Fair value measurement in accounting standards refers to the process of determining the price at which an asset could be sold or a liability transferred in an orderly transaction between market participants at the measurement date. Essentially, it's an exit price concept.
Understanding Fair Value
Fair value isn't about what an entity would sell an asset for, or what it thinks someone might pay. Instead, it's a standardized approach for determining a hypothetical price in a hypothetical transaction. IFRS 13 provides the definitive guidance.
Key Principles of Fair Value Measurement (Based on IFRS 13)
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Exit Price: Fair value represents the price that would be received to sell an asset or paid to transfer a liability. It's not an entry price (the price paid to acquire the asset or assume the liability).
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Market Participants: These are independent, knowledgeable, and willing buyers and sellers in the principal (or most advantageous) market for the asset or liability. Market participants are not specific to the reporting entity.
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Orderly Transaction: This assumes a transaction that isn't forced or distressed (e.g., a forced liquidation). It implies adequate exposure to the market before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities.
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Measurement Date: Fair value is determined as of a specific date, reflecting market conditions at that time.
Fair Value Hierarchy
To increase consistency and comparability, IFRS 13 establishes a hierarchy for the inputs used in fair value measurement:
| Level | Input Type | Description | Example |
|---|---|---|---|
| 1 | Quoted prices (unadjusted) in active markets for identical assets or liabilities | The most reliable evidence of fair value. | Stock price on a major exchange. |
| 2 | Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. | Inputs that are derived from or corroborated by observable market data. | Quoted prices for similar assets/liabilities in active markets; quoted prices for identical assets/liabilities in inactive markets; interest rates; yield curves. |
| 3 | Unobservable inputs | Used when relevant observable inputs are not available, reflecting the reporting entity's own assumptions about what market participants would use in pricing the asset or liability. | Discounted cash flow analysis using entity-specific assumptions. |
Practical Implications
Fair value measurement is used across various accounting standards. Some common examples include:
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Financial Instruments: Many financial assets and liabilities (e.g., derivatives, some investments) are measured at fair value.
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Impairment Testing: Fair value less costs of disposal is often used in impairment calculations for assets like property, plant, and equipment.
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Business Combinations: Assets acquired and liabilities assumed in a business combination are initially measured at fair value.
Challenges
Determining fair value can be challenging, especially for assets or liabilities that are not actively traded or when observable market data is limited. Level 3 inputs require significant judgment and can be subject to manipulation.
