As market turbulence and uncertainty continue, estimating fair value will continue to be a significant challenge for many companies. In this memorandum, we provide key reminders about the fair value requirements of IAS 39, Financial Instruments: Recognition and Measurement and IFRS 7, Financial Instruments: Disclosures.
1. Don't forget that fair value of assets and traded liabilities is a current market price! More properly, it's the price at which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. Many non-accountants confuse an asset's fair value with its so-called "fundamental value" – the value of the future cash flows that management expects to derive from the asset. This value will be very different than fair value when management's expectations about future cash flows differ from those of market participants.
2. Consider the sources of fair value guidance. IAS 39, Appendix A, paragraphs 43 65 establishes basic requirements for making fair value estimates. Another very useful source of guidance is the IASB Expert Advisory Panel's publication, "Measuring and disclosing the fair value of financial instruments in markets that are no longer active".
3. Use market prices as a basis for estimating fair value whenever possible. IAS 39.48A distinguishes betweenprices quoted in an active market and thosein an inactive market. If a market is active,the entity must use the quoted marketprice, unadjusted, as its best estimate of fairvalue. If the market is inactive, the entitymust estimate fair value using a valuationtechnique. A market is considered to beactive when prices are "readily and regularlyavailable", meaning that price informationis accessible and trades are occurringregularly. An absence of transactions for ashort period, or a lower than normal volumeof transactions, doesn't necessarily mean amarket is inactive.
In an August letter regarding the valuation of Greek bonds, the Chair of the IASB, Hans Hoogervorst, commented:
"A company cannot ignore observable transaction prices when it is clear that market participants are regularly entering into transactions for the same or similar financial assets, even if they are doing so less frequently than they have in the past. Although the level of trading activity in Greek government bonds has decreased, transactions are still taking place. IAS 39 is clear that unless there is evidence that the prices in those transactions do not represent fair value (for example, because those transactions are forced or because they require significant adjustment because of timing differences between the transaction date and the measurement date, which are matters of judgement and depend on the facts and circumstances), the observed transactions prices should be used to measure fair value."
The following discussion assumes that market prices aren't available or appropriate to use in estimating fair value and that it is necessary to use a valuation technique.
4. Understand the terms of the instrument being valued. Identifyingall of the terms of an instrument that canaffect its price is critical to its estimating itsfair value. For example, these may include:
- the expected timing and amount of cash flows;
- any optionality in the contract;
- the protective rights of the parties;
- terms relating to credit risk in debt
- instruments such as collateral;
- the subordination of the instrument; and
- legal enforceability.
Treat with caution summaries of terms used as a basis for valuing instruments; they may have overlooked important details.
5. Apply appropriate valuation techniques and assumptions. The Hoogervorst letter mentioned earlierprovides a useful summary of IAS 39'srequirements:
"Even when a model is used to measure fair value, that model must reflect current market conditions (including those as evidenced by observable transaction prices) and it should include appropriate adjustments that market participants would make for credit and liquidity risks. Furthermore, the model must maximise the use of relevant observable inputs (eg market data) and minimise the use of unobservable inputs (eg the company's own assumptions). A company cannot ignore relevant market data (including observable transaction prices) when it is clear that market participants would use that data in determining the price at which they would be willing to enter into a transaction for the financial asset."
This leads us to our next reminder.
6. Beware of DCF and option pricing models. We often find that companiesmake single point estimates of future cashflows and discount those cash flows at arate that is designed to compensate theholder for taking on the risks associatedwith the contract. The source of thediscount rate is often the effective yieldto maturity determined using the marketprice of instruments traded in the marketthat are thought to be comparable.Warning! To be truly comparable, notonly must issuers have the same creditrisk, but the instruments must also havethe same terms, such as timing of cashflows, maturity, compounding, options,etc. Alternative approaches (e.g., usingprobability weighted cash flows scenariosdiscounted based on risk free rates) oftenwill provide more appropriate results.Applying option pricing models can becomplex and can lead to inadvertent errors.For example, if you ask valuation specialistswhether it is appropriate to use a Black-Scholes model to value warrants that givethe holder the option to acquire commonshares and additional warrants of the issuerfor a single fixed price, you're likely to hearvociferous objections.
When in doubt, consult a valuation specialist.
7. Back test valuation models. IAS 39 specifically requires an entity to"calibrate" or "back test" valuation modelsto observable market information to ensurethat the model reflects current marketconditions and to identify any potentialdeficiencies in the model. Consider, forexample, the issuance of a warrant forcash in an arm's length transaction. Thewarrant qualifies as a derivative financialliability and thus must be measured at fairvalue initially and on an ongoing basis.On initial recognition, the warrant will bevalued at the cash proceeds received andin subsequent periods, using a valuationmodel. In such circumstances, the entityshould determine whether applyingthe model on day one would produce adifferent value than the cash proceedsreceived, and if so, adjust the modelappropriately. Not doing this would meanthat any difference between the cash priceand the model price would be automaticallyrecognized in net income the first time themodel was used. In effect, the financialstatements would adjust the day onevaluation to a price that is different thanthe actual transaction price received. Thisis contrary to IAS 39.
8. Be sceptical about "indicativevaluations". Companies often obtainestimates of the fair value of derivativessuch as interest rate or foreign exchangeswaps from banks or other financialinstitutions. With respect to such valuations,the IASB Expert Advisory Panel states:
"When markets are not active, brokers andpricing services are likely to rely more onmodels than on actual transactions, withinputs based on information available onlyto the broker or pricing service. Beforerelying on those prices, an entity obtainsan understanding of how the prices weredetermined to assess whether they areconsistent with the fair value measurementobjective (i.e., the price at which an orderlytransaction would take place betweenmarket participants on the measurementdate). For example, an entity places lessreliance on prices that do not reflect theresult of market transactions, takes intoaccount whether the prices are indicativeprices or binding offers and considershow frequently the prices are estimatedto assess whether they reflect marketconditions at the measurement date."
Indicative offers are less reliable than binding offers because the financial institution doing the valuation often is the one that sold the derivative to the entity, thus raising questions about its independence, and whether it provides them solely to maintain its relationship with the entity. Often indicative valuations state expressly that they cannot be relied upon for any purpose. Management should do additional work to be comfortable with the valuation in such circumstances.
9. Allocate valuations to the fair value hierarchy table based on the reliability and significance of inputs used in the valuation. IFRS7.27A requires fair value measurementsto be categorized within a three levelhierarchy based on the lowest level inputthat is significant to the measurement in itsentirety (Level 1 being valuations that useonly quoted prices in active markets, Level 2being valuations where all significant inputsare based on objective data such as marketinterests rates and Level 3 being valuationswhere at least one significant input can't beobserved but rather must be management'sassumption as to how market participantswould . Unobservable inputs are oftensignificant. For example, unobservablevolatility used to measure the fair value ofan option is likely to be significant unlessthe option is deep in the money.
10. Be transparent in disclosing the method of valuations and assumptions used. Examples ofassumptions that should be disclosedare discount rates, interest rates, rates ofestimated credit losses and prepayments.If the valuation technique was changedduring the period, that fact and the reasonfor change should also be disclosed.
11. Consider whether an approach to the valuation should be identified as a critical accounting judgment in accordance with IAS 1.125. If so,disclosure about the basis for the judgmentsis required.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.