“Are you ready for the new fair value accounting?” by Francisco Roque A. Lumbres (January 23, 2012)

SUITS THE C-SUITE By Francisco Roque A. Lumbres
Business World (01/23/2012)

Fair value accounting, often referred to as mark-to-market accounting, has been the subject of much discussion and controversy, and the fact that various ways of measuring fair value were spread among different International Financial Reporting Standards (IFRS) has contributed to many questions regarding fair value accounting.

To create a uniform framework for fair value measurements that consolidates into one single standard the various ways of measuring fair value, the International Accounting Standards Board (IASB) issued IFRS 13, Fair Value Measurements to reduce complexity and improve consistency in the application of fair value measurements. IFRS 13 also aims to enhance fair value disclosures to help users assess the valuation techniques and inputs used to measure fair value. IFRS 13 was published last May 12, 2011 and will become effective by January 1, 2013. It is applied prospectively, and early adoption is allowed.

IFRS 13 clarifies how to measure fair value when it is required or permitted in IFRS. It does not change when an entity is required to use fair value. Furthermore, IFRS 13 covers both financial and non-financial assets and liabilities.

Key principles of IFRS 13

IFRS 13 applies when another IFRS standard requires or permits fair value measurements or disclosures. It does not, however, apply to transactions within the scope of:

• International Accounting Standards (IAS) 17, Leases;
• IFRS 2 Share-Based Payments; and,
• Certain other measurements that are similar but are not fair value, that are required by other standards, such as value in use in IAS 36, Impairment of Assets and net realizable value in IAS 2, Inventories.

Fair value defined

IFRS 13 now defines “fair value” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e., an exit price). Therefore, the focus now is on exit price as against entry price.

Market participant assumptions

When measuring fair value, IFRS 13 requires an entity to consider the characteristics of the asset or liability as market participants would. Hence, fair value is not an entity-specific measurement; it is market-based.

Principal or most advantageous market

A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place in the “principal market” for the asset or liability or, in the absence of a principal market, in the “most advantageous market” for the asset or liability.

The principal market is the market with the greatest volume and level of activity for the asset or liability to which the entity has access to. On the other hand, the most advantageous market is the market that maximizes the amount that would be received for the sale of the asset or minimizes the cost to transfer the liability, after considering transaction and transport costs.

Highest and best use

The concept of “highest and best use” applies to non-financial assets only. Fair value considers a market participant’s ability to generate economic benefits by using the asset in its highest and best use. Highest and best use is always considered when measuring fair value, even if the entity intends a different use of the asset.

Fair value hierarchy

Fair value measurements are classified into three levels which prioritize the observable inputs to the valuation techniques used and minimize the use of unobservable data.

• Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.
• Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.
• Level 3: Unobservable inputs for the asset or liability.

Valuation techniques and inputs

IFRS 13 describes the valuation approaches to be used to measure fair value: the market approach, income approach and cost approach. IFRS 13 does not specify a valuation technique in any particular circumstance; it is up to the entity to determine the most appropriate valuation technique.

• Market approach: Uses prices and other relevant information from market transactions involving identical or similar assets or liabilities. A commonly-used technique is the use of market multiples derived from “comparables.”
• Income approach: Converts future amounts (e.g., cash flows or income and expenses) to a single current (discounted) amount. Valuation techniques may include a discounted cash flows approach, option-pricing models, or other present-value techniques.
• Cost approach: Reflects the amount currently needed to replace the service capacity of an asset (also known as the current replacement cost)

Disclosure requirements

IFRS 13 expanded required disclosures to help the users understand the valuation techniques and inputs used to measure fair value and the impact of fair value measurements on profit and loss. The required disclosures include:

• Information about the level of fair value hierarchy;
• Transfers between levels 1 and 2;
• Methods and inputs to the fair value measurements and changes in valuation techniques; and

For level 3 disclosures, quantitative information about the significant unobservable inputs and assumptions used, and qualitative information about the sensitivity of recurring level 3 measurements.

Business impact and next steps

Practically all entities using fair value measurements will be subject to IFRS 13, which will require certain fair value principles and disclosures that will significantly impact application and practice. Therefore, management should:

• Begin to assess the effect of IFRS 13 on valuation policies and procedures;
• Have competent knowledge when making judgments in fair value measurements;
• Consider whether it has appropriate expertise, processes, controls and systems to meet the new requirements in determining fair value and disclosures;
• Revisit loan covenants, compensation plans, shareholder communications and analyst expectations;
• Have discussions with systems vendors, appraisers, investment advisors and/or investment custodians; and,
• Be able to demonstrate to regulators and its external auditors that it understands the requirements of IFRS 13. This will greatly assist both regulators and external auditors in their annual examination and audit.

The mandatory implementation of this new standard is less than a year away. The clock is ticking; the time to act is now.

Francisco Roque A. Lumbres, CFA, PRM, is a Partner of SGV & Co.

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.