (see Chapter 20). An entity may also consider the selling price of an asset, for example, in determining net realisable value for inventories in accordance with IAS 2 (see Chapter 22). Despite these similarities, the objective is not to measure fair value. Therefore, IFRS 13 does not apply to these measurements.

2.2.4 Exemptions from the disclosure requirements of IFRS 13

As noted above, IFRS 13's disclosure requirements do not apply to plan assets measured at fair value in accordance with IAS 19, retirement benefit plan investments measured at fair value in accordance with IAS 26 and assets for which recoverable amount is fair value less costs of disposal in accordance with IAS 36.

In addition, the disclosure requirements in IFRS 13 do not apply to any fair value measurements at initial recognition. That is, the disclosure requirements of IFRS 13 apply to fair value measurements after initial recognition (this is discussed further at 20 below).

The fair value measurement requirements of IFRS 13 still apply to each of these items above, even though the disclosure requirements do not. Therefore, an entity would measure the item in accordance with IFRS 13 and then make the required disclosures in accordance with the applicable standard (i.e. IAS 19, IAS 26, IAS 36) or the standard that requires fair value at initial recognition. For example, an entity that acquires a brand as part of a business combination would be required by IFRS 3 to measure the intangible asset at fair value at initial recognition. The acquirer would measure the asset's fair value in accordance with IFRS 13, but would disclose information about that fair value measurement in accordance with IFRS 3 (since those fair values are measured at initial recognition), not IFRS 13.

2.4.1 Fair value measurement exceptions

Some standards provide an exception to a requirement to measure an asset or liability at fair value. IFRS 13 does not eliminate these exceptions. [IFRS 13.BC8].

IFRS typically limits fair value measurement exceptions to circumstances where fair value is not reliably measurable and, where applied, requires the application of a cost model. For example, IAS 41 permits the use of a cost model if, on initial recognition of a biological asset, an entity is able to rebut the presumption that fair value can be reliably measured. In addition, it requires an entity to revert to the fair value model if fair value subsequently becomes reliably measurable. [IAS 41.30]. Additional disclosures are often required to explain why fair value cannot be reliably measured and, if possible, the range of estimates within which fair value is highly likely to lie, as is required in IAS 40 for investment properties, for example. [IAS 40.79(e)(iii)].

In these situations, an entity would need to consider the requirements of IFRS 13 in order to determine whether fair value can be reliably measured. If the entity concludes that it could reliably measure fair value based on the requirements of IFRS 13, even in situations where observable information is not available, it would not be able to apply these exceptions.

2.4.2 Practical expedient for impaired financial assets carried at amortised cost

Prior to the issuance of IFRS 9, IAS 39 allowed, as a practical expedient, creditors to measure the impairment of a financial asset carried at amortised cost based on an instrument's fair value using an observable market price. [IAS 39 (2017).AG84]. If the practical expedient was used, IFRS 13 applied to the measurement of fair value. When the practical expedient was not used, the measurement objective was not intended to be fair value (and IFRS 13 did not apply). Instead, IAS 39's requirements for measuring the impairment of the financial asset carried at amortised cost applied.

Under IFRS 9, entities are allowed to use observable market information to estimate the credit risk of a particular or similar financial instrument and as a consequence the fair value can no longer be used. Instead, IFRS 9's requirements for measuring the impairment of the financial asset carried at amortised cost would apply.

2.5.1 Practical expedients in IFRS 13

In addition to maintaining the various practicability exceptions that existed in other IFRSs (as discussed at 2.4 above), IFRS 13 provides its own practical expedients to assist with applying the fair value framework in certain instances. These practical expedients, each of which is discussed separately in this chapter, include the use of mid-market pricing within a bid-ask spread (see 15 below).

Under US GAAP, the equivalent standard, Topic 820 – Fair Value Measurement – in the FASB Accounting Standards Codification (ASC 820), provides a practical expedient to measure the fair value of certain investments in investment companies using net asset value (NAV) or its equivalent if certain criteria are met. However, IFRS 13 does not explicitly permit the use of NAV to estimate the fair value of certain alternative investments. Therefore, under IFRS, NAV cannot be presumed to equal fair value, as the asset that is being measured is the equity investment in an investment entity, not the underlying assets (and liabilities) of the investment entity itself. While NAV may represent the fair value of the equity interest in certain situations (for example, in situations where an open-ended fund provides a source of liquidity through ongoing subscriptions and redemptions at NAV), one cannot presume this to be the case. Instead, the characteristics of the investment being measured need be considered when determining its fair value (differences from US GAAP are discussed further at 23 below).

If a quoted price in an active market for an identical instrument is available (i.e. a Level 1 input), the fair value of the equity instrument would need to be measured using that price, even if this deviates from NAV. An example where the Level 1 input may differ from NAV is shares in certain closed-end funds that trade on exchanges at prices that differ from the reported NAV of the funds.

In situations where there is no quoted price for an identical instrument, reported NAV may represent a starting point in estimating fair value. However, adjustments may be required to reflect the specific characteristics that market participants would consider in pricing the equity investment in an investment entity. It may be helpful to understand the factors that would reconcile a reported NAV of the investment entity to the fair value used by the reporting entity in order to provide explanations to investors, if necessary, and to support disclosures required by IFRS 13 and other IFRSs. Factors to consider include, but are not limited to, the following:

1. Is the reported NAV an appropriate input for use in measuring fair value?

   Before concluding that the reported NAV is an appropriate input when measuring fair value, a reporting entity should evaluate the effectiveness of the investment entity's valuation practices, by considering the valuation techniques and inputs used by the investment entity when estimating NAV. This assists in determining whether the investment entity's valuation practices and inputs are aligned with those that would need to be used by a market participant in respect of the equity instruments of the investment entity.

2. Are adjustments to reported NAV needed to reflect characteristics that market participants would consider in pricing an equity investment?

   A reporting entity should consider the characteristics of the equity investment that are not reflected in reported NAV. The fair value of the underlying assets within an investment entity would, for example, ignore any restrictions or possible obligations imposed on the holder of an equity investment in an investment entity. Obligations may take the form of commitments to contribute further capital, as and when called for by the investment entity. If market participants would be expected to place a discount or premium on the reported NAV because of features, risk or other factors relating to the equity investment, then the fair value measurement of the investment would need to be adjusted for those factors.

   However, in some cases adjustments to NAV may not be required. For example, if a fund is open to new investors, presumably the fair value of the fund investment would not be expected to exceed the amount that a new investor would be required to invest directly with the fund to obtain a similar interest. Similarly, the hypothetical seller of a fund investment would not be expected to accept lower proceeds than it would receive by redeeming its investment directly with the fund (if possible). As such, the willingness and ability of an investment entity to provide a source of liquidity for the investment through subscriptions and redemptions are important considerations in assessing whether adjustments to NAV would be required in determining the exit price of an investment.

   Information related to relevant secondary market transactions should be considered unless they are determined to be disorderly. Limited Partners in such funds may seek to sell their investments for a variety of reasons, including mergers or acquisitions, the need for liquidity or a change in strategy, among others. While premiums have been observed in practice, discounts on sales of investments in investment entities are also common. Likewise, sales of an investment in an investment entity to independent third parties at the reported NAV without a premium or discount, may suggest that no adjustment is needed.

2.5.2 Measurement exception to the fair value principles for financial instruments

IFRS 13 makes it clear that the concepts of ‘highest and best use’ and ‘valuation premise’ only apply to the measurement of non-financial assets. Such concepts could have significantly changed the valuation of some over-the-counter (OTC) derivatives, many of which are measured on a portfolio basis. That is, reporting entities typically determine valuation adjustments related to bid-ask spreads and credit risk for OTC derivative contracts considering the net exposure of a portfolio of contracts to a particular market risk or credit risk. To address this concern, IFRS 13 provides an exception to the principles of fair value when measuring financial instruments with offsetting risks, if certain criteria are met.

The exception allows an entity to estimate the fair value of a portfolio of financial instruments based on the sale or transfer of its net position for a particular market risk exposure (rather than to the individual instruments in the portfolio). The exception also enables an entity to consider its credit exposure to a particular counterparty on a net basis, provided there is an arrangement in place that mitigates credit risk upon default (e.g. a master netting agreement).

See 12 below for additional discussion on measuring the fair value of financial assets and financial liabilities with offsetting risks.

5.1.1 Unit of account and P×Q

IFRS 13 does specify the unit of account to be used when measuring fair value in relation to a reporting entity that holds a position in a single asset or liability that is traded in an active market (including a position comprising a large number of identical assets or liabilities, such as a holding of financial instruments). In this situation, IFRS 13 requires an entity to measure the asset or liability based on the product of the quoted price for the individual asset or liability and the quantity held (P×Q).

This requirement is generally accepted when the asset or liability being measured is a financial instrument in the scope of IFRS 9. However, when an entity holds an investment in a listed subsidiary, joint venture or associate, some believe the unit of account is the entire holding and the fair value should include an adjustment (e.g. a control premium) to reflect the value of the investor's control, joint control or significant influence over their investment as a whole.

Questions have also arisen on to how this requirement applies to cash-generating units that are equivalent to listed investments. Some argue that, because IAS 36 requires certain assets and liabilities to be excluded from a cash-generating unit (CGU), the unit of account is not identical to a listed subsidiary, joint venture or associate and an entity can include adjustments that are consistent with the CGU as a whole. Similarly, some argue that approach is appropriate because in group financial statements an entity is accounting for the assets and liabilities of consolidated entities, rather than the investment. However, others argue that if the CGU is effectively the same as an entity's investment in a listed subsidiary, joint venture or associate, the requirement to use P×Q should apply.

IFRS 13 requires entities to select inputs that are consistent with the characteristics of the asset or liability being measured and would be considered by market participants when pricing the asset or liability (see 7.2 below). Apart from block discounts (which are specifically prohibited), determining whether a premium or discount applies to a particular fair value measurement requires judgement and depends on specific facts and circumstances.

As discussed at 15.2 below, the standard indicates that premiums or discounts should not be incorporated into fair value measurements unless all of the following conditions are met:

• the application of the premium or discount reflects the characteristics of the asset or liability being measured;
• market participants, acting in their economic best interest, would consider these premiums or discounts when pricing the asset or liability; and
• the inclusion of the premium or discount is not inconsistent with the unit of account in the IFRS that requires (or permits) the fair value measurement.

Therefore, when an entity holds an investment in a listed subsidiary, joint venture or associate, if the unit of account is deemed to be the entire holding, it would be appropriate to include, for example, a control premium when determining fair value, provided that market participants would take this into consideration when pricing the asset. If, however, the unit of account is deemed to be the individual share of the listed subsidiary, joint venture or associate, the requirement to use P×Q (without adjustment) to measure the fair value would override the requirements in IFRS 13 that permit premiums or discounts to be included in certain circumstances.

In September 2014, in response to these questions regarding the unit of account for an investment in a listed subsidiary, joint venture or associate, the IASB proposed amendments to clarify that:⁶

• The unit of account for investments in subsidiaries, joint ventures and associates should be the investment as a whole and not the individual financial instruments that constitute the investment.
• For investments that are comprised of financial instruments for which a quoted price in an active market is available, the requirement to use P×Q would take precedence, irrespective of the unit of account. Therefore, for all such investments, the fair value measurement would be the product of P×Q, even when the reporting entity has an interest that gives it control, joint control or significant influence over the investee.
• When testing CGUs for impairment, if those CGUs correspond to an entity whose financial instruments are quoted in an active market, the fair value measurement would be the product of P×Q.

  When testing for impairment in accordance with IAS 36, the recoverable amount of a CGU is the higher of its value in use or fair value less costs of disposal. The fair value component of fair value less costs of disposal is required to be measured in accordance with IFRS 13.

  When a CGU effectively corresponds to a listed entity, the same issue arises regarding whether the requirement to use P×Q, without adjustment, to measure fair value applies.

  Consistent with its proposal in relation to listed investments in subsidiaries, joint ventures and associates, the IASB proposed that, if the CGU corresponds to an entity whose financial instruments are quoted in an active market, the requirement to use P×Q would apply.

The exposure draft also included proposed clarifications for the portfolio exception, discussed at 5.1.2 below.

The IASB proposed the following transition requirements:

• For quoted investments in subsidiaries, joint ventures and associates, an entity would recognise a cumulative catch-up adjustment to opening retained earnings for the period in which the proposed amendments are first applied. The entity would then recognise the change in measurement of the quoted investments during that period in profit or loss (i.e. retrospective application).
• For impairment testing in accordance with IAS 36, an entity would apply the requirements on a prospective basis. If an entity incurs an impairment loss or reversal during the period of initial application, it would provide quantitative information about the likely effect on the impairment loss, or reversal amount, had the amendments been applied in the immediately preceding period presented.

The exposure draft did not include a proposed effective date. However, permitting early adoption was proposed. Furthermore, the Board proposed that a first-time adopter of IFRS be able to apply the amendments at the beginning of the earliest period for which it presents full comparative information under IFRS in its first IFRS financial statements (i.e. prospectively from the date of the first-time adopter's transition to IFRS). The comment period for this exposure draft ended on 16 January 2015 and the Board began redeliberations in March 2015. During redeliberations, additional research was undertaken on fair value measurements of investments in subsidiaries, associates and joint ventures that are quoted in an active market and on the measurement of the recoverable amount of cash-generating units on the basis of fair value less costs of disposal when the cash-generating unit is an entity that is quoted in an active market.

Following the redeliberations, in its January 2016 meeting, the IASB concluded that the research would be fed into the PIR of IFRS 13.⁷ As part of its PIR of IFRS 13, the IASB specifically asked about prioritising Level 1 inputs in relation to the unit of account. The feedback was discussed at the IASB's March 2018 meeting. In respect of the valuation of quoted subsidiaries, associates and joint ventures, the PIR found that there were continuing differences in views between users and preparers over whether to prioritise Level 1 inputs or the unit of account. The issue is not pervasive in practice according to the PIR findings. However, respondents noted it can have a material effect when it does occur. Some stakeholders said that there are material differences between measuring an investment using the P×Q and a valuation using a method such as discounted cash flows. Respondents indicated the reasons for such differences include:

• share prices do not reflect market liquidity for the shares or;
• that they do not reflect the value of control and/or synergies.

A few respondents also noted that markets may lack depth and are, therefore, susceptible to speculative trading, asymmetrical information and other factors.⁸

As noted at 1.1 above, the IASB released its Report and Feedback Statement on the PIR in December 2018. The Board decided not to conduct any follow-up activities as a result of findings from the PIR and stated, as an example, that it will not do any further work on the issue of unit of account versus P×Q because the costs of such work would outweigh the benefits for the following reasons:

• the Board's previous significant work on the topic and the PIR suggest the issue is narrow and affects only a limited population of entities;
• users have not expressed major concerns with reporting in practice, although they would like better transparency; and
• there are differences in views between preparers and users, meaning any follow-up work would be likely to require significant resource. Thus, this project may be possible only as part of a major amendment to IFRS 13 or other IFRS Standards.⁹

5.1.2 Unit of account and the portfolio exception

There is some debate about whether IFRS 13 prescribes the unit of account in relation to the portfolio exception. Under IFRS 13, a reporting entity that manages a group of financial assets and financial liabilities with offsetting risks on the basis of its net exposure to market or credit risks is allowed to measure the group based on the price that would be received to sell its net long position, or paid to transfer its net short position, for a particular risk (if certain criteria are met).

Some believe the portfolio exception in IFRS 13 specifies the unit of measurement for any financial instruments within the portfolio(s), i.e. that the net exposure of the identified group to a particular risk, and not the individual instruments within the group, represents the new unit of measurement. This may have a number of consequences. For example, the entity may be able to include premiums or discounts in the fair value measurement of the portfolio that are consistent with that unit of account, but not the individual instruments that make up the portfolio. In addition, because the net exposure for the identified group may not be actively traded (even though some financial instruments within the portfolio may be) P×Q may not be applied to the actively traded instruments within the portfolio.

Others believe that the portfolio exception does not override the unit of account as provided in IFRS 9. Therefore, any premiums or discounts that are inconsistent with this unit of account, i.e. the individual financial instruments within the portfolio, would be excluded from the fair value measurement under the portfolio exception, including any premiums or discounts related to the size of the portfolio.

Regardless of which view is taken, it is clear in the standard that the portfolio exception does not change the financial statement presentation requirements (see 12 below for further discussion on the portfolio exception and 15 below for further discussion on premiums and discounts).

In the US, ASC 820 has been interpreted by many as prescribing the unit of measurement when the portfolio exception is used. That is, when the portfolio approach is used to measure an entity's net exposure to a particular market risk, the net position becomes the unit of measurement. This view is consistent with how many US financial institutions determined the fair value of their over-the-counter derivative portfolios prior to the amendments to ASC 820 (ASU 2011‑04)¹⁰ (see 23 below). We understand that the IASB did not intend application of the portfolio exception to override the requirements in IFRS 13 regarding the use of P×Q to measure instruments traded in active markets and the prohibition on block discounts which raises questions as to how the portfolio exception would be applied to Level 1 instruments.

In 2013, the IFRS Interpretations Committee referred a request to the Board on the interaction between the use of Level 1 inputs and the portfolio exception. The IASB noted that this issue had similarities with the issues of the interaction between the use of Level 1 inputs and the unit of account that arises when measuring the fair value of investments in listed subsidiaries, joint ventures and associates (see 5.1.1 above). The IASB discussed this issue in December 2013, but only in relation to portfolios that comprise only Level 1 financial instruments whose market risks are substantially the same. For that specific circumstance, the Board tentatively decided that the measurement of such portfolios should be the one that results from multiplying the net position by the Level 1 prices (e.g. multiplying the net long or short position by the Level 1 price for either a gross long or short position). Given this tentative decision, in September 2014 the IASB proposed adding a non-authoritative example to illustrate the application of the portfolio exception in this specific circumstance.¹¹ However, after reviewing the comments received on the proposal, the Board concluded that it was not necessary to add the proposed non-authoritative illustrative example to IFRS 13 (see 12.2 below for further discussion) because the example would have been non-authoritative and the comments received did not reveal significant diversity in practice for the specific circumstance of portfolios that comprise only Level 1 financial instruments whose market risks are substantially the same.¹²

5.1.3 Unit of account versus the valuation premise

In valuing non-financial assets, the concepts of ‘unit of account’ and ‘valuation premise’ are distinct, even though both concepts deal with determining the appropriate level of aggregation (or disaggregation) for assets and liabilities. The unit of account identifies what is being measured for financial reporting and drives the level of aggregation (or disaggregation) for presentation and disclosure purposes (e.g. whether categorisation in the fair value hierarchy is determined at the individual asset level or for a group of assets). Valuation premise is a valuation concept that addresses how a non-financial asset derives its maximum value to market participants, either on a stand-alone basis or through its use in combination with other assets and liabilities.

Since financial instruments do not have alternative uses and their fair values typically do not depend on their use within a group of other assets or liabilities, the concepts of highest and best use and valuation premise are not relevant for financial instruments. As a result, the fair value for financial instruments should be largely based on the unit of account prescribed by the standard that requires (or permits) the fair value measurement.

The distinction between these two concepts becomes clear when the unit of account of a non-financial asset differs from its valuation premise. Consider an asset (e.g. customised machinery) that was acquired other than by way of a business combination, along with other assets as part of an operating line. Although the unit of account for the customised machinery may be as a stand-alone asset (i.e. it is presented for financial reporting purposes at the individual asset level in accordance with IAS 16 – Property, Plant and Equipment), the determination of the fair value of the machinery may be derived from its use with other assets in the operating line (see 10 below for additional discussion on the concept of valuation premise).

5.1.4 Does IFRS 13 allow fair value to be measured by reference to an asset's (or liability's) components?

IFRS 13 states that the objective of a fair value measurement is to determine the price that would be received for an asset or paid to transfer a liability at the measurement date. That is, a fair value measurement is to be determined for a particular asset or liability. The unit of account determines what is being measured by reference to the level at which the asset or liability is aggregated (or disaggregated) for accounting purposes.

Unless separation of an asset (or liability) into its component parts is required or allowed under IFRS (e.g. a requirement to separate under IFRS 9), we generally do not believe it is appropriate to consider the unit of account at a level below that of the legal form of the asset or liability being measured. A valuation methodology that uses a ‘sum-of-the-parts’ approach may still be appropriate under IFRS 13; for example, when measuring complex financial instruments, entities often use valuation methodologies that attempt to determine the value of the entire instrument based on its component parts.

However, in situations where fair value can be determined for an asset or liability as a whole, we would generally not expect that an entity would use a higher amount to measure fair value because the sum of the parts exceeds the whole. Using a higher value inherently suggests that the asset would be broken down and the various components, or risk attributes, transferred to different market participants who would pay more for the pieces than a market participant would for the asset or liability as a whole. Such an approach is not consistent with IFRS 13's principles, which contemplate the sale of an asset or transfer of a liability (consistent with its unit of account) in a single transaction.

5.2.1 Condition and location

An asset may not be in the condition or location that market participants would require for its sale at an observable market price. In order to determine the fair value of the asset as it currently exists, the market price needs to be adjusted to the price market participants would be prepared to pay for the asset in its current condition and location. This includes deducting the cost of transporting the asset to the market, if location is a characteristic of the asset being measured, and may include deducting the costs of converting or transforming the asset, as well as a normal profit margin.

For non-financial assets, condition and location considerations may influence, or be dependent on, the highest and best use of an asset (see 10 below). That is, an asset's highest and best use may require an asset to be in a different condition. However, the objective of a fair value measurement is to determine the price for the asset in its current form. Therefore, if no market exists for an asset in its current form, but there is a market for the converted or transformed asset, an entity could adjust this market price for the costs a market participant would incur to re-condition the asset (after acquiring the asset in its current condition) and the compensation they would expect for the effort. Example 14.1 below illustrates how costs to convert or transform an asset might be considered in determining fair value based on the current use of the asset.

5.2.2 Restrictions on assets or liabilities

IFRS 13 indicates that the effect on fair value of a restriction on the sale or use of an asset will differ depending on whether the restriction is deemed to be a characteristic of the asset or the entity holding the asset. A restriction that would transfer with the asset in an assumed sale would generally be deemed a characteristic of the asset and, therefore, would likely be considered by market participants when pricing the asset. Conversely, a restriction that is specific to the entity holding the asset would not transfer with the asset in an assumed sale and, therefore, would not be considered when measuring fair value. Determining whether a restriction is a characteristic of the asset or of the entity holding the asset may be contractual in some cases. In other cases, this determination may require judgement based on the specific facts and circumstances.

The following illustrative examples highlight the distinction between restrictions that are characteristics of the asset and those of the entity holding the asset, including how this determination affects the fair value measurement. [IFRS 13.IE28‑29]. Restrictions on non-financial assets are discussed further at 10 below.

In contrast to Example 14.2 above, Example 14.3 illustrates a restriction on the use of donated land that applies to a specific entity, but not to other market participants.

The calculation of the fair value should take account of any restrictions on the sale or use of an asset, if those restrictions relate to the asset rather than to the holder of the asset and the market participant would take those restrictions into account in his determination of the price that he is prepared to pay.

A liability or an entity's own equity instrument may be subject to restrictions that prevent the transfer of the item. When measuring the fair value of a liability or equity instrument, IFRS 13 does not allow an entity to include a separate input (or an adjustment to other inputs) for such restrictions. This is because the effect of the restriction is either implicitly or explicitly included in other inputs to the fair value measurement. Restrictions on liabilities and an entity's own equity are discussed further at 11 below.

IFRS 13 has different treatments for restrictions on assets and those over liabilities. The IASB believes this is appropriate because restrictions on the transfer of a liability relate to the performance of the obligation (i.e. the entity is legally obliged to satisfy the obligation and needs to do something to be relieved of the obligation), whereas restrictions on the transfer of an asset generally relate to the marketability of the asset. In addition, nearly all liabilities include a restriction preventing the transfer of the liability. In contrast, most assets do not include a similar restriction. As a result, the effect of a restriction preventing the transfer of a liability, theoretically, would be consistent for all liabilities and, therefore, would require no additional adjustment beyond the factors considered in determining the original transaction price. If an entity is aware that a restriction on the transfer of a liability is not already reflected in the price (or in the other inputs used in the measurement), it would adjust the price or inputs to reflect the existence of the restriction. [IFRS 13.BC99, BC100]. However, this would be rare because nearly all liabilities include a restriction and, when measuring fair value, market participants are assumed by IFRS 13 to be sufficiently knowledgeable about the liability to be transferred.

6.1.1 Can an entity have more than one principal market for the same asset or liability?

IFRS 13 states that ‘because different entities (and businesses within those entities) with different activities may have access to different markets, the principal (or most advantageous) market for the same asset or liability might be different for different entities (and businesses within those entities). Therefore, the principal (or most advantageous) market (and thus, market participants) shall be considered from the perspective of the entity, thereby allowing for differences between and among entities with different activities.’ [IFRS 13.19].

Therefore, in certain instances it may be appropriate for a reporting entity to determine that it has different principal markets for the same asset or liability. However, such a determination would need to be based on the reporting entity's business units engaging in different activities to ensure they were accessing different markets.

Determining the principal market is not based on management's intent. Therefore, we would not expect a reporting entity to have different principal markets for identical assets held within a business unit solely because management has different exit strategies for those assets.

Consider Example 14.5 below, in which multiple exit markets exist for an asset and the reporting entity has access to all of the various exit markets. The fact that a reporting entity (or business unit within a reporting entity) has historically exited virtually identical assets in different markets does not justify the entity utilising different exit markets in determining the fair value of these assets, unless the entity has different business units engaging in different activities. Instead, the concept of a principal market (and most advantageous market) implies that one consistent market should generally be considered in determining the fair value of these identical assets.

6.1.2 In situations where an entity has access to multiple markets, should the determination of the principal market be based on entity-specific volume and activity or market-based volume and activity?

In most instances, the market in which a reporting entity would sell an asset (or transfer a liability) with the greatest frequency will also represent the market with the greatest volume and deepest liquidity for all market participants. In these instances, the principal market would be the same regardless of whether it is determined based on entity-specific volume and activity or market-based volume and activity. However, when this is not the case, a reporting entity's principal market is determined using market-based volume.

Different entities engage in different activities. Therefore, some entities have access to certain markets that other entities do not. For example, an entity that does not function as a wholesaler would not have access to the wholesale market and, therefore, would need to look to the retail market as its principal market. Once the markets to which a particular entity has access have been identified, the determination of the principal market should not be based on management's intent or entity-specific volume, but rather should be based on the market with the greatest volume and level of activity for the asset or liability.

8.1.1 Can a market exhibit a significant decrease in volume or level of activity and still be considered active?

A significant decrease in the volume of transactions does not automatically imply that a market is no longer active. IFRS 13 defines a market as active if transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. While the same factors may be used to assess whether a market has experienced a significant decrease in activity and to determine whether a market is active or inactive, these are separate and distinct determinations.

The determination that a market has experienced a significant decrease in volume does not change the requirements of IFRS 13 related to the use of relevant observable data from active markets. That is, despite a decrease from recent (or historical) levels of activity, transactions for an asset or liability in a particular market may still occur with sufficient frequency and volume to provide pricing information on an ongoing basis, thereby qualifying as an active market. If there has been a significant decrease in activity, but a market is still deemed to be active, entities would continue to measure the fair value of identical instruments that trade in this market using P×Q (Level 1 measurement).

An example of this is related to 2011 trading activity for Greek sovereign bonds. During that calendar year, the economic situation in Greece had deteriorated and some had questioned whether the Greek sovereign bonds were still being actively traded. In a public statement, ESMA indicated that, ‘[b]ased on trading data obtained from the Bank of Greece, it [was their] opinion that, as of 30 June 2011, the market was active for some Greek sovereign bonds but could be judged inactive for some others.’¹³ While ESMA provided no predictions about the level of trading activity as at 31 December 2011, ESMA clearly stated their expectation that a fair value measurement of Greek sovereign bonds, in interim and annual financial statements during 2011 should be a Level 1 measurement in situations where there was still an active market. Furthermore, ESMA expected entities to use a Level 2 measurement method that maximises the use of observable market data to measure the fair value of those bonds that were traded in inactive markets.

Determining whether a particular market is considered liquid or active versus illiquid or inactive may require significant judgement and consider a variety of factors (e.g. what the bid-ask spread represents, how deep the bid-ask spread has to be to signal an inactive market, what is the sufficient level of trade volume to signify an active market, etc.). This can be particularly challenging in emerging markets.

While traditionally, the focus of such assessments has been public markets and listed securities, we have observed that sometimes trading in unlisted securities may be more active than in some listed securities.¹⁴ In its 2008 report, the IASB Expert Advisory Panel noted ‘There is no bright line between active markets and inactive markets. However, the biggest distinction between prices observed in active markets and prices observed in inactive markets is typically that, for inactive markets, an entity needs to put more work into the valuation process to gain assurance that the transaction price provides evidence of fair value or to determine the adjustments to transaction prices that are necessary to measure the fair value of the instrument.

‘The issue to be addressed, therefore, is not about market activity per se, but about whether the transaction price observed represents fair value. Characteristics of an inactive market include a significant decline in the volume and level of trading activity, the available prices vary significantly over time or among market participants or the prices are not current. However, these factors alone do not necessarily mean that a market is no longer active. An active market is one in which transactions are taking place regularly on an arm's length basis. What is “regularly” is a matter of judgement and depends upon the facts and circumstances of the market for the instrument being measured at fair value’.¹⁵

Similar challenges exist for entities assessing whether a market is active for thinly traded investments. While trading volumes may be low, it may be challenging to conclude a market is not active when it regularly provides pricing information. This may be particularly difficult in some emerging markets. Therefore, significant judgement will be needed to assess whether a market is active, based on the weight of evidence available.

Determining whether a market is active may be more challenging if regulators challenge an entity's judgement. For example, in its July 2015 enforcement report, ESMA noted that, in order to assess the existence of an active market, the entity had ‘calculated a number of ratios and compared them against the following benchmarks:

• daily % of average value of trades / capitalisation lower than 0.05%;
• daily equivalent value of trades lower than CU50,000;
• daily bid-ask spread higher or equal to 3%;
• maximum number of consecutive days with unvaried prices higher than 3;
• % of trading days lower than 100%.’¹⁶

After performing this analysis and considering the limited trading volume, the issuer concluded that shares held in three of its listed available-for-sale investments were not traded in active markets. As a result, it measured fair value using a valuation technique based on Level 3 inputs. The enforcer disagreed with the issuer's assessment of whether the markets were active and thought that the quoted prices for these investments should have been used to measure fair value. In reaching this decision, the enforcer specifically noted that ‘the indicators used by the issuer were insufficient to conclude that the transaction price did not represent fair value or that transactions occurred with insufficient frequency and volume. … [T]he issuer did not gather sufficient information to determine whether transactions were orderly or took place with sufficient frequency and volume to provide pricing information. Therefore, based on available data, it was not possible to conclude that the markets, where the investments were listed, were not active and further analysis should have been performed to measure fair value.’¹⁷ The enforcer also raised concerns that the valuations based on Level 3 inputs were much higher than the quoted prices. Care will be needed when reaching a conclusion that a market is not active as this is a high hurdle.

During the PIR on IFRS 13, many respondents indicated they found the assessment of whether a market is active to be challenging and asked for additional guidance. The IASB decided not to provide additional guidance, noting in particular that the requirements are principles-based and, as such, judgement will always be needed in their application.¹⁸

8.2.1 Are all transactions entered into to meet regulatory requirements or transactions initiated during bankruptcy assumed to be not orderly?

Although an entity may be viewed as being compelled to sell assets to comply with regulatory requirements, such transfers are not necessarily disorderly. If the entity was provided with the usual and customary period of time to market the asset to multiple potential buyers, the transaction price may be representative of the asset's fair value. Similarly, transactions initiated during bankruptcy are not automatically assumed to be disorderly. The determination of whether a transaction is not orderly requires a thorough evaluation of the specific facts and circumstances, including the exposure period and the number of potential buyers.

8.2.2 Is it possible for orderly transactions to take place in a ‘distressed’ market?

Yes. While there may be increased instances of transactions that are not orderly when a market has undergone a significant decrease in volume, it is not appropriate to assume that all transactions that occur in a market during a period of dislocation are distressed or forced. This determination is made at the individual transaction level and requires the use of judgement based on the specific facts and circumstances. While market factors such as an imbalance in supply and demand can affect the prices at which transactions occur in a given market, such an imbalance, in and of itself, does not indicate that the parties to a transaction were not knowledgeable and willing market participants or that a transaction was not orderly. For example, a transaction in a dislocated market is less likely to be considered a ‘distressed sale’ when multiple buyers have bid on the asset.

In addition, while a fair value measurement incorporates the assumptions that sellers, as well as buyers, would consider in pricing the asset or liability, an entity's conclusion that it would not sell its own asset (or transfer its own liability) at prices currently observed in the market does not mean these transactions should be presumed to be distressed. IFRS 13 makes clear that fair value is a market-based measurement, not an entity-specific measurement, and notes that the entity's intention to hold an asset or liability is not relevant in estimating its fair value. The objective of a fair value measurement is to estimate the exit price in an orderly transaction between willing market participants at the measurement date under current market conditions. This price should include a risk premium that reflects the amount market participants would require as compensation for bearing any uncertainty inherent in the cash flows, and this uncertainty (as well as the compensation demanded to assume it) may be affected by current marketplace conditions. The objective of a fair value measurement does not change when markets are inactive or in a period of dislocation.

8.3.1 Assessing the relevance of observable data

While observable prices from inactive markets may not be representative of fair value in all cases, this data should not be ignored. Instead, paragraphs B38 and B44 of IFRS 13 clarify that additional analysis is required to assess the relevance of the observable data. [IFRS 13.B38, B44]. The relevance of a quoted price from an inactive market is dependent on whether the transaction is determined to be orderly. If the observed price is based on a transaction that is determined to be forced or disorderly, little, if any, weight should be placed on it compared with other indications of value.

If the quoted price is based on a transaction that is determined to be orderly, this data point should be considered in the estimation of fair value. However, the relevance of quoted prices associated with orderly transactions can vary based on factors specific to the asset or liability being measured and the facts and circumstances surrounding the price. Some of the factors to be considered include:

• the condition and(or) location of the asset or liability;
• the similarity of the transactions to the asset or liability being measured (e.g. the extent to which the inputs relate to items that are comparable to the asset or liability);
• the size of the transactions;
• the volume or level of activity in the markets within which the transactions are observed;
• the proximity of the transactions to the measurement date; and
• whether the market participants involved in the transaction had access to information about the asset or liability that is usual and customary.

If the adjustments made to the observable price are significant and based on unobservable data, the resulting measurement would represent a Level 3 measurement.

8.3.2 Selection and use of valuation techniques when there has been a significant decrease in volume or level of activity

As discussed above, when activity has significantly decreased for an asset or liability, an assessment of the relevance of observable market data will be required and adjustments to observable market data may be warranted. A significant decrease in volume or activity can also influence which valuation technique(s) are used and how those techniques are applied.

The following example from IFRS 13 highlights some key valuation considerations for assets that trade in markets that have experienced a significant decrease in volume and level of activity. [IFRS 13.IE49‑58].

In Example 14.9 above, Entity A uses an income approach (i.e. discount rate adjustment technique, see 21 below for further discussion regarding present value techniques) to estimate the fair value of its residential mortgage-backed security (RMBS), because limited trading activity precluded a market approach as at the measurement date.

Example 14.9 illustrates that the entity's use of an income approach does not change the objective of the fair value measurement, which is a current exit price. Valuation models should take into account all the factors that market participants would consider when pricing an asset or liability. The discount rate used by Entity A, for example, tries to incorporate all of the risks (e.g. liquidity risk, non-performance risk) market participants would consider in pricing the RMBS under current market conditions. Liquidity, credit or any other risk factors market participants would consider in pricing the asset or liability may require adjustments to model values if such factors are not sufficiently captured in the model.

Entity A prioritises observable inputs (to the extent available) over unobservable inputs in its application of the income approach. Entity A assesses market-based data from various sources to estimate the discount rate. For example, the entity estimates the change in the credit spread of the RMBS since its issuance based on spread changes observed from the most comparable index, for which trades continue to occur. Using the best available market information, the entity adjusts this input to account for differences between the observed index and the RMBS. These adjustments include the entity's assessment of the additional liquidity risk inherent in the RMBS compared to the index.

Paragraph 89 of IFRS 13 indicates that an entity may use its own internal assumptions when relevant observable market data does not exist. [IFRS 13.89]. However, if reasonably available data indicates that market participant assumptions would differ, the entity should adjust its assumptions to incorporate that information. Relevant market data is not limited to transactions for the identical asset or liability being measured.

In the above example, Entity A is unable to use a market approach because of limited trading activity for the RMBS. Therefore, Entity A considers implied liquidity risk premiums from recent transactions for a range of similar securities to estimate the incremental premium market participants would demand for its RMBS in the current market (as compared to the benchmark spread). In addition, Entity A considers two indicative broker quotes to estimate an appropriate discount rate for its RMBS. Although these quotes are specific to the RMBS being valued, Entity A puts less weight on these quotes since they are not binding and are not based on actual transactions. Furthermore, Entity A was unable to evaluate the valuation techniques and underlying data used by the brokers.

Importantly, the illustrative example is not intended to imply that an entity's own assumptions carry more weight than non-binding broker quotes. Rather, the example illustrates that each indication of value needs to be assessed based on the extent these indications rely on observable versus unobservable inputs.

Even though the market approach could not be used because of limited trading activity for the RMBS, Entity A was able to corroborate many of the assumptions used in developing the discount rate with relevant observable market data. As a result, the decision by the entity to place additional weight on its own market-corroborated assumptions (and less on the broker quotes) was warranted. When differences between broker quotes or pricing service data and an entity's own determination of value are significant, management should seek to understand the reasons behind these differences, if possible.

9.1.1 Are transaction costs in IFRS 13 the same as ‘costs to sell’ in other IFRSs?

As discussed at 2.1.2 above, some IFRSs permit or require measurements based on fair value, where costs to sell or costs of disposal are deducted from the fair value measurement. IFRS 13 does not change the measurement objective for assets accounted for at fair value less cost to sell. The ‘fair value less cost to sell’ measurement objective includes: (1) fair value; and (2) cost to sell. The fair value component is measured in accordance with the IFRS 13.

Consistent with the definition of transaction costs in IFRS 13, IAS 36 describes costs of disposal as ‘the direct incremental costs attributable to the disposal of the asset or cash-generating unit, excluding finance costs and income tax expense’. [IAS 36.6]. IAS 41 and IFRS 5 similarly define costs to sell.

As such, transaction costs excluded from the determination of fair value in accordance with IFRS 13 will generally be consistent with costs to sell or costs of disposal, determined in other IFRSs (listed at 2.1.2 above), provided they exclude transportation costs.

Since the fair value component is measured in accordance with IFRS 13, the standard's disclosure requirements apply in situations where the fair value less cost to sell measurement is required subsequent to the initial recognition (unless specifically exempt from the disclosure requirements, see 20 below). In addition, IFRS 13 clarifies that adjustments used to arrive at measurements based on fair value (e.g. the cost to sell when estimating fair value less cost to sell) should not be considered when determining where to categorise the measurement in the fair value hierarchy (see 16 below).

9.1.2 Transaction costs in IFRS 13 versus acquisition-related transaction costs in other IFRSs

The term ‘transaction costs’ is used in many IFRSs, but sometimes it refers to transaction costs actually incurred when acquiring an item and sometimes to transaction costs expected to be incurred when selling an item. While the same term might be used, it is important to differentiate between these types of transaction costs.

IAS 36, IAS 41 and IFRS 5 discuss costs to sell or dispose of an item (as discussed at 9.1.1 above).

In contrast, other standards refer to capitalising or expensing transaction costs incurred in the context of acquiring an asset, assuming a liability or issuing an entity's own equity (a buyer's perspective). IFRS 3, for example, requires acquisition-related costs to be expensed in the period incurred. [IFRS 3.53].

IFRS 13 indicates that transaction costs are not included in a fair value measurement. As such, actual transaction costs (e.g. commissions paid) that are incurred by an entity when acquiring an asset would not be included at initial recognition when fair value is the measurement objective. Likewise, transaction costs that would be incurred in a hypothetical sales transaction would also not be included in a fair value measurement.

Some standards permit acquisition-related transaction costs to be capitalised at initial recognition, then permit or require the item, to which those costs relate, to be subsequently measured at fair value. In those situations, some or all of the acquisition-related transaction costs that were capitalised will effectively be expensed as part of the resulting fair value gain or loss. This is consistent with current practice. For example, IAS 40 permits transaction costs to be capitalised as part of an investment property's cost on initial recognition. [IAS 40.20]. However, if the fair value model is applied to the subsequent measurement of the investment property, transaction costs would be excluded from the fair value measurement.

Similarly, at initial recognition, financial assets or liabilities in the scope of IFRS 9 are generally measured at their ‘fair value plus or minus, in the case of a financial asset or liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or liability’. [IFRS 9.5.1.1]. For those items subsequently measured at amortised cost, these transaction costs will be captured as part of the instrument's effective interest rate.

10.1.1 Highest and best use: determining what is legally permissible

To be legally permissible, the standard indicates a use of a non-financial asset need not be legal (or have legal approval) at the measurement date, but it must not be legally prohibited in the jurisdiction. [IFRS 13.BC69].

What is legally permissible is a matter of law. However, the IASB seems to be distinguishing between a use that is explicitly prohibited and a use that would be permitted if the jurisdiction's specific legal requirements were met. However, in some situations it may be difficult to determine whether a use is capable of being legally permitted when, at the measurement date, it is subject to legal restrictions that are not easily overcome.

The standard gives the example of a land development. Assume the government has prohibited building on or developing certain land (i.e. the land is a protected area). For the entity to develop the land, a change of law would be required. Since development of this land would be illegal, it cannot be the highest and best use of the land. Alternatively, assume the land has been zoned for commercial use, but nearby areas have recently been developed for residential use and, as such, market participants would consider residential development as a potential use of the land. Since re-zoning the land for residential development would only require approval from an authority and that approval is usually given, this alternative use could be deemed to be legally permissible.

It is assumed that market participants would consider all relevant factors, as they exist at the measurement date, in determining whether the legally permissible use of the non-financial asset may be something other than its current use. That is, market participants would consider the probability, extent and timing of different types of approvals that may be required in assessing whether a change in the legal use of the non-financial asset could be obtained.

The scenarios, of protected land and re-zoning of land, considered above illustrate either end of the spectrum; uses that are unlikely and likely to be legally permissible, respectively. However, consider the protected land example above. Assume the government were expected to change the law in the near future to permit residential development, but there had not been any similar changes in law to date. An entity would need to consider the weight of evidence available and whether market participants would have similar expectations. This may be more difficult without past history of similar changes in law. However, an entity might consider factors such as whether expectations are based on verbal assurances or written evidence; whether the process to change the law has begun; and the risk that the change in law will not be approved. It may also help to determine whether market participants would pay for this potential. However, this fact, on its own, is unlikely to be sufficient to support a use being legally permissible.

In our view, an entity would need to have sufficient evidence to support its assumption about the potential for an alternative use, particularly in light of IFRS 13's presumption that the highest and best use is an asset's current use. In the example above of re-zoning land for residential development, the entity's belief that re-zoning was possible (or even likely) is unlikely to be sufficient evidence that the re-zoning is legally permissible. However, the fact that nearby areas had recently been re-zoned for residential use may provide additional evidence as to the likelihood that the land being measured could similarly be re-zoned. If obtaining re-zoning permission is not merely perfunctory, there may be a significant burden on the entity to prove that market participants would consider commercial use of the land ‘legally permissible’.

10.1.2 Highest and best use versus current use

Although IFRS 13 presumes that an entity's current use of an asset is its highest and best use, market or other factors may suggest that a different use by market participants would maximise the value of that asset. [IFRS 13.29]. Because the highest and best use of an asset is determined based on market participants’ expectations, reporting entities may need to consider alternative uses of an asset (e.g. land) in their analysis of fair value. An entity's current or intended use of a non-financial asset might not be the highest and best use of the asset, and thus would not determine its premise of value. Instead, the highest and best use of the asset (or asset group) should be determined based on how market participants would maximise the asset's value. For example, market participants may maximise the value of land, currently used as a site for a manufacturing facility, for residential housing instead.

The consideration of alternative uses is not intended to be exhaustive. It is not necessary that all possible alternatives be considered. Instead, judgement is required in assessing those alternative uses that market participants would consider in pricing the asset. As noted above, consideration of what is physically possible, legally permissible and financially feasible would be part of this assessment. Example 14.11, based on an example in IFRS 13, illustrates this further. If an entity determines that the highest and best use of an asset is different from its current use, IFRS 13 requires that fact to be disclosed as well as the reason why the non-financial asset is being used in a manner that differs from its highest and best use (disclosures are discussed further at 20 below). [IFRS 13.93(i)].

It is important to note that even if the current use of a non-financial asset is the same as its highest and best use, the underlying assumptions used to value the asset should not be entity-specific, but instead should be based on the assumptions that market participants would use when transacting for the asset in its current condition. Entity-specific synergies, if they would differ from market participant synergies, would not be considered in the determination of the highest and best use of the asset. This is illustrated in Example 14.11. [IFRS 13.IE7‑8].

10.1.3 Highest and best use versus intended use (including defensive value)

An entity's intended use of an asset, at the time it is acquired, may not be the same as how market participants would use the asset. If the highest and best use and the entity's intended use of an asset are not the same, it could result in differences between the price to acquire the asset and fair value measured in accordance with IFRS 13 (see 13 below). IFRS 13 requires that the highest and best use of an asset be determined from the perspective of market participants, even if management intends a different use, [IFRS 13.29, 30], as is illustrated in Example 14.12.

In certain instances, the highest and best use of an asset may be to not actively use it, but instead to lock it up or ‘shelve it’ (commonly referred to as a defensive asset). That is, the maximum value provided by an asset may be its defensive value. IFRS 13 clarifies that the fair value of an asset used defensively is not assumed to be zero or a nominal amount. Instead, an entity should consider the incremental value such a use provides to the assets being protected, such as the incremental value provided to an entity's existing brand name by acquiring and shelving a competing brand. Generally speaking, a nominal fair value is appropriate only when an asset is abandoned (i.e. when an entity would be willing to give the asset away for no consideration).

Importantly, an entity's decision to use an asset defensively does not mean that market participants would necessarily maximise the asset's value in a similar manner. Likewise, an entity's decision to actively use an asset does not preclude its highest and best use to market participants as being defensive in nature. The following example in IFRS 13 illustrates these points. [IFRS 13.IE9].

The fair value of the in-process research and development project in Example 14.12 above depends on whether market participants would use the asset offensively, defensively or abandon it (as illustrated by points (a), (b) and (c) in the example, respectively). As discussed at 10.1 above, if there are multiple types of market participants who would use the asset differently, these alternative scenarios must be considered before concluding on the asset's highest and best use.

10.2.1 Valuation premise – stand-alone basis

If the highest and best use of the asset is to use it on a stand-alone basis, an entity measures the fair value of the asset individually. In other words, the asset is assumed to be sold to market participants for use on its own. Fair value is the price that would be received in a current transaction under those circumstances. [IFRS 13.31(b)]. For instance, alternative (c) of Example 14.12 above suggests the highest and best use of the research and development project could be to cease development. Since its highest and best use is on a stand-alone basis, the fair value of the project would be the price that would be received in a current transaction to sell the project on its own and assuming a market participant would cease development of the project. In addition, the asset should be measured based only on its current characteristics, potentially requiring an adjustment for transformation costs. For example, if land that is used as a factory site is to be valued on a stand-alone basis, transformation costs (e.g. the cost of removing the factory) should be considered in the fair value measurement.

When the valuation premise of one non-financial asset in an asset group is valued on a stand-alone basis, all of the other assets in the group should also be valued using a consistent valuation premise. For example, based on Example 14.11 at 10.1.2 above, if the highest and best use of the land is determined to be on a stand-alone basis (i.e. as vacant land), the fair value of the equipment in the factory could be determined under two alternative valuation premises: (a) stand-alone (i.e. the value of the equipment sold on a stand-alone basis); or (b) in conjunction with other equipment on the operating line, but in a different factory (i.e. not in combination with the land, since the land would be valued on a stand-alone basis). Regardless of the valuation premise used to measure the equipment, market participant assumptions regarding the cost of redeployment, such as costs for disassembling, transporting and reinstalling the equipment should be considered in the fair value measurement.

10.2.2 Valuation premise – in combination with other assets and/or liabilities

If the highest and best use of a non-financial asset is in combination with other assets as a group or in combination with other assets and liabilities, the fair value of the asset is the price that would be received in a current transaction to sell the asset and would assume that:

1. market participants would use the asset together with other assets or with other assets and liabilities; and
2. those assets and liabilities (i.e. its complementary assets and the associated liabilities) would be available to market participants. [IFRS 13.31(a)(i)]. That is, the fair value of the asset would be measured from the perspective of market participants who are presumed to hold the complementary assets and liabilities (see 10.2.3 below for further discussion regarding associated liabilities).

Once an entity determines that the valuation premise for a non-financial asset is its use in combination with a set of assets (or assets and liabilities), all of the complementary non-financial assets in that group should be valued using the same valuation premise (i.e. assuming the same highest and best use), regardless of whether any individual asset within the group would have a higher value under another premise. [IFRS 13.31(a)(iii)]. Example 14.13 illustrates this further.

When the asset's highest and best use is in combination with other items, the effect of the valuation premise on the measurement of fair value will depend on the specific circumstances. IFRS 13 gives the following examples.

1. The fair value of the asset might be the same whether it is on a stand-alone basis or in an asset group.

   This may occur if the asset is a business that market participants would continue to operate, for example, when a business is measured at fair value at initial recognition in accordance with IFRS 3. The transaction would involve valuing the business in its entirety. The use of the assets as a group in an ongoing business would generate synergies that would be available to market participants (i.e. market participant synergies that, therefore, should affect the fair value of the asset on either a stand-alone basis or in combination with other assets or with other assets and liabilities).

2. An asset's use in an asset group might be incorporated into the fair value measurement through adjustments to the value of the asset used on a stand-alone basis.

   For example, assume the asset to be measured at fair value is a machine that is installed and configured for use. If the fair value measurement is determined using an observed price for a similar machine that is not installed or otherwise configured for use, it would need to be adjusted for transport and installation costs so that the fair value measurement reflects the current condition and location of the machine.

3. An asset's use in an asset group might be incorporated into the fair value measurement through the market participant assumptions used to measure the fair value of the asset.

   For example, the asset might be work in progress inventory that is unique and market participants would convert the inventory into finished goods. In that situation, the fair value of the inventory would assume that market participants have acquired or would acquire any specialised machinery necessary to convert the inventory into finished goods.

4. An asset's use in combination with other assets or with other assets and liabilities might be incorporated into the valuation technique used to measure the fair value of the asset.

   That might be the case when using the multi-period excess earnings method to measure the fair value of an intangible asset because that valuation technique specifically takes into account the contribution of any complementary assets and the associated liabilities in the group in which such an intangible asset would be used.

5. In more limited situations, when an entity uses an asset within a group of assets, the entity might measure the asset at an amount that approximates its fair value when allocating the fair value of the asset group to the individual assets of the group.

   For example, this might be the case if the valuation involves real property and the fair value of improved property (i.e. an asset group) is allocated to its component assets (such as land and improvements). [IFRS 13.B3].

Although the approach used to incorporate the valuation premise into a fair value measurement may differ based on the facts and circumstances, the determination of a non-financial asset's valuation premise (based on its highest and best use) and the inputs applied in the valuation technique used to estimate fair value should always be considered from the perspective of market participants, not the reporting entity.

10.2.3 How should associated liabilities be considered when measuring the fair value of a non-financial asset?

As discussed at 10.2.2 above, an asset's highest and best use might be in combination with associated liabilities and complementary assets in an asset group. IFRS 13.B3(d), for example, notes that an asset's use in combination with other assets and liabilities might be incorporated when using the multi-period excess earnings method to measure the fair value of an intangible asset that has been acquired in a business acquisition. [IFRS 13.B3]. The multi-period excess earnings method specifically takes into account the contribution of any complementary assets and the associated liabilities in the group in which such an intangible asset would be used.

‘Associated liabilities’ is not defined and IFRS 13 provides limited guidance on the types of liabilities that could be considered associated to a non-financial asset. IFRS 13 provides some guidance, stating that associated liabilities can include those that fund working capital, but must exclude liabilities used to fund assets other than those within the group of assets. [IFRS 13.31(a)(ii)].

Management will need to exercise judgement in determining which liabilities to include or exclude from the group, based on the specific facts and circumstances. This assessment must reflect what market participants would consider when determining the non-financial asset's highest and best use. Entities will need to be careful to exclude entity-specific assumptions when valuing liabilities, particularly if valuation techniques are used that are based on their own data (valuation techniques are discussed further at 14 below).

The clarification on considering associated liabilities when measuring the fair value of non-financial assets was generally intended to align the guidance in IFRS 13 with current practice for measuring the fair value of certain non-financial assets (e.g. intangible assets). We generally would not expect this clarification to result in significant changes to the valuation of most non-financial assets. For example, real estate should generally be valued independently from any debt used to finance the property.

10.2.4 Unit of account versus the valuation premise

Fair value measurement of a non-financial asset assumes the asset is sold consistently with its unit of account (as specified in other IFRSs), irrespective of its valuation premise. This assumption applies even if the highest and best use of the asset is in combination with other assets and/or liabilities. This is because the fair value measurement contemplates the sale of the individual asset to market participants that already hold, or are able to obtain, the complementary assets and liabilities. [IFRS 13.32]. Only when the unit of account of the item being measured at fair value is an asset group (which may be the case when measuring non-financial assets for impairment as part of a cash-generating unit), can one consider the sale of an asset group. That is, the valuation premise for a non-financial asset does not override the unit of account as defined by the applicable IFRS. However, this can be confusing in practice as both concepts deal with determining the appropriate level of aggregation or disaggregation for assets and liabilities.

Unit of account is an accounting concept. It identifies what is being measured for financial reporting purposes. When applying IFRS 13, this drives the level of aggregation (or disaggregation) for presentation and disclosure purposes, for example, whether the information presented and disclosed in the financial statements is for an individual asset or for a group of assets.

The valuation premise is a valuation concept (sometimes referred to as the ‘unit of valuation’). It determines how the asset or liability is measured, i.e. based on the value it derives on a stand-alone basis or the value it derives in conjunction with other assets and liabilities. As discussed above, the unit of account established by an IFRS may be an individual item. However, that item may need to be grouped with others for the purpose of measuring fair value, i.e. the valuation premise may differ from the unit of account.

For example, an entity may own an investment property that is attached to land and contains other assets, such as fixtures and fittings. The unit of account for the investment property would likely be the stand-alone asset in accordance with IAS 40. However, the value of this asset on a stand-alone basis may have little meaning since it is physically attached to the land and derives its benefit in combination with the fixtures and fittings in the building. Therefore, when determining fair value, the valuation premise would likely reflect its use in combination with other assets.

It is important to note that when the valuation premise for measuring the fair value of a non-financial asset (or group of assets and corresponding liabilities) differs from its unit of account, categorisation within IFRS 13's fair value hierarchy (for disclosure purposes) must be determined at a level consistent with the unit of account for the asset or liability (see 16.2 below).

11.1.1 Fair value of a liability

IFRS 13 states that the fair value measurement of a liability contemplates the transfer of the liability to a market participant at the measurement date. The liability is assumed to continue (i.e. it is not settled or extinguished), and the market participant to whom the liability is transferred would be required to fulfil the obligation.

The fair value of a liability also reflects the effect of non-performance risk. Non-performance risk is the risk that an obligation will not be fulfilled. This risk includes, but may not be limited to, the entity's own credit risk (see 11.2 below). The requirement that non-performance risk remains unchanged before and after the transfer implies that the liability is hypothetically transferred to a market participant of equal credit standing.

The clarification in IFRS 13 that fair value is not based on the price to settle a liability with the existing counterparty, but rather to transfer it to a market participant of equal credit standing, affects the assumptions about the principal (or most advantageous) market and the market participants in the exit market for the liability (see 11.1.3 below for further detail on the distinction between the settlement notion for liabilities and the transfer notion in IFRS 13).

11.1.2 Fair value of an entity's own equity

For an entity's own equity, IFRS 13 states that the fair value measurement would contemplate a transfer of the equity instrument. The equity instrument would remain outstanding and the market participant transferee would take on the rights and responsibilities associated with the instrument. The instrument would not be cancelled or otherwise extinguished on the measurement date.

The requirements for measuring the fair value of an entity's own equity are generally consistent with the requirements for measuring liabilities, except for the requirement to incorporate non-performance risk, which does not apply directly to an entity's own equity.

11.1.3 Settlement value versus transfer value

While IFRS 13 requires the use of an exit price to measure fair value, an entity might not intend (or be able) to transfer its liability to a third party. For example, it might be more beneficial for the entity to fulfil or settle a liability or the counterparty might not permit the liability to be transferred to another party. The issuer of an equity instrument may only be able to exit from that instrument if it ceases to exist or if the entity repurchases the instrument from the holder. Even if an entity is unable to transfer a liability, the IASB believes the transfer notion is necessary for measuring fair value, because ‘it captures market participants’ expectations about the liquidity, uncertainty and other associated factors whereas, a settlement notion may not because it may consider entity-specific factors’. [IFRS 13.BC82].

Under a transfer notion, the fair value of a liability is based on the price that would be paid to market participants to assume the obligation. The guidance is clear that an entity's intention to settle or otherwise fulfil the liability or exit the equity instrument is not relevant when measuring its fair value. Because the fair value of the liability is considered from the perspective of market participants, and not the entity itself, any relative efficiencies (or inefficiencies) of the reporting entity in settling the liability would not be considered in the fair value measurement.

Unlike a transfer notion, a settlement notion may allow for the consideration of a reporting entity's specific advantages (or disadvantages) in settling (or performing) the obligation. However, the Boards concluded that ‘when a liability is measured at fair value, the relative efficiency of an entity in settling the liability using its own internal resources appears in profit or loss over the course of its settlement, and not before’. [IFRS 13.BC81].

While similar thought processes are needed to estimate both the amount to settle a liability and the amount to transfer that liability, [IFRS 13.BC82], IFRS 13 requires the fair value of a liability to be measured on the assumption that the liability is transferred to a market participant. Therefore, an entity cannot presume that the fair value of a liability is the same as its settlement value. In particular, the requirement to reflect the effect of non-performance risk in the fair value measurement of a liability could result in a difference between the fair value of a liability and the settlement value because it is unlikely that the counterparty would accept a different amount as settlement of the obligation if the entity's credit standing changed (i.e. the settlement value would not necessarily consider changes in credit risk). The IASB was expected to address this issue in its project on non-financial liabilities (see Chapter 26), but further development on this research project had been on hold pending developments in the Conceptual Framework project. The IASB issued the new conceptual framework in March 2018 and following this, is consulting with stakeholders on the possible scope of the project on non-financial liabilities.²⁰

11.2.1 Liabilities or an entity's own equity that are held by other parties as assets

If there are no quoted prices available for the transfer of an identical or a similar liability or the entity's own equity instrument and the identical item is held by another party as an asset, an entity uses the fair value of the corresponding asset to measure the fair value of the liability or equity instrument. [IFRS 13.37]. The fair value of the asset should be measured from the perspective of the market participant that holds that asset at the measurement date. This approach applies even when the identical item held as an asset is not traded (i.e. when the fair value of the corresponding asset is a Level 3 measurement). For example, under the guidance in IFRS 13, the fair value of a contingent consideration liability should equal its fair value when held as an asset despite the fact that the asset would likely be a Level 3 measurement.

In these situations, the entity measures the fair value of the liability or its own equity by:

1. using the quoted price in an active market for the identical item held by another party as an asset, if that price is available. This is illustrated in Example 14.14 below;
2. if that price is not available, using other observable inputs, such as the quoted price in a market that is not active for the identical item held by another party as an asset; or
3. if the observable prices in (a) and (b) are not available, using another valuation technique (see 14 below for further discussion), such as:
   1. an income approach, as is illustrated in Example 14.15 below; or
   2. a market approach. [IFRS 13.38].

As with all fair value measurements, inputs used to determine the fair value of a liability or an entity's own equity from the perspective of a market participant that holds the identical instrument as an asset must be prioritised in accordance with the fair value hierarchy. Accordingly, IFRS 13 indicates that the fair value of a liability or equity instrument held by another party as an asset should be determined based on the quoted price of the corresponding asset in an active market, if available. This is illustrated in Example 14.14 below. If such a price is not available, other observable inputs for the identical asset would be used, such as a quoted price in an inactive market. In the absence of quoted prices for the identical instrument held as an asset, other valuation techniques, including an income approach (as is illustrated in Example 14.15 below) or a market approach, would be used to determine the liability's or equity's fair value. In these instances, the objective is still to determine the fair value of the liability or equity from the perspective of a market participant that holds the identical instrument as an asset.

In some cases, the corresponding asset price may need to be adjusted for factors specific to the identical item held as an asset but not applicable to the liability, such as the following:

• the quoted price for the asset relates to a similar (but not identical) liability or equity instrument held by another party as an asset. IFRS 13 gives the example of a liability or equity instrument where the credit quality of the issuer is different from that reflected in the fair value of the similar liability or equity instrument held as an asset; and
• the unit of account for the asset is not the same as for the liability or equity instrument. For instance, assume the price for an asset reflected a combined price for a package that comprised both the amounts due from the issuer and a third-party credit enhancement. If the unit of account for the liability is only its own liability, not the combined package, the entity would adjust the observed price for the asset to exclude the effect of the third-party credit enhancement. [IFRS 13.39].

In addition, IFRS 13 states that when using the price of a corresponding asset to determine the fair value of a liability or entity's own equity, the fair value of the liability or equity should not incorporate the effect of any restriction preventing the sale of that asset. [IFRS 13.39]. If the quoted price did reflect the effect of a restriction, it would need to be adjusted. That is, all else being equal, the liability's or equity's fair value would be the same as the fair value of an otherwise unrestricted corresponding asset.

The fair value of a liability may also differ from the price of its corresponding asset when the instrument is priced within a bid-ask spread. In these instances, the liability should be valued based on the price within the bid-ask spread that is most representative of where the liability would be exited, not the corresponding asset (see 15.3 below for discussion on pricing within the bid-ask spread).

The Boards believe the fair value of a liability or equity instrument will equal the fair value of a properly defined corresponding asset (i.e. an asset whose features mirror those of the liability), assuming an exit from both positions in the same market. This assumes markets are efficient and arbitrage free. For example, if the prices differed for a liability and the corresponding asset, the market participant taking on the liability would be able to earn a profit by financing the purchase of the asset with the proceeds received by taking on the liability. In an efficient market, the price for the liability and the price for the asset would adjust until the arbitrage opportunity was eliminated. In the Boards’ view, the price for the liability or equity instrument and the corresponding asset would generally only differ if the entity was measuring an asset relating to a similar (not identical) instrument or the unit of account was different. The Boards did consider whether the effects of illiquidity could create a difference but noted that they are difficult to differentiate from credit-related effects. [IFRS 13.BC88, BC89].

The following two examples extracted from IFRS 13 include factors to consider when measuring the fair value of a liability or entity's own equity by estimating the fair value of the corresponding asset held by another party. [IFRS 13.IE40‑42]. The first example highlights how entities need to assess whether the quoted price for a corresponding asset includes the effects of factors not applicable to the liability. However, for the sake of simplicity, the example does not consider bid-ask spread considerations.

The second example provides factors that would be incorporated when using a present value technique to estimate the fair value of a financial liability (e.g. changes in credit spreads for the liability), as well as factors that would be excluded (e.g. adjustments related to transferability restrictions or profit margin). [IFRS 13.IE43‑47].

While the example above assumes that relevant market data on the non-performance risk of the debt obligation is readily available, estimating the appropriate credit spreads is often the most challenging aspect of using a present value technique to value a debt instrument. Credit spreads on identical or similar liabilities issued by the same obligor represent high quality market data. But even when issued by the same obligor, credit spreads on liabilities with significantly different features or characteristics may not appropriately capture the credit risk of the liability being measured. When spreads on identical instruments do not exist and data from comparable debt instruments (e.g. option adjusted spreads (OAS)) is used, the specific characteristics of these comparable liabilities (e.g. tenor, seniority, collateral, coupon, principal amortisation, covenant strength, etc.) should be analysed carefully. In addition, credit default swap (CDS) spreads, which represent the compensation required by the CDS issuer to accept the default risk of a debt issuer (i.e. the reference obligor), may also provide useful market data.

In some instances, observable market data is not available for a specific debt issuer, but the issuer has a reported credit rating. In these circumstances, credit spreads or CDS spreads of similarly rated entities or debt instruments may be used as a proxy to evaluate the credit risk of the liability being measured. Once again, the specific characteristics of these similar debt instruments and the subject liability should be compared.

Other situations may involve a liability with no observable credit quality measures (e.g. credit spreads) issued by an entity that is not rated. In these circumstances, techniques such as a regression or other quantitative analysis may be performed to determine the credit quality of the issuer. Comparing financial metrics such as profit margins, leverage ratios, and asset sizes between the non-rated issuer of the liability being measured to rated entities may allow a credit rating to be estimated. Once a credit rating has been determined, an appropriate credit spread could be quantified from other comparable (i.e. similarly rated) debt instruments.

11.2.2 Liabilities or an entity's own equity not held by other parties as assets

While many liabilities are held by market participants as corresponding assets, some are not. For example, there is typically no corresponding asset holder for a decommissioning liability. When no observable price is available for a liability and no corresponding asset exists, the fair value of the liability is measured from the perspective of a market participant that owes the liability, using an appropriate valuation technique (e.g. a present value technique). [IFRS 13.40].

Generally, an instrument classified as an entity's own equity would have a corresponding asset. However, if no corresponding asset exists and no observable price is available for an entity's own equity, fair value is measured from the perspective of a market participant that has issued the claim on equity, using an appropriate valuation technique.

IFRS 13 gives two examples of what an entity might take into account in measuring fair value in this situation:

1. the future cash outflows that a market participant would expect to incur in fulfilling the obligation (i.e. a present value technique). This includes any compensation a market participant would require for taking on the obligation. This approach is discussed further at 11.2.2.A below; and
2. the amount that a market participant would receive to enter into an identical liability, or issue an identical equity instrument. This approach is discussed further at 11.2.2.B below. [IFRS 13.41].

11.3.1 Liabilities issued with third-party credit enhancements

As discussed at 11.3 above, IFRS 13 requires entities to measure the fair value of a liability issued with an inseparable third-party credit enhancement from the issuer's perspective, i.e. considering the issuer's credit risk rather than that of the third-party providing the credit enhancement. This would apply in situations where a credit enhancement (or guarantee) is purchased by an issuer, then combined with a liability and issued as a combined security to an investor. IFRS 13's requirements are based on the fact that the third-party credit enhancement does not relieve the issuer of its ultimate obligation under the liability. Generally, if the issuer fails to meet its payment obligations to the investor, the guarantor has an obligation to make the payments on the issuer's behalf and the issuer has an obligation to the guarantor. By issuing debt combined with a credit enhancement, the issuer is able to market its debt more easily and can either reduce the interest rate paid to the investor or receive higher proceeds when the debt is issued.

IFRS 13 requires the fair value measurement of a liability to follow the unit of account of the liability for financial reporting purposes. The standard anticipates that there may be instances where, even though it may be inseparable, the credit enhancement may need to be separated (i.e. separately recognised) for financial reporting purposes. However, this assumes that: (i) the unit of account is clear in other standards, which may not be the case; and (ii) that standards, such as IFRS 9, may permit or require separation when a credit enhancement is inseparable.

As discussed in Figure 14.4 below, if the unit of account excludes the credit enhancement, the fair value of the liability measured from the issuer's perspective in accordance with IFRS 13, will not equal its fair value as a guaranteed liability held by another party as an asset. The fair value of the asset held by the investor considers the credit standing of the guarantor. However, under the guarantee, any payments made by the guarantor result in a transfer of the issuer's debt obligation from the investor to the guarantor. That is, the amount owed by the issuer does not change; the issuer must now pay the guarantor instead of the investor. Therefore, as discussed at 11.2.1 above, if the fair value of a third-party guaranteed liability is measured based on the fair value of the corresponding asset, it would need to be adjusted. [IFRS 13.BC96‑BC98].

11.3.2 Does IFRS 13 require an entity to consider the effects of both counterparty credit risk and its own credit risk when valuing its derivative transactions?

IFRS 13 addresses the issue of credit risk both explicitly and implicitly. As discussed at 11.3 above, in relation to an entity's own credit risk in the valuation of liabilities, the guidance is explicit; the fair value of a liability should reflect the effect of non-performance risk, which includes own credit risk.

The standard's requirements are less explicit regarding counterparty credit risk. IFRS 13 requires the fair value of an asset or liability to be measured based on market participant assumptions. Because market participants consider counterparty credit risk in pricing a derivative contract, an entity's valuation methodology should incorporate counterparty credit risk in its measurement of fair value.

11.3.3 How should an entity incorporate credit risk into the valuation of its derivative contracts?

As discussed at 11.3.2 above, IFRS 13 requires entities to consider the effects of credit risk when determining a fair value measurement, e.g. by calculating a debit valuation adjustment (DVA) or a credit valuation adjustment (CVA) on their derivatives.

As no specific method is prescribed in IFRS 13, various approaches are used in practice by derivatives dealers and end-users to estimate the effect of credit risk on the fair value of OTC derivatives.

The degree of sophistication in the credit adjustment valuation method used by a reporting entity is influenced by the qualitative factors noted below. Estimation can be complex and requires the use of significant judgement which is often influenced by various qualitative factors, including:

• the materiality of the entity's derivative's carrying value to its financial statements;
• the number and type of contracts for derivatives in the entity's portfolio;
• the extent to which derivative instruments are either deeply in or out of the money;
• the existence and terms of credit mitigation arrangements (e.g. collateral arrangements in place);
• the cost and availability of technology to model complex credit exposures;
• the cost and consistent availability of suitable input data to calculate an accurate credit adjustment; and
• the credit worthiness of the entity and its counterparties.

While the degree of sophistication and complexity may differ by entity and by the size and nature of the derivative portfolio, any inputs used under any methodology should be consistent with assumptions market participants would use. The complexity and judgement involved in selecting and consistently applying a method may require entities to provide additional disclosures to assist users of financial statements (see 20 below). 11.3.3.A to 11.3.4.B below provide further insights into some of the considerations for determining valuation adjustments for credit risk on derivatives measured at fair value, except for which a quoted price in an active market is available (i.e. over-the-counter derivatives).

In situations where an entity has a master netting agreement or credit support annex²² (CSA) with a counterparty, the entity may consider the credit risk of its derivative instruments with that counterparty on a net basis if it qualifies to use the measurement exception noted at 2.5.2 above (see 12 below for more detail on applying the measurement exception for financial instruments with offsetting credit risks).

11.3.3.A How do credit adjustments work?

In simple terms, the requirement for a credit adjustment as a component of fair value measurement can be analogised to the need for a provision on a trade receivable or an impairment charge on an item of property, plant and equipment. Whilst this analogy helps conceptualise the requirement, the characteristics of derivatives mean that the calculation itself can be significantly more complex than for assets measured at amortised cost.

Consistent with the fact that credit risk affects the initial measurement of a derivative asset or liability, IFRS 13 requires that changes in counterparty credit risk or an entity's own credit standing be considered in subsequent fair value measurements. It cannot be assumed that the parties to the derivative contract will perform.

The terms of the asset or liability were determined based on the counterparty's or entity's credit standing at the time of entering into the contract. In addition, IFRS 13 assumes a liability is transferred to another party with the same credit standing at the measurement date. As a result, subsequent changes in a counterparty's or entity's credit standing will result in the derivative's terms being favourable or unfavourable relative to current market conditions.

Unlike the credit exposure of a ‘vanilla’ receivable, which generally remains constant over time (typically at the principal amount of the receivable), the bilateral nature of the credit exposure in many derivatives varies, whereby both parties to the contract may face potential exposure in the future. As such, many instruments may possibly have a value that is either positive (a derivative asset) or negative (a derivative liability) at different points in time based on changes in the underlying variables of the contract.

Figure 14.5 below illustrates the effect on the income statement and on the statement of financial position of CVA and DVA adjustments as a component of fair value measurement on a single derivative asset or liability.

11.3.4 Does the existence of master netting agreements and/or CSAs eliminate the need to consider an entity's own credit risk when measuring the fair value of derivative liabilities?

IFRS 13 is clear that non-performance risk should be considered from the perspective of the liability being measured, not the entity obligated under the liability. As such, non-performance risk may differ for various liabilities of the same entity. This difference may result from the specific terms of the liability (e.g. seniority or priority in the event of liquidation) or from specific credit enhancements related to the liability (e.g. collateral).

Bilateral collateral arrangements, master netting agreements and other credit enhancement or risk mitigation tools will reduce the credit exposure associated with a liability (or asset) and should be considered in determining the fair value of the liability. Although these agreements reduce credit exposure, they typically do not eliminate the exposure completely. For example, most CSAs do not require collateral to be posted until a certain threshold has been reached, and once reached require collateral only for the exposure in excess of the threshold. Therefore, while the existence of master netting agreements or CSAs mitigates the effect of own credit risk on the fair value of a liability, their presence alone would not enable an entity to ignore its own credit risk. Entities should assess their credit exposure to a specific liability when determining how their own credit risk would affect its fair value.

12.1.1 Accounting policy considerations

As noted above, the use of the portfolio approach is an accounting policy decision, to be made in accordance with IAS 8 (see Chapter 3), which must include an entity's policy regarding measurement assumptions – i.e. for both allocating bid-ask adjustments and credit adjustments (see 12.2 below).

An entity can choose to use the portfolio approach on a portfolio-by-portfolio basis. In addition, if entities choose this policy for a particular portfolio, they are not required to apply the portfolio approach to all of the risks of the financial assets and liabilities that make up the particular group. For example, an entity could choose to measure only the credit risk associated with a group of financial instruments on a net basis, but not the group's exposure to market risk.

An entity may also decide to apply the portfolio approach to only certain market risks related to the group. For example, an entity that is exposed to both interest rate and foreign currency risk in a portfolio of financial assets and liabilities could choose to measure only its interest rate risk exposure on a net basis.

The accounting policy decision can be changed if an entity's risk exposure preferences change, for example, a change in strategy to have fewer offsetting positions. In that case, the entity can decide not to use the exception but instead to measure the fair value of its financial instruments on an individual instrument basis. We generally expect that an entity's use of the portfolio approach would be consistent from period to period as changes in risk management policies are typically not common. [IFRS 13.51, BC121].

12.1.2 Presentation considerations

IFRS 13 is clear that applying the portfolio approach for measurement purposes does not affect financial statement presentation. For example, an entity might manage a group of financial assets and liabilities based on the net exposure(s) for internal risk management or investment strategy purposes, but be unable to present those instruments on a net basis in the statement of financial position because the entity does not have a positive intention and ability to settle those instruments on a net basis, as is required by IAS 32. [IAS 32.42].

If the requirements for presentation of financial instruments in the statement of financial position differ from the basis for the measurement, an entity may need to allocate the portfolio-level adjustments (see 12.2 below) to the individual assets or liabilities that make up the portfolio. Entities may also need to allocate portfolio-level adjustments for disclosure purposes when items in the group would be categorised within different levels of the fair value hierarchy (see 16 below for additional discussion on the allocation of portfolio-level adjustments related to the fair value hierarchy disclosures).

IFRS 13 does not prescribe any methodologies for allocating portfolio-level adjustments; instead, it states that the allocation should be performed in a reasonable and consistent manner that is appropriate in the circumstances. [IFRS 13.50].

12.1.3 Is there a minimum level of offset required to use the portfolio approach?

While there are explicit criteria that an entity must meet in order to use the portfolio approach, IFRS 13 does not specify any minimum level of offset within the group of financial instruments. For example, if an entity has positions with offsetting credit risk to a particular counterparty, we believe use of the portfolio approach is appropriate even if the extent of offset is minimal (provided that the entity has in place a legally enforceable agreement, as discussed at 12.2.2 below, that provides for offsetting upon default and all the other required criteria are met). To illustrate, even if the gross credit exposure was CU 100,000 (long) and CU 5,000 (short), upon counterparty default the entity would be exposed to a credit loss of only CU 95,000 under the terms of its master netting agreement.

With respect to market risk, considering the degree of offset may require additional judgement. Entities should assess the appropriateness of using the portfolio approach based on the nature of the portfolio being managed (e.g. derivative versus cash instruments) and its documented risk management policies (or investment strategies). An entity should use the portfolio approach in a manner consistent with the IASB's basis for providing the measurement exception and not in a manner to circumvent other principles within the standard.

12.1.4 Can Level 1 instruments be included in a portfolio of financial instruments with offsetting risks when calculating the net exposure to a particular market risk?

It is our understanding that Level 1 instruments can be included when using the exception to value financial instruments with offsetting risks. An entity is allowed to consider the effect of holding futures contracts when evaluating its net exposure to a particular market risk, such as interest rate risk. Paragraph 54 of IFRS 13 gives an example stating that ‘an entity would not combine the interest rate risk associated with a financial asset with the commodity price risk associated with a financial liability because doing so would not mitigate the entity's exposure to interest rate risk or commodity price risk’. [IFRS 13.54].

We understand that some constituents believe that the requirement in IFRS 13 to measure instruments that trade in active markets based on P×Q does not apply to the measurement of the net exposure when the portfolio exception is used, since the net exposure does not trade in an active market. As such, these constituents argue that the measurement of the net exposure and the allocation of this value back to the instruments that comprise the group are not constrained by the price at which the individual instruments trade in active markets. Others believe that although Level 1 instruments, such as futures contracts, may be considered when calculating an entity's net exposure to a particular market risk, the quoted price (unadjusted) for these Level 1 instruments should be used when allocating the fair value to the individual units of account for presentation and disclosure purposes, to comply with the requirement in IFRS 13 to measure Level 1 instruments at P×Q. However, depending on the extent of Level 1 instruments in the group, it may not always be possible to allocate the fair value determined for the net exposure back to the individual instruments in a manner that results in each of these instruments being recorded at P×Q. For this reason, there are constituents who believe that the use of the portfolio exception should never result in the measurement of Level 1 instruments at an amount other than P×Q. That is, the determination of the fair value of the net exposure is constrained by the requirement that all Level 1 instruments within the group are recorded at a value based on P×Q.

As discussed at 5.1.2 above, we understand that the IASB did not intend the portfolio exception to change existing practice under IFRS or override the requirement in IFRS 13 to measure Level 1 instruments at P×Q or the prohibition on block discounts. However, given the lack of clarity, some have asked questions about how these requirements would apply in practice. In 2013, the IFRS Interpretations Committee referred a request to the Board on the interaction between the use of Level 1 inputs and the portfolio exception. The IASB discussed this issue in December 2013, but only in relation to portfolios that comprise only Level 1 financial instruments whose market risks are substantially the same. The Board tentatively decided that the measurement of such portfolios should be the one that results from multiplying the net position by the Level 1 prices. Therefore, in September 2014, the IASB proposed adding a non-authoritative example to illustrate the application of the portfolio exception in these circumstances.

As discussed at 5.1.2 above and 12.2 below, in April 2015, after considering responses to this proposal from constituents, the IASB concluded it was not necessary to add the proposed illustrative example to IFRS 13.

12.2.1 Exposure to market risks

When measuring fair value using the measurement exception for offsetting positions, the entity is required to ensure the following in relation to market risks:

• Market risk (or risks), to which the entity is exposed within that portfolio, is substantially the same. For example, combining the interest rate risk associated with a financial asset with the commodity price risk associated with a financial liability would not be appropriate because it would not mitigate the entity's exposure to interest rate risk or commodity price risk.

  The standard requires any basis risk resulting from the market risk parameters not being identical to be taken into account in the fair value measurement of the financial assets and financial liabilities within the group; [IFRS 13.54]

• The duration of the entity's exposure to a particular market risk (or risks) must be substantially the same. [IFRS 13.55].

  The standard gives the example of an entity that uses a 12-month futures contract against the cash flows associated with 12 months’ worth of interest rate risk exposure on a five-year financial instrument. The futures and five-year financial instruments are within a group that is made up of only those financial assets and financial liabilities. The entity measures the fair value of the exposure to 12-month interest rate risk on a net basis and the remaining interest rate risk exposure (i.e. years 2‑5) on a gross basis.

Management selects the price within the bid-ask spread that is most representative of fair value in the circumstances to the entity's net exposure to the particular market risk(s) (pricing within the bid-ask spread is discussed further at 15.3 below). [IFRS 13.53].

12.2.2 Exposure to the credit risk of a particular counterparty

In some cases, an entity might enter into an arrangement to mitigate the credit risk exposure in the event of default, for example, a master netting agreement with the counterparty or the exchange of collateral on the basis of each party's net exposure to the credit risk of the other party.

An entity is not required to prove that such agreements will be legally enforceable in all jurisdictions to use the measurement exception. Instead, an entity should consider market participant expectations about the likelihood that such an arrangement would be legally enforceable in the event of default when valuing the net credit exposure. [IFRS 13.56].

When market participants would take into account any of these existing arrangements, the fair value measurement (using the measurement exception for offsetting positions) must include the effect of the entity's net exposure to the credit risk of that counterparty and/or the counterparty's net exposure to the credit risk of the entity.

13.1.1 Assessing whether the transaction price equals fair value at initial recognition

Prior to the issuance of IFRS 13, it was common for entities to use the transaction price as fair value of an asset or liability on its initial recognition. While IFRS 13 acknowledges that in many situations, an entry price may equal an exit price, it does not presume that these prices are equal. Therefore, an entity must determine whether the transaction price represents the fair value of an asset or liability at initial recognition. [IFRS 13.59].

Paragraph B4 of IFRS 13 provides certain factors that an entity should consider in making this determination. For example, a transaction price may not represent fair value if the unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value. [IFRS 13.B4(c)]. This may be the case with a complex financial instrument where the transaction price includes a fee for structuring the transaction or when an entity acquires a block and the transaction price includes a block discount.

Another factor to consider is whether the market in which an entity acquired the asset (or assumed the liability) is different from the principal (or most advantageous) market in which the entity will sell the asset (or transfer the liability). [IFRS 13.B4(d)]. For example, a securities dealer may acquire an asset in the retail market but sell it in the inter-dealer market. However, the fair value measurement should consider the fact that, while the inter-dealer price (i.e. the exit price in a hypothetical transaction) may differ from the retail price (i.e. transaction price), another dealer would also expect to earn a profit on the transaction. Accordingly, a pricing model's value should incorporate assumptions regarding the appropriate profit margin that market participants (i.e. other dealers) would demand when estimating the instrument's fair value at inception.

Other examples identified by paragraph B4 of IFRS 13 include:

• the transaction is between related parties – although IFRS 13 does allow the price in a related party transaction to be used as an input into a fair value measurement if the entity has evidence that the transaction was entered into at market terms; and
• the transaction takes place under duress or the seller is forced to accept the price in the transaction – for example, if the seller is experiencing financial difficulty. [IFRS 13.B4(a)-(b)].

In addition, the measurement of fair value in accordance with IFRS 13 should take into consideration market participant assumptions about risk. Adjustments for uncertainty associated with a valuation technique or certain inputs used to measure fair value are required if market participants would incorporate such risk adjustments when pricing the asset or liability. A measurement (e.g. a ‘mark-to-model’ measurement) that ignores these market participant adjustments for risk is not representative of fair value.

While helpful in identifying the factors entities should consider in assessing whether a transaction price would equal fair value, the examples provided in the standard are not intended to be exhaustive.

13.2.1 Day one losses for over-the-counter derivative transactions

The definition of fair value as an exit price affects the accounting by retail customers as much as financial institutions (i.e. dealers). For example, retail customers whose entry and exit market for a financial asset (or financial liability) measured at fair value is with a wholesaler (e.g. a dealer) could experience a day one loss, because the price at which a wholesaler would sell a financial asset to a retail customer would generally exceed the price a wholesaler would pay to acquire that financial asset from a retail customer (this difference in price is commonly referred to as the bid-ask spread in many financial markets).

The following example from IFRS 13 discusses how an interest rate swap at initial recognition may be measured differently by a retail counterparty (i.e. an end-user) and a dealer. [IFRS 13.IE24‑26].

This example seems to indicate that a retail counterparty may not have any gain or loss at initial recognition because the retail counterparty would likely be presumed to transact both at inception and on disposal (i.e. a hypothetical exit) in the same principal market (i.e. the retail market with securities dealers). However, this example does not address the bid-ask spread.

The bid-ask spread is the difference between the price a prospective dealer is willing to pay for an instrument (the ‘bid’ price) and the price at which the dealer would sell that same instrument (the ‘ask’ price), allowing the dealer to earn a profit for its role as a ‘market maker’ in the over-the-counter marketplace. The bid-ask spread may differ by dealer, as well as by the market and type of instrument that is being transacted.

IFRS 13 requires that instruments that trade in markets with bid-ask spreads (e.g. a dealer market) be measured at the price within the bid-ask spread that is most representative of fair value in the circumstances (pricing within the bid-ask spread is discussed further at 15.3 below). Therefore, an inception loss could be experienced by the retail counterparty due to a difference in the price within the bid-ask spread that the retail counterparty could hypothetically exit the instrument and the price within the bid-ask spread that the retail counterparty actually transacted.

The IASB has acknowledged that the fair value of an interest rate swap may differ from its transaction price because of the bid-ask spread, even when the entry and exit markets for the swap are identical. [IFRS 13.BC165]. In addition to the bid-ask spread, retail counterparties may recognise additional losses or expenses at the inception of derivative contracts. For example, if the transaction price for a complex derivative includes a structuring fee, the retail counterparty would likely recognise a loss when measuring the fair value of the derivative. Because the transaction price includes the price for the derivative instrument, as well as the fee paid by the retail counterparty to the dealer for structuring the transaction, the unit of account represented by the transaction price differs from the unit of account for the instrument being measured, as discussed in paragraph B4(c) of IFRS 13. [IFRS 13.B4(c)].

13.2.2 Day one gains and losses when entry and exit markets for the transaction are deemed to be the same

IFRS 13 contains no explicit prohibitions on the recognition of day one gains or losses, even in situations where the entry and exit markets are the same. For example, it may be acceptable in certain situations for a dealer to recognise a day one gain or loss on a transaction where the entry and exit markets are deemed to be the same (e.g. inter-dealer market). A difference in the price within the bid-ask spread at which a dealer could exit a transaction versus where it entered the transaction could be one reason to record an inception gain or loss. IFRS 13 clarifies that the exit price within the bid-ask spread that is most representative of fair value in the circumstances should be used to measure fair value, regardless of where in the fair value hierarchy the input falls (pricing within the bid-ask spread is discussed further at 15.3 below).

Notwithstanding the guidance in IFRS 13, IFRS 9 provide specific requirements in relation to the recognition of any day one gains or losses. For example, where fair value is not measured using a quoted price in an active market (without adjustment), recognition of day one gains or losses is generally prohibited (see Chapter 49).

14.1.1 Single versus multiple valuation techniques

The standard does not contain a hierarchy of valuation techniques because particular valuation techniques might be more appropriate in some circumstances than in others.

Selecting a single valuation technique may be appropriate in some circumstances, for example, when measuring a financial asset or liability using a quoted price in an active market. However, in other situations, more than one valuation technique may be deemed appropriate and multiple approaches should be applied. For example, it may be appropriate to use multiple valuation techniques when measuring fair value less costs of disposal for a cash-generating unit to test for impairment.

The nature of the characteristics of the asset or liability being measured and the availability of observable market prices may contribute to the number of valuation techniques used in a fair value analysis. For example, the fair value of a business is often estimated by giving consideration to multiple valuation approaches; such as an income approach that derives value from the present value of the expected future cash flows specific to the business and a market approach that derives value from market data (such as EBITDA or revenue multiples) based on observed transactions for comparable assets. On the other hand, financial assets that frequently trade in active markets are often valued using only a market approach given the availability and relevance of observable data.

Even when the use of a single approach is deemed appropriate, entities should be aware of changing circumstances that could indicate using multiple approaches may be more appropriate. For example, this might be the case if there is a significant decrease in the volume and level of activity for an asset or liability in relation to normal market activity. Observable transactions that once formed the basis for the fair value estimate may cease to exist altogether or may not be determinative of fair value and, therefore, require an adjustment to the fair value measurement (this is discussed further at 8.3 above). As such, the use of multiple valuation techniques may be more appropriate.

14.1.2 Using multiple valuation techniques to measure fair value

When the use of multiple valuation techniques is considered appropriate, their application is likely to result in a range of possible values. IFRS 13 requires that management evaluate the reasonableness of the range and select the point within the range that is most representative of fair value in the circumstances. [IFRS 13.63].

As with the selection of the valuation techniques, the evaluation of the results of multiple techniques requires significant judgement. The merits of each valuation technique applied, and the underlying assumptions embedded in each of the techniques, will need to be considered. Evaluation of the range does not necessarily require the approaches to be calibrated to one another (i.e. the results from different approaches do not have to be equal). The objective is to find the point in the range that most reflects the price to sell an asset or transfer a liability between market participants.

If the results from different valuation techniques are similar, the issue of weighting multiple value indications becomes less important since the assigned weights will not significantly alter the fair value estimate. However, when indications of value are disparate, entities should seek to understand why significant differences exist and what assumptions might contribute to the variance. Paragraph B40 of IFRS 13 indicates that when evaluating results from multiple valuation approaches, a wide range of fair value measurements may be an indication that further analysis is needed. [IFRS 13.B40]. For example, divergent results between a market approach and income approach may indicate a misapplication of one or both of the techniques and would likely necessitate additional analysis.

The standard gives two examples that illustrate situations where the use of multiple valuation techniques is appropriate and, when used, how different indications of value are assessed.

Firstly, an entity might determine that a technique uses assumptions that are not consistent with market participant assumptions (and, therefore, is not representative of fair value). This is illustrated in Example 14.22 below, where the entity eliminates use of the cost approach because it determines a market participant would not be able to construct the asset itself. [IFRS 13.IE15‑17].

Secondly, as is illustrated in Example 14.23 below, [IFRS 13.IE11‑14], an entity considers the possible range of fair value measures and considers what is most representative of fair value by taking into consideration that:

• one valuation technique may be more representative of fair value than others;
• inputs used in one valuation technique may be more readily observable in the marketplace or require fewer adjustments (inputs are discussed further at 15 below);
• the resulting range in estimates using one valuation technique may be narrower than the resulting range from other valuation techniques; and
• divergent results from the application of the market and income approaches would indicate that additional analysis is required, as one technique may have been misapplied, or the quality of inputs used in one technique may be less reliable.

Both Examples 14.22 and 14.23 highlight situations where it was appropriate to use more than one valuation approach to estimate fair value. Although the indication of value from the cost approach was ultimately not given much weight in either example, performing this valuation technique was an important part of the estimation process. Even when a particular valuation technique is given little weight, its application can highlight specific characteristics of the item being measured and may help in assessing the value indications from other techniques.

Determining the point in a range of values that is ‘most representative of fair value’ can be subjective and requires the use of judgement by management. In addition, although Example 14.23 refers to ‘weighting’ the results of the valuation techniques used, in our view, this is not meant to imply that an entity must explicitly apply a percentage weighting to the results of each technique to determine fair value. However, this may be appropriate in certain circumstances.

The standard does not prescribe a specific weighting methodology (e.g. explicit assignment of percentages versus qualitative assessment of value indications). As such, evaluating the techniques applied in an analysis will require judgement based on the merits of each methodology and their respective assumptions.

Identifying a single point within a range is not the same as finding the point within the range that is most representative of fair value. As such, simply assigning arbitrary weights to different indications of value is not appropriate. The weighting of multiple value indications is a process that requires significant judgement and a working knowledge of the different valuation techniques and inputs. Such knowledge is necessary to properly assess the relevance of these methodologies and inputs to the asset or liability being measured. For example, in certain instances it may be more appropriate to rely primarily on the fair value indicated by the technique that maximises the use of observable inputs and minimises the use of unobservable inputs. In all cases, entities should document how they considered the various indications of value, including how they evaluated qualitative and quantitative factors, in determining fair value.

14.1.3 Valuation adjustments

In certain instances, adjustments to the output from a valuation technique may be required to appropriately determine a fair value measurement in accordance with IFRS 13. An entity makes valuation adjustments if market participants would make those adjustments when pricing an asset or liability (under the market conditions at the measurement date). This includes any adjustments for measurement uncertainty (e.g. a risk premium).

Valuation adjustments may include the following:

1. an adjustment to a valuation technique to take into account a characteristic of an asset or a liability that is not captured by the valuation technique (the need for such an adjustment is typically identified during calibration of the value calculated using the valuation technique with observable market information – see 14.1.3.A below);
2. applying the point within the bid-ask spread that is most representative of fair value in the circumstances (see 15.3 below);
3. an adjustment to take into account credit risk (e.g. an entity's non-performance risk or the credit risk of the counterparty to a transaction); and
4. an adjustment to take into account measurement uncertainty (e.g. when there has been a significant decrease in the volume or level of activity when compared with normal market activity for the asset or liability, or similar assets or liabilities, and the entity has determined that the transaction price or quoted price does not represent fair value). [IFRS 13.BC145].

14.1.4 Making changes to valuation techniques

The standard requires that valuation techniques used to measure fair value be applied on a consistent basis among similar assets or liabilities and across reporting periods. [IFRS 13.65]. This is not meant to preclude subsequent changes, such as a change in its weighting when multiple valuation techniques are used or a change in an adjustment applied to a valuation technique.

An entity can make a change to a valuation technique or its application (or a change in the relative importance of one technique over another), provided that change results in a measurement that is equally representative (or more representative) of fair value in the circumstances.

IFRS 13 provides the following examples of circumstances that may trigger a change in valuation technique or relative weights assigned to valuation techniques:

1. new markets develop;
2. new information becomes available;
3. information previously used is no longer available;
4. valuation techniques improve; or
5. market conditions change. [IFRS 13.65].

In addition, a change in the exit market, characteristics of market participants that would transact for the asset or liability, or the highest and best use of an asset by market participants could also warrant a change in valuation techniques in certain circumstances.

Changes to fair value resulting from a change in the valuation technique or its application are accounted for as a change in accounting estimate in accordance with IAS 8. However, IFRS 13 states that the disclosures in IAS 8 for a change in accounting estimate are not required for such changes. [IFRS 13.65, 66]. Instead, information would be disclosed in accordance with IFRS 13 (see 20.3.5 below for further discussion). If a valuation technique is applied in error, the correction of the technique would be accounted as a correction of an error in accordance with IAS 8.

14.3.1 Use of depreciated replacement cost to measure fair value

As discussed at 14.3 above, IFRS 13 permits the use of a cost approach for measuring fair value. However, care is needed in using depreciated replacement cost to ensure the resulting measurement is consistent with the requirements of IFRS 13 for measuring fair value.

Before using depreciated replacement cost as a method to measure fair value, an entity should ensure that both:

• the highest and best use of the asset is its current use (see 10 above); and
• the exit market for the asset (i.e. the principal market or in its absence, the most advantageous market, see 6 above) is the same as the entry market (i.e. the market in which the asset was/will be purchased).

In addition, an entity should ensure that both:

• the inputs used to determine replacement cost are consistent with what market participant buyers would pay to acquire or construct a substitute asset of comparable utility; and
• the replacement cost has been adjusted for obsolescence that market participant buyers would consider – i.e. that the depreciation adjustment reflects all forms of obsolescence (i.e. physical deterioration, technological (functional) and economic obsolescence), which is broader than depreciation calculated in accordance with IAS 16.

Even after considering these factors, the resulting depreciated replacement cost must be assessed to ensure market participants would actually transact for the asset, in its current condition and location, at this price. The Illustrative Examples to IFRS 13 reflect this stating that ‘the price received for the sale of the machine (i.e. an exit price) would not be more than either of the following:

1. the cost that a market participant buyer would incur to acquire or construct a substitute machine of comparable utility; or
2. the economic benefit that a market participant buyer would derive from the use of the machine.’ [IFRS 13.IE11-IE14].

15.2.1 Blockage factors (or block discounts)

IFRS 13 explicitly prohibits the consideration of blockage factors (or block discounts) in a fair value measurement. [IFRS 13.69, 80]. While the term blockage factor may be subject to different interpretations, during their deliberations the Boards indicated that they view a blockage factor as an adjustment to the quoted price of an asset or liability because the market's normal trading volume is not sufficient to absorb the quantity held by a reporting entity.

Regardless of the hierarchy level in which a measurement is categorised, blockage factors are excluded from a fair value measurement because such an adjustment is specific to the size of an entity's holding and its decision to transact in a block. That is, the Boards believe such an adjustment is entity-specific in nature. [IFRS 13.BC157]. However, the standard clarifies that there is a difference between size being a characteristic of the asset or liability being measured (based on its unit of account) and size being a characteristic of the reporting entity's holding. While any adjustment for the latter is not permitted, the former should be considered if it is consistent with how market participants would price the asset or liability. [IFRS 13.69].

The following example illustrates how IFRS 13 distinguishes between size as a characteristic of the item being measured and size as a characteristic of an entity's holding.

As discussed at 5.1 above, the unit of account is determined by the relevant IFRS that permits or requires an asset or liability to be measured at fair value, unless IFRS 13 states otherwise. In some cases, the unit of account may be clear, for example, the unit of account for financial instruments in the scope of IFRS 9 is typically the individual instrument. However, it may be less clear in other standards, for example, the unit of account for a cash-generating unit when testing non-financial assets for impairment in accordance with IAS 36. In December 2018, the IASB concluded its PIR of IFRS 13, in which it had considered issues relating to prioritising Level 1 inputs or the unit of account. This is discussed further at 5.1.1 above.

15.3.1 Mid-market pricing

As a practical expedient, IFRS 13 allows the use of mid-market pricing, or other pricing conventions that are used by market participants, when measuring fair value within the bid-ask spread. [IFRS 13.71]. Use of a mid-market pricing convention results in a valuation of an asset or liability at the mid-point of the bid-ask spread. Extract 14.1 at 20.2 below illustrates use of mid-market pricing.

The guidance does not limit or restrict the use of mid-market pricing to specific types of instruments or entities. However, as discussed at 14 above, valuation techniques used to measure fair value should be consistently applied. [IFRS 13.65].

15.3.2 What does the bid-ask spread include?

The commentary in the Basis for Conclusions acknowledges that the previous guidance in paragraph AG70 of IAS 39 only includes transaction costs in the bid-ask spread. The Boards chose not to specify what is included in the bid-ask spread, except for transaction costs. However, they did make it clear that, in their view, the bid-ask spread does not include adjustments for counterparty credit risk. [IFRS 13.BC164].

The IASB has not provided any clarity regarding the interaction between the guidance in IFRS 13 on transaction costs (i.e. transaction costs are not considered an attribute of the asset or liability and, accordingly, are excluded from fair value measurements) and the guidance on the use of prices within the bid-ask spread. If transaction costs are included in the bid-ask spread, measuring an asset at the bid price would include certain future transaction costs in the fair value measurement for the asset.

Given the lack of any specific guidance on this issue, there may be some diversity in practice between entities with respect to how transaction costs are considered. However, we would expect an entity to apply a consistent approach to all of its own fair value measurements.

15.5.1 How should values provided by central clearing organisations for margin purposes be evaluated when determining the fair value of centrally cleared derivatives for financial reporting?

For OTC derivatives that are centrally cleared, counterparties are typically required on an ongoing basis to post collateral based on the change in value of the derivative (sometimes referred to as ‘variation margin’). As a result, entities with centrally cleared OTC derivatives will periodically receive a ‘value mark’ from a clearing organisation that states the amount of variation margin to be posted or received.

However, this value should not be presumed to represent fair value (an exit price) in accordance with IFRS 13. Different clearing organisations may have different approaches for calculating variation margin requirements and while practice may continue to evolve, it is our understanding that the ‘value marks’ provided generally do not represent an actual transaction price (i.e. a price at which the reporting entity could execute a trade to buy or sell the contract). Instead, this value may be based on a clearing organisation's analysis of information provided by clearing members and certain of its own assumptions. While this value may potentially be an appropriate estimate of fair value in certain instances, the reporting entity should understand how this value is determined and evaluate whether it includes only those factors that would be considered by market participants in an orderly transaction to sell or transfer the derivative. For example, to provide themselves with additional protection, some clearing organisations may include an incremental amount in their variation margin requirement in excess of the ‘true’ change in the value of the derivative.

As with pricing information provided by brokers or third-party pricing services, reporting entities are responsible for understanding the source and nature of information provided by central clearing organisations. An entity should assess whether the value indication represents fair value in accordance with IFRS 13 or whether an adjustment may be needed. See 16.2.4 below for a discussion of the classification of centrally cleared OTC derivatives in the fair value hierarchy.

16.2.1 Assessing the significance of inputs

Assessing the significance of a particular input to the entire measurement requires judgement and consideration of factors specific to the asset or liability (or group of assets and/or liabilities) being measured. [IFRS 13.73].

IFRS 13 does not provide specific guidance on how entities should evaluate the significance of individual inputs. This determination will require judgement and consideration of factors specific to the asset or liability (or group of assets and liabilities) being measured. In the absence of any ‘bright lines’ for determining significance, there may be a lack of comparability between different entities with fair value measurements that use the same inputs.

The standard is clear that it considers significance in relation to ‘the entire measurement’. In our view, this requires the assessment to consider the fair value measure itself, rather than any resulting change in fair value, regardless of whether that change is recognised (i.e. in profit or loss or other comprehensive income) or unrecognised. For example, assume an investment property is measured at fair value at the end of each reporting period. In the current reporting period the fair value of the investment property reduces by CU 200,000 to CU 500,000. The significance of any inputs to the fair value measurement would be assessed by reference to the CU 500,000, even though CU 200,000 is the amount that will be recognised in profit or loss. However, a reporting entity may deem it appropriate to also consider significance in relation to the change in fair value from prior periods, in addition to considering the significance of an input in relation to the entire fair value measurement. Such an approach may be helpful in relation to cash-based instruments (e.g. loans or structured notes with embedded derivatives) whose carrying amounts, based on fair value, are heavily affected by their principal or face amount.

As noted in 16.2 above, if an observable input requires an adjustment using an unobservable input and that adjustment actually results in a significantly higher or lower fair value measurement, the standard is clear that the resulting fair value measurement would be categorised within Level 3 of the hierarchy. [IFRS 13.75]. What is not clear, however, is the appropriate categorisation when an observable input requires an adjustment using an unobservable input and: (a) that adjustment does not actually result in a significantly higher or lower fair value in the current period; but (b) the potential adjustment from using a different unobservable input would result in a significantly higher or lower fair value measurement. As noted in 16.2 above, the categorisation of a fair value measurement indicates the overall observability or subjectivity of a measurement, in its entirety. To this end, in some cases, the use of sensitivity analysis or stress testing (i.e. using a range of reasonably possible alternative input values as of the measurement date) might be appropriate to assess the effects of unobservable inputs on a fair value measure. In situations where more than one unobservable input is used in a fair value measure, the assessment of significance should be considered based on the aggregate effect of all the unobservable inputs.

During the PIR on IFRS 13, many respondents indicated they found the assessment of whether an unobservable input is significant to the measurement as a whole challenging and asked for additional guidance. Some indicated that this assessment may be affected by negative perceptions associated with categorisation within Level 3 of the fair value hierarchy (e.g. including the volume of disclosure required). The IASB decided not to provide additional guidance, noting in particular that the requirements are principles-based and, as such, judgement will always be needed in their application.²⁷

Entities should have a documented policy with respect to their approach to determining the significance of unobservable inputs on its fair value measurements and apply that policy consistently. This is important in light of the disclosure requirements in IFRS 13, particularly for fair value measurements categorised within Level 3 of the fair value hierarchy (see 20.3 below).

16.2.2 Transfers between levels within the fair value hierarchy

For assets or liabilities that are measured at fair value (or measurements based on fair value) at the end of each reporting period, their categorisation within the fair value hierarchy may change over time. This might be the case if the market for a particular asset or liability that was previously considered active (Level 1) becomes inactive (Level 2 or Level 3) or if significant inputs used in a valuation technique that were previously unobservable (Level 3) become observable (Level 2) given transactions that were observed around the measurement date. Such changes in categorisation within the hierarchy are referred to in IFRS 13 as transfers between levels within the fair value hierarchy.

An entity is required to select, and consistently apply, a policy for determining when transfers between levels of the fair value hierarchy are deemed to have occurred, that is, the timing of recognising transfers. This policy must be the same for transfers into and out of the levels. Examples of policies for determining the timing of transfers include:

• the date of the event or change in circumstances that caused the transfer;
• the beginning of the reporting period; or
• the end of the reporting period. [IFRS 13.95].

The standard requires an entity to disclose this policy (see 20.2 below). In addition, the selected timing (i.e. when transfers are deemed to have occurred) has a direct impact on the information an entity needs to collate in order to meet the disclosure requirements in IFRS 13 – specifically those required by IFRS 13.93(c) and (e)(iv) – for both transfers between Levels 1 and 2 and transfers into and out of Level 3 (these disclosure requirements are discussed at 20.3.2 below). [IFRS 13.93(c), 93(e)(iv)].

16.2.3 Information provided by third-party pricing services or brokers

IFRS 13 does not preclude the use of quoted prices provided by third parties, such as pricing services or brokers, provided those quoted prices are developed in accordance with the standard. Quoted prices provided by third parties represent an important source of information in estimating fair value for many entities. While not precluded, the standard makes it clear that the use of broker quotes, third-party pricing services, or a third-party valuation specialist does not alleviate management's responsibility for the fair value measurements (and the related disclosures) that will be included in its financial statements. [IFRS 13.B45].

It is important for entities to understand the source of information received from brokers and pricing services, particularly when there has been a significant decrease in the volume or level of activity for the asset or liability, as management needs to assess the relevance of these quotes. This is discussed further at 8.3 above.

As discussed at 15.5 above, an entity should evaluate whether quotes from brokers and pricing services are based on current information that reflects orderly transactions or were determined using valuation techniques that appropriately reflect market participant assumptions regarding risk. Entities should place less weight on third-party quotes that are not based on transactions compared to fair value indications that are based on market transactions.

Determining the level in which assets and liabilities are categorised within the fair value hierarchy for disclosure purposes often requires judgement. Information provided by third-party pricing services or brokers could represent Level 1, Level 2, or Level 3 inputs depending on the source of the information and the type of instrument being measured. For example, pricing services may provide quoted market prices (e.g. closing price) for financial instruments traded in active markets. These prices are Level 1 measurements.

Alternatively, a pricing service may provide an entity with consensus pricing information (e.g. information obtained by polling dealers for indications of mid-market prices for a particular asset class). The non-binding nature of consensus pricing would generally result in its categorisation as Level 3 information, assuming no additional corroborating evidence.

Pricing services may also use valuation models to estimate values for certain instruments. For example, pricing services may use matrix pricing to determine the value of many fixed-income securities. The hierarchy level in which these instruments would be categorised depends on the observability of the valuation model's inputs. Therefore, entities that use pricing services should understand the data sources and valuation methods used to derive those third-party quotes. This information will determine where the entity's instruments would be categorised within the fair value hierarchy.

Similarly, the level within the hierarchy in which a broker quote is categorised depends on the nature of the quote. [IFRS 13.B47]. In certain brokered markets, firm quotes are disclosed and an entity has the ability to ‘hit’ or execute a transaction at the quoted price. Depending on the level of activity in these markets, those quotes may be categorised as Level 1 or Level 2. However, when an entity has to solicit a quote from a broker, the quotes are often non-binding and may include a disclaimer that releases the broker from being held to that price in an actual transaction. On their own, non-binding quotes would generally represent a Level 3 input. In addition, when the quote includes explanatory language or a disclaimer, the entity should assess whether the quote represents fair value (exit price) or whether an adjustment is needed.

If an entity uses multiple quotes within a narrow range when measuring fair value, it will likely provide stronger evidence of fair value than a single quote or quotes that are widely dispersed. However, the number of quotes should not, in and of itself, affect the categorisation within the fair value hierarchy. An entity would still need to consider the nature of those quotes. For example, multiple Level 3 inputs, within a reasonable range, would not result in a Level 2 measurement without additional observable corroborating evidence.

In August 2014, the IFRS Interpretations Committee received a request to clarify the circumstances in which a fair value measurement, in its entirety, that uses prices that are provided by third parties (e.g. consensus prices) could be categorised within Level 1 of the fair value hierarchy, particularly in relation to debt securities that are actively traded. The submitter highlighted that categorisation within the fair value hierarchy for debt securities is not straightforward and that there were divergent views on the appropriate level within the hierarchy such fair value measurements should be categorised.

After considering the analyses and outreach performed by its staff, the Interpretations Committee decided not to add this issue to its agenda, noting the following:²⁸

• the guidance in IFRS 13 relating to the categorisation within the fair value hierarchy was sufficient to draw an appropriate conclusion on this issue;
• the fair value hierarchy prioritises the inputs to valuation techniques, not the valuation techniques used to measure fair value. When the fair value of assets or liabilities is measured based on prices provided by third parties, the categorisation of those measurements within the fair value hierarchy depends on the evaluation of the inputs used by the third party to derive those prices; not on the pricing methodology the third party has used; and
• only unadjusted quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date qualify as Level 1 measurement. Therefore, a fair value measurement that is based on prices provided by third parties can only be categorised within Level 1 of the fair value hierarchy if that measurement relies solely on unadjusted quoted prices in an active market for an identical instrument that the entity can access at the measurement date (i.e. P×Q, without adjustment).

16.2.4 Categorisation of over-the-counter derivative instruments

Depending on the observability of the inputs used, fair value measurements of over-the-counter derivatives that are not centrally cleared would likely be within either Level 2 or Level 3 of the fair value hierarchy.

Although these instruments may initially be executed in active markets, quoted prices for the identical asset or liability will often not be available when measuring fair value subsequently. For example, consider a 10-year plain vanilla interest-rate swap entered into on 1 January 20X9 that is not centrally cleared. While there may be quoted prices for 10-year swaps, when measuring the fair value of the swap on 31 March 20X9, the subject instrument would represent a 9.75 year swap for which quoted prices are generally not available. As a result, most over-the-counter derivative contracts that are not centrally cleared are valued based on inputs used in pricing models.

In addition, centrally cleared derivatives would not be categorised within Level 1 unless their fair value was determined based on an unadjusted quoted price in active markets for an identical instrument. Some constituents have questioned whether a ‘value mark’, periodically provided by a central clearing organisation for variation margin purposes, represents a Level 1 measurement. As discussed at 15.5.1 above, a reporting entity should not presume that the value provided by a central clearing organisation for margin purposes represents fair value in accordance with IFRS 13. Instead, entities need to understand the source and nature of the information provided by the central clearing organisation and assess whether the value indication represents fair value in accordance with IFRS 13 or whether an adjustment may be needed.

Even in those circumstances where an entity determines that the information received from the central clearing organisation is representative of fair value and does not require adjustment, it is our understanding that the ‘value marks’ provided typically do not represent actual trades of the identical instrument and therefore would not be a Level 1 measurement. See 15.5.1 above for additional discussion on the consideration of values provided by central clearing organisations when determining the fair value.

17.1.1 Level 1 liabilities and instruments classified in an entity's own equity

Quoted prices in active markets for identical liabilities and instruments classified as an entity's own equity are Level 1 measurements. These instruments would likewise be categorised within Level 1 when a quoted price exists for the identical instrument traded as an asset in an active market, provided no adjustment to the quoted price is required.

The fair value of corporate debt issued by a reporting entity, for example, would be a Level 1 measurement if the asset corresponding to the issuer's liability (i.e. the corporate bond) trades in an active market and no adjustment is made to the quoted price. While the liability itself is not transferred in an active market, the IASB concluded that Level 1 categorisation is appropriate when the identical instrument trades as an asset in an active market.

If an adjustment to the corresponding asset's price is required to address differences between the asset and the liability or equity instrument (as discussed at 11 above), [IFRS 13.79(c)], the adjusted price would not be a Level 1 measurement. For example, an adjustment to the quoted price of an asset that includes the effect of a third-party credit enhancement would be warranted when measuring the fair value of the liability. In this case, the corresponding asset and the liability would have different units of account (as discussed at 11.3.1 above).

20.1.1 Format of disclosures

IFRS 13's requirements, with regard to the format of disclosures, are limited to the presentation of quantitative information. An entity is required to use a tabular format to present the quantitative disclosures required by IFRS 13, unless another format is more appropriate. [IFRS 13.99].

20.1.2 Level of disaggregation

IFRS 13 requires disclosures to be presented by class of asset or liability (the definition of a class of asset or liability is discussed at 20.1.2.A below). Unlike certain other IFRSs, IFRS 13 does not specify the level of aggregation or disaggregation an entity must use when complying with its disclosure requirements. Instead, as discussed below, it simply provides the basis for making this determination. As such, the appropriate class of assets and liabilities may depend on the entity's specific facts and circumstances and the needs of users of its financial statements.

According to the standard, a class of assets and liabilities will often require greater disaggregation than the line items presented in the statement of financial position. Therefore, an entity must present information in sufficient detail to permit reconciliation back to the statement of financial position. [IFRS 13.99]. Such a reconciliation could be presented through the use of subtotals that correspond to line items disclosed in the statement of financial position; however, other approaches may be acceptable.

During the PIR of IFRS 13, respondents indicated that the level of aggregation or disaggregation was a challenge. In particular, respondents said that the information was less useful if aggregated too much and suggested more guidance and examples would be helpful to promote more appropriate levels of aggregation. This is expected to be a consideration of the Board's targeted standards-level review of IFRS 13 (see 20 above).³⁰

20.1.3 Differentiating between ‘recurring’ and ‘non-recurring’

IFRS 13 has different disclosure requirements for those fair value measurements that are recognised (rather than just disclosed), depending on whether those measurements are recurring or non-recurring in nature (see 20.3 below). Therefore, it is important to understand the distinction.

• Recurring fair value measurements are those that another IFRS requires or permits to be recognised in the statement of financial position at the end of each reporting period. For example, the fair value of a financial asset classified as fair value through profit or loss in accordance with IFRS 9 would need to be measured at the end each reporting period. Other examples include a liability to distribute non-cash assets to shareholders, measured at fair value in accordance with IFRIC 17 – Distributions of Non-cash Assets to Owners.

  In our view, revaluations of property, plant and equipment in accordance with IAS 16 represent a recurring fair value measurement. The revaluation model in IAS 16 requires that revaluations be made ‘with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the end of the reporting period’. [IAS 16.31]. Furthermore, ‘the frequency of revaluations depends upon the changes in fair values of the items of property, plant and equipment being revalued. When the fair value of a revalued asset differs materially from its carrying amount, a further revaluation is required’. [IAS 16.34]. Therefore, while an entity might not revalue an asset each year, the objective is to ensure the carrying amount approximates fair value, subject to materiality.

• Non-recurring fair value measurements are those that another IFRS requires or permits to be recognised in the statement of financial position in particular circumstances. For example, IFRS 5 requires an entity to measure an asset held for sale at the lower of its carrying amount and fair value less costs to sell. Since the asset's fair value less costs to sell is only recognised in the statement of financial position when it is lower than its carrying amount, that fair value measurement is non-recurring. However, it should be noted that in a disposal group, not all assets and liabilities are subject to the measurement requirements of IFRS 5. If financial assets categorised as fair value through other comprehensive income in accordance of IFRS 9 were included in a disposal group, an entity would continue to measure these assets in accordance with IFRS 9 at fair value. These fair value measurements would continue to be recurring. [IFRS 13.93].

20.3.1 Disclosures for recognised recurring fair value measurements

The disclosure requirements in paragraph 93 of IFRS 13 (see 20.3 above and 20.3.1.A and 20.3.1.B below) apply to all fair value measurements that are recognised in the financial statements on a recurring basis. Given the increased subjectivity, IFRS 13 requires additional disclosures for fair value measurements categorised within Level 3 of the fair value hierarchy than for those categorised within Levels 1 or 2 (see 20.3.1.B below).

20.3.2 Disclosures for recognised non-recurring fair value measurements

Certain disclosure requirements in IFRS 13 do not apply to fair value measurements that are non-recurring in nature (e.g. a non-current asset (or disposal group) held for sale measured at fair value less costs to sell in accordance with IFRS 5 where the fair value less costs to sell is lower than its carrying amount). Specifically, the following disclosures are not required for non-recurring recognised fair value measurements:

• information about any transfers between Level 1 and Level 2 of the fair value hierarchy;
• a reconciliation of the opening balances to the closing balances for Level 3 measurements (also referred to as the Level 3 roll-forward);
• a narrative description of the sensitivity of Level 3 fair value measurements to changes in unobservable inputs; and
• for financial assets and financial liabilities, quantitative sensitivity analysis for Level 3 fair value measurements. [IFRS 13.93].

Information regarding transfers between hierarchy levels and the Level 3 reconciliation do not lend themselves to non-recurring measurements and, therefore, are not required. While discussing the sensitivity of Level 3 measurements to changes in unobservable inputs might provide financial statement users with some information about how the selection of these inputs affects non-recurring valuations, the Boards ultimately decided that this information is most relevant for recurring measurements.

However, entities are required to disclose the reason for any non-recurring fair value measurements made subsequent to the initial recognition of an asset or liability. [IFRS 13.93]. For example, the entity may intend to sell or otherwise dispose of it, thereby resulting in the need for its measurement at fair value less costs to sell based on the requirements of IFRS 5, if lower than the asset's carrying amount.

While obvious for recurring measurements, determining the periods in which the fair value disclosures should be made for non-recurring measurements is less clear. For example, assume a listed entity classifies a building as held for sale in accordance with IFRS 5 at the end of its second quarter and appropriately decreases the carrying value of the asset to its then fair value less costs to sell. In its interim financial statements, the entity would make all of the disclosures required by IFRS 13 for non-recurring fair value measurements. During the second half of the financial year, the sale falls through and the asset is no longer held for sale. In accordance with IFRS 5, the asset is measured at its carrying amount before the asset (or disposal group) was classified as held for sale, adjusted for any depreciation, as this is lower than its recoverable amount. The entity continues to account for the asset in accordance with IAS 16. While the carrying value of the asset at the end of the financial year is no longer at fair value less costs to sell, the asset was adjusted to fair value less costs to sell during the year. Therefore, in its annual financial statements, the entity would again disclose the information required by IFRS 13 for non-recurring fair value measurements. While not explicit in IFRS 13, we believe this approach is consistent with the interim and annual disclosure requirements for assets subsequently measured under the revaluation model in IAS 34 and IFRS 5.

In these situations, we recommend that the disclosures clearly indicate that the fair value information presented is not current, but rather as at the date fair value was measured. Entities should also indicate if the carrying amount of the asset no longer equals its fair value.

20.3.3 Fair value hierarchy categorisation

IFRS 13 requires entities to disclose the fair value hierarchy level in which each fair value measurement is categorised. As noted at 16.2 above, the categorisation of a fair value measurement of an asset or liability in the fair value hierarchy is based on the lowest level input that is significant to the fair value measurement in its entirety. Although the hierarchy disclosure is presented by class of asset or liability, it is important to understand that the determination of the hierarchy level in which a fair value measurement falls (and therefore the category in which it will be disclosed) is based on the fair value measurement for the specific item being measured and is, therefore, driven by the unit of account for the asset or liability.

For example, in situations where the unit of account for a financial instrument is the individual item, but the measurement exception for financial instruments is used (as discussed at 12 above), entities may need to allocate portfolio-level adjustments to the various instruments that make up the net exposure for purposes of hierarchy categorisation.

This may seem inconsistent to certain constituents given the discussion at 12 above about the consideration of size as a characteristic of the net risk exposure when the measurement exception for financial instruments is used. However, the IASB and FASB staffs have indicated that the determination of the net risk exposure as the unit of measurement applies only for measurement considerations and was not intended to change current practice with respect to disclosures. As such, the entire net exposure would not be categorised within a single level of the fair value hierarchy (e.g. Level 2), unless all of the individual items that make up the net exposure fell within that level.

To illustrate, consider an individual derivative that is valued using the measurement exception as part of a group of derivative instruments with offsetting credit risk (due to the existence of a legally enforceable netting agreement). Assuming the portfolio included instruments that on their own must be categorised within different levels of the fair value hierarchy (i.e. Level 2 and Level 3), for disclosure purposes, the portfolio-level adjustment for credit risk (considering the effect of master netting agreements) may need to be attributed to the individual derivative transactions within the portfolio or to the group of transactions that fall within each of the levels of the hierarchy. This example assumes that the portfolio-level adjustment for credit risk is based on observable market data. If the portfolio-level adjustment was determined using unobservable inputs, the significance of the adjustment to the measurement of the individual derivative instruments would need to be considered in order to determine if categorisation in Level 2 or Level 3 was appropriate.

The following example from IFRS 13 illustrates how an entity might disclose, in tabular format, the fair value hierarchy category for each class of assets and liabilities measured at fair value at the end of each reporting period. [IFRS 13.IE60].

In the above example, the gain or loss recognised during the period for assets and liabilities measured at fair value on a non-recurring basis is separately disclosed and discussed in the notes to the financial statements.

20.3.4 Transfers between hierarchy levels for recurring fair value measurements

IFRS 13 requires entities to disclose information regarding all transfers between fair value hierarchy levels (i.e. situations where an asset or liability was categorised within a different level in the fair value hierarchy in the previous reporting period). [IFRS 13.93(c), 93(e)(iv)]. However, this disclosure requirement only applies to assets and liabilities held at the end of the reporting period which are measured at fair value on a recurring basis. Information regarding transfers into or out of Level 3 is captured in the Level 3 reconciliation (discussed at 20.3.6 below) as these amounts are needed to roll forward Level 3 balances from the beginning to the end of the period being disclosed. The amounts of any transfers between Level 1 and Level 2 of the fair value hierarchy are also required to be disclosed. Regardless of the hierarchy levels involved, transfers into each level of the hierarchy are disclosed separately from transfers out of each level. That is, all transfers are required to be presented on a gross basis by hierarchy level, whether included in the Level 3 reconciliation or disclosed separately.

For all transfer amounts disclosed, an entity is required to discuss the reasons why the categorisation within the fair value hierarchy has changed (i.e. transferred between hierarchy levels). [IFRS 13.93(c), 93(e)(iv)]. Reasons might include the market for a particular asset or liability previously considered active (Level 1) becoming inactive (Level 2 or Level 3), or significant inputs used in a valuation technique that were previously unobservable (Level 3) becoming observable (Level 2) given transactions that were observed around the measurement date.

As discussed at 16.2.2 and 20.2 above, IFRS 13 also requires that entities disclose and consistently follow their policy for determining when transfers between fair value hierarchy levels are deemed to have occurred. That is, an entity's policy about the timing of recognising transfers into the hierarchy levels should be the same as the policy for recognising transfers out, and this policy should be used consistently from period to period. Paragraph 95 of IFRS 13 includes the following examples of potential policies: the actual date of the event or change in circumstances that caused the transfer, the beginning of the reporting period or the end of the reporting period. In practice, some variation of these approaches may also be used by entities. For example, some entities may use an intra-period approach using a transfer amount based on the fair value as at the month-end in which the transfer occurred, as opposed to the actual date within the month. [IFRS 13.95]. The following illustrative example demonstrates the differences between the three methods noted above.

As previously noted, the disclosures under IFRS 13 are intended to provide information that enables users to identify the effects of fair value measurements that are more subjective in nature on reported earnings, and, thereby, enhance financial statement users’ ability to make their own assessment regarding earnings quality. We believe that this objective is best met by considering the level of observability associated with the fair value measurement made at the end of the reporting period (i.e. the observability of the inputs used to determine fair value on the last day in the period). As such, while no specific approach is required under IFRS, we believe a beginning-of-period approach for recognising transfers provides greater transparency on the effect that unobservable inputs have on fair value measurements and reported earnings. Under this view, all changes in fair value that arise during the reporting period of the transfer are disclosed as a component of the Level 3 reconciliation.

While the ‘actual date’ approach more precisely captures the date on which a change in the observability of inputs occurred, its application can be more operationally complex. In addition, in our view, it does not necessarily provide more decision-useful information than the beginning-of-period approach. This is because, for a given period, the intra-period approach results in an allocation of the fair value changes between hierarchy levels that is inconsistent with the actual categorisation of the item as at the end of the reporting period. As such, the intra-period approach implies that a portion of the earnings recognised during the period is of a higher (or lower) quality solely because there was observable information regarding the value of the instrument at some point during the period.

To further illustrate this point, assume an entity acquires an investment in a private company in Q1 for CU 1,000. In the middle of Q2, the company completes an initial public offering that values the investment at CU 1,500. At the end of Q2, the fair value of the investment is CU 2,200 based on a quoted market price. Under the intra-period approach for the six-month period ended Q2, CU 500 would be included as an unrealised gain in the Level 3 reconciliation, despite the fact that the entire CU 1,200 unrealised gain recognised during the six-month period is supported by observable market information (i.e. a quoted price less cash paid).

Of the three alternatives, we believe the end-of-period approach is the least effective in achieving IFRS 13's disclosure objectives. Under this approach, the Level 3 reconciliation would not reflect any unrealised gains or losses for items that move from Level 2 to Level 3 during the reporting period.

20.3.5 Disclosure of valuation techniques and inputs

Entities are required to describe the valuation techniques and inputs used to measure the fair value of items categorised within Level 2 or Level 3 of the fair value hierarchy. In addition, entities are required to disclose instances where there has been a change in the valuation technique(s) used during the period, and the reason for making the change. As discussed at 20.3.5.A below, the standard also requires quantitative information about the significant unobservable inputs to be disclosed for Level 3 fair value measurements. [IFRS 13.93(d)].

Importantly, the disclosures related to valuation techniques and inputs (including the requirement to disclose quantitative information about unobservable inputs) apply to both recurring and non-recurring fair value measurements. [IFRS 13.93(d)].

20.3.6 Level 3 reconciliation

IFRS 13 requires a reconciliation (also referred to as the Level 3 roll-forward) of the beginning and ending balances for any recurring fair value measurements that utilise significant unobservable inputs (i.e. Level 3 inputs). Therefore, any asset or liability (measured at fair value on a recurring basis) that was determined to be a Level 3 measurement at either the beginning or the end of a reporting period would need to be considered in the Level 3 reconciliation.

To reconcile Level 3 balances for the period presented, entities must present the following information for each class of assets and liabilities:

• balance of Level 3 assets or liabilities (as at the beginning of the period);
• total gains or losses;
• purchases, sales, issues and settlements (presented separately);
• transfers in and/or out of Level 3 (presented separately); and
• balance of Level 3 assets or liabilities (as at the end of the period).

In addition, entities are required to separately present gains or losses included in earnings from those gains or losses recognised in other comprehensive income, and to describe in which line items these gains or losses are reported in profit or loss, or in other comprehensive income. To enhance the ability of financial statement users to assess an entity's quality of earnings, IFRS 13 also requires entities to separately disclose the amount of total gains and losses reported in profit or loss (for the period) that are attributable to changes in unrealised gains and losses for assets and liabilities categorised within Level 3 and are still held at the end of the reporting period. Effectively, this requires an entity to distinguish its unrealised gains and losses from its realised gains and losses for Level 3 measurements.

The following example from IFRS 13 illustrates how an entity could comply with the Level 3 reconciliation requirements. [IFRS 13.IE61]. Extract 14.3 from BP p.l.c. and Extract 14.4 from Rio Tinto plc at 20.3.8.A below also illustrates these disclosure requirements in relation to derivatives categorised within Level 3.

IFRS 13 also provides the following example to illustrate how an entity could comply with the requirements to separately disclose the amount of total gains and losses reported in profit or loss that are attributable to changes in unrealised gains and losses for assets and liabilities categorised within Level 3 and are still held at the end of the reporting period. [IFRS 13.IE62].

20.3.7 Disclosure of valuation processes for Level 3 measurements

Entities are required to describe the valuation processes used for fair value measurements categorised within Level 3 of the fair value hierarchy, whether on a recurring or non-recurring basis. This is illustrated in the extract below from the financial statements of UBS Group AG. The Boards decided to require these disclosures for Level 3 measurements because they believe this information, in conjunction with the other Level 3 disclosures, will help users assess the relative subjectivity of these measurements.

IFRS 13 provides an example of how an entity could comply with the requirements to disclose the valuation processes for its Level 3 fair value measurements, suggesting this disclosure might include the following:

1. for the group within the entity that decides the entity's valuation policies and procedures:
   • its description;
   • to whom that group reports; and
   • the internal reporting procedures in place (e.g. whether and, if so, how pricing, risk management or audit committees discuss and assess the fair value measurements);
2. the frequency and methods for calibration, back testing and other testing procedures of pricing models;
3. the process for analysing changes in fair value measurements from period to period;
4. how the entity determined that third-party information, such as broker quotes or pricing services, used in the fair value measurement was developed in accordance with the IFRS; and
5. the methods used to develop and substantiate the unobservable inputs used in a fair value measurement. [IFRS 13.IE65].

20.3.8 Sensitivity of Level 3 measurements to changes in significant unobservable inputs

IFRS 13 requires entities to provide a narrative description of the sensitivity of recurring Level 3 fair value measurements to changes in the unobservable inputs used, if changing those inputs would significantly affect the fair value measurement. However, except in relation to financial instruments (see 20.3.8.A below) there is no requirement to quantify the extent of the change to the unobservable input, or the quantitative effect of this change on the measurement (i.e. only discuss directional change).

At a minimum, the unobservable inputs quantitatively disclosed based on the requirements described at 20.3.5 above must be addressed in the narrative description. In addition, entities are required to describe any interrelationships between the unobservable inputs and discuss how they might magnify or mitigate the effect of changes on the fair value measurement.

This disclosure, combined with the quantitative disclosure of significant unobservable inputs, is designed to enable financial statement users to understand the directional effect of certain inputs on an item's fair value and to evaluate whether the entity's views about individual unobservable inputs differ from their own. The Boards believe these disclosures can provide meaningful information to users who are not familiar with the pricing models and valuation techniques used to measure a particular class of assets or liabilities (e.g. complex structured instruments).

The following example from IFRS 13 illustrates how an entity could comply with the disclosure requirements related to the sensitivity of Level 3 measurements to changes in significant unobservable inputs. [IFRS 13.IE66].

We note that the above example is fairly general in nature, because no numbers relating to how the unobservable inputs might be changed, or how such a change would affect fair value, are required to be disclosed. However, in making this disclosure we would encourage entities to avoid over-generalisations that may not hold true in all cases.

20.3.9 Highest and best use

As discussed at 10 above, if the highest and best use of a non-financial asset differs from its current use, entities are required to disclose this fact and why the non-financial asset is being used in a manner that differs from its highest and best use. [IFRS 13.93(i)]. The Boards believe this information is useful to financial statement users who project expected cash flows based on how an asset is actually being used.

21.2.1 Time value of money

The objective of a present value technique is to convert future cash flows into a present amount (i.e. a value as at the measurement date). Therefore, time value of money is a fundamental element of any present value technique. [IFRS 13.B13(c)]. A basic principle in finance theory, time value of money holds that ‘a dollar today is worth more than a dollar tomorrow’, because the dollar today can be invested and earn interest immediately. Therefore, the discount rate in a present value technique must capture, at a minimum, the time value of money. For example, a discount rate equal to the risk-free rate of interest encompasses only the time value element of a present value technique. If the risk-free rate is used as a discount rate, the expected cash flows must be adjusted into certainty-equivalent cash flows to capture any uncertainty associated with the item being measured and the compensation market participants would require for this uncertainty.

21.2.2 Risk and uncertainty in a present value technique

At its core, the concept of value measures expected rewards against the risks of realising those rewards. Present value techniques implicitly contain uncertainty as they generally deal with estimates rather than known amounts. In many cases, both the amount and timing of the cash flows are uncertain. The standard notes that even contractually fixed amounts are uncertain if there is risk of default. [IFRS 13.B15].

Market participants generally require compensation for taking on the uncertainty inherent in the cash flows of an asset or a liability. This compensation is known as a risk premium. IFRS 13 states that in order to faithfully represent fair value, a present value technique should include a risk premium. The standard acknowledges that determining the appropriate risk premium might be difficult. However, the degree of difficulty alone is not a sufficient reason to exclude a risk premium if market participants would demand one. [IFRS 13.B16].

Depending on the present value technique used, risk may be incorporated in the cash flows or in the discount rate. However, identical risks should not be captured in both the cash flows and the discount rate in the same valuation analysis. For example, if the probability of default and loss given default for a liability are already incorporated in the discount rate (i.e. a risk-adjusted discount rate), the projected cash flows should not be further adjusted for the expected losses.

The present value techniques discussed in the application guidance to IFRS 13 differ in how they adjust for risk and in the type of cash flows they use.

• The discount rate adjustment technique uses a risk-adjusted discount rate and contractual, promised or most likely cash flows (see 21.3 below).
• Method 1 of the expected present value technique uses cash certain equivalent cash flows and a risk-free rate (see 21.4 below).
• Method 2 of the expected present value technique uses expected cash flows that are not risk-adjusted and a discount rate adjusted to include the risk premium that market participants require. That rate is different from the rate used in the discount rate adjustment technique (see 21.4 below). [IFRS 13.B17].

If the risks are accounted for fully and appropriately, the three present value techniques noted above should all produce an identical fair value measurement, regardless of whether risk is captured in the cash flows or the discount rate (see 21.4.1 below for a numerical example illustrating this point).

21.3.1 Illustrative example of the discount rate adjustment technique

The following example from IFRS 13 illustrates how a build-up approach is applied when using the discount rate adjustment technique. [IFRS 13.B20‑21].

As evidenced in the example above, using a build-up approach requires that market data for comparable assets be available. In addition, when applying the build-up approach, significant judgement may be required in determining comparability between the item being measured and the available benchmarks, as well as quantifying the appropriate adjustments necessary to account for any differences that may exist between the item being measured and the applicable benchmark (e.g. differences in credit risks, nature and timing of the cash flows, etc.).

21.4.1 Expected present value technique – method 1 and method 2

The standard describes two methods of the expected present value technique. The key difference between Method 1 and Method 2 is where the market risk premium is captured. However, either method should provide the same fair value measurement, i.e. where the risk premium is treated should have no effect on relative fair values.

• Method 1 – the expected cash flows are adjusted for the systematic (market) risk by subtracting a cash risk premium. This results in risk-adjusted expected cash flows that represent a certainty-equivalent cash flow. The cash flows are then discounted at a risk-free interest rate. [IFRS 13.B25].

  Because all of the risk factors have been incorporated into the cash flows under Method 1, the discount rate used would only capture the time value of money. That is, use of a risk-free discount rate is appropriate when using this technique, provided that credit risk considerations are not applicable or have already been considered in the cash flows.

  A certainty-equivalent cash flow is an expected cash flow adjusted for risk so that a market participant is indifferent to trading a certain cash flow for an expected cash flow. For example, if a market participant was willing to trade an expected cash flow of CU 1,200 for a cash flow that the market participant is certain to receive of CU 1,000, the CU 1,000 is the certainty-equivalent of the CU 1,200 (i.e. the CU 200 would represent the cash risk premium). [IFRS 13.B25].

• Method 2 – adjusts for systematic (market) risk by applying a risk premium to the risk-free interest rate (i.e. the risk premium is captured in the discount rate). As such, the discount rate represents an expected rate of return (i.e. the expected rate associated with probability-weighted cash flows). In Method 2, the expected cash flows are discounted using this rate. [IFRS 13.B26].

  The use of a risk-free discount rate is not appropriate under Method 2, because the expected cash flows, while probability weighted, do not represent a certainty-equivalent cash flow. The standard suggests that models used for pricing risky assets, such as the capital asset pricing model, could be used to estimate the expected rate of return. As discussed at 21.3 above, the discount rate used in the discount rate adjustment technique also uses a rate of return, but it is related to conditional cash flows. A discount rate determined in accordance with the discount rate adjustment technique is likely to be higher than the discount rate used in Method 2, which is an expected rate of return relating to expected or probability-weighted cash flows. [IFRS 13.B26].

Capturing the risk premium in the cash flows versus the discount rate has no effect on relative fair values under each method. That is, Method 1 and Method 2 should result in the same fair value measurement, all else being equal.

Example 14.32 below illustrates the application of Method 1 and Method 2 when measuring fair value. [IFRS 13.B27‑B29]. The selection of Method 1 or Method 2 will depend on facts and circumstances specific to the asset or liability being measured, the extent to which sufficient data are available and the judgements applied. [IFRS 13.B30]. However, in practice, Method 1 is rarely used because in most cases, to mathematically estimate the cash certainty adjustment, one must already know the market risk premium that would be applied to the discount rate under Method 2.

In Example 14.33 below, we have expanded the example from IFRS 13 to include the discount rate adjustment technique (described at 21.3 above). Example 14.33 shows how all three techniques converge to the same fair value measurement, while highlighting the difference in the discount rates applied under each approach.

23.2.1 Practical expedient for alternative investments

ASC 820 provides a practical expedient to measure the fair value of certain investments in investment companies (e.g. investments in hedge funds or private equity funds that do not have readily determinable fair values) using net asset value (NAV), without adjustment.³⁶ Furthermore, in May 2015, the FASB issued ASU 2015‑07 – Fair Value Measurement (Topic 820): Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent), which eliminates the requirement to categorise in the fair value hierarchy investments measured using the NAV practical expedient.³⁷ While this exemption provides some relief for entities, they now have additional disclosure requirements specific to investments that are measured using the NAV practical expedient. These requirements are intended to help financial statement users reconcile amounts reported to the face of the financial statements and better understand the nature and risk of these investments, including whether the investments, if sold, are likely to be sold at amounts different from their NAV.

IFRS 13 does not have a similar practical expedient. Nor does it provide a similar disclosure exemption or requirements specific to such investments. Therefore, IFRS preparers cannot presume that NAV, or an equivalent measure, will be the same as fair value as measured in accordance with IFRS 13 (this is discussed further at 2.5.1 above). In addition, entities will need to categorise such investments within the fair value hierarchy and comply with the general disclosure requirements in IFRS 13.

At the time IFRS 13 was issued, the IASB believed it would be difficult to identify when such a practical expedient would be applied, given the different practices entities across the world use to calculate NAV. This difference was expected to be addressed as part of the IASB's project on Investment Entities. However, when the IASB issued Investment Entities (Amendments to IFRS 10, IFRS 12 and IAS 27) in October 2012, a footnote was added to paragraph 238(a) of the Basis for Conclusions to IFRS 13 which confirmed it had reconsidered providing a net asset value practical expedient, but decided against providing one for the reason outlined above and because it was outside the scope of the Investment Entities project to provide fair value measurement guidance for investments in investment entities. [IFRS 13.BC238(a)].

23.2.2 Fair value of liabilities with a demand feature

The guidance in IFRS on measuring the fair value of a financial liability with a demand feature differs slightly from US GAAP. IFRS 13 states that the fair value of a liability with a demand feature cannot be less than the present value of the amount payable on demand, which is consistent with the existing requirements in IFRS. US GAAP has specific industry guidance for banks and depository institutions.³⁸ The industry specific guidance states that the fair value of deposit liabilities with no defined maturities is the amount payable on demand at the reporting date. Since deposit liabilities, withdrawable on demand, of banks and depository institutions are excluded from the scope of the fair value option guidance in ASC 825, the industry guidance in US GAAP around how to fair value these liabilities is applicable to disclosure, only. [IFRS 13.BC238(b)].

23.2.3 Recognition of day-one gains and losses

While fair value is defined in IFRS 13 as an exit price (which can differ from an entry price), the standard defers to other IFRSs on whether to recognise any difference between fair value and transaction price at initial recognition, that is, day-one gains or losses. IFRS 9 restricts the recognition of day-one gains and losses when fair value is determined using unobservable inputs.

US GAAP contains no specific threshold regarding the observability of fair value inputs. As such, US GAAP does not specifically prohibit the recognition of day-one gains or losses even when the fair value measurement is based on significant unobservable inputs (i.e. a Level 3 measurement – see 16.2 above for further discussion regarding categorisation within the fair value hierarchy).

23.2.4 Disclosures

IFRS 13 and ASC 820 have some differences in the disclosure requirements for fair value measurements. For example, IFRS 13 does not provide exceptions to its disclosure requirements for non-public entities, whereas ASC 820 does. The IASB believes that IFRS for Small and Medium-Sized Entities addresses the accounting for entities that do not have public accountability, and the disclosures about their fair value measurements. [IFRS 13.BC238(c)].