B. Fair value measurement issues
3. Methods to determine a fair value
It has to be noted that if the alternative ‘cost model’ is chosen for investment properties under IAS 40, the fair values have to be disclosed in the notes. Therefore, although not carried at fair value and changes not being reported in profit or loss, a fair value needs to be determined in any case.29 It should also be added that the optional "revaluation model" under IAS 38 for intangibles and for property, plant &
equipment under IAS 16 are of limited importance in practice.
observed in an active market might be adjusted for small differences because the item to be measured is quite similar, but not identical to the item traded in the active market.
Another approach would be to discount the contractual cash flows associated with a particular financial instrument using a risk-adjusted interest rate. This discounted cash flow method also draws the attention to a very important aspect:
Apart from the validity of the valuation technique, which may be assured by periodical back-testing31 and the correct usage of the technique itself, the input parameters used with the technique are of the utmost importance.32 These input parameters might be:
(1) market data, that is, data observed in an active market; or
(2) assumptions the entity made because the relevant information may not be observed in the active market but the assumption tries to reflect market information as much as possible.
(3) This type of assumption is sometimes referred to as “assumptions that market participants would use”. The parameters might also be entity- specific assumptions.
Of course, also assumptions mentioned under (2) are entity-specific in the sense that the entity will produce the assumptions. The term "entity-specific" in this context should be thought of as relying,for example, on entity-specific expectations that cannot be justified to reliably represent market expectations. However, both types of assumptions will involve estimation.
The higher the degree of estimation and the more significantly the assumptions will influence the fair value to be determined, the more reliability and comparability will be reduced. As assumptions may never be “true” but only “neutral” and
“understandable”33 to a higher or lesser degree, there will always be a range of possible fair values. However, since the reported amount is only a point estimate from that range, the fair value will not be as reliable as other measurement bases (e.g. cost) and probably not as reliable as it is perceived to be. As different entities might use different assumptions, they are likely to report different fair values for similar items.
However, this lack of comparability might be compensated by additional disclosures.
On the contrary, if only market data are used with the valuation technique, there should be no problems with respect to reliability or comparability, provided a valid valuation technique is used correctly, as the determination of the fair value will be a calculation.
31 To check the validity of the valuation technique by way of back-testing, the technique is used on a financial instrument traded on an active market using market input data to enable a comparison between model prices and market prices. IAS 39.AG76 also mentions back-testing.
32 See IAS 39.AG82, dealing exclusively with the input parameters. However, paragraph AG74et seq.
also mention input parameters.
33 See, for example par. 40 of the International Standard on Auditing 545 Auditing Fair Value Measurements and Disclosures (ISA 545). Note also the difference between the criteria to assess assumptions involving, by definition, estimation (relevant, reliable, neutral, understandable complete) and the criteria relating to data. Data is observed at the market and, by definition, not estimated.
Consequently, the criteria in paragraph 51 of ISA 545 (accurate, complete, relevant) do not contain reliability or neutrality. Observed data may only be either accurate or not.
Level 1-fair values may be characterized as observed fair values, level 2-fair values determined solely by market data as calculated fair values. Level 2-fair values based on either type of assumption may be characterized as estimated fair values.
IAS 40 contains a slightly different fair value measurement hierarchy (see figure VI.3).34 A level 1-fair value will probably be rather rare, as it is highly unlikely that two identical items of investment property will exist. Note that both level 2 and level 3 fair values involve adjustments: Level 2 because the properties are different and level 3 for the time-lag between the day the price was observed and the measurement date. Level 4 involves a good deal of estimation with respect to the cash flows and risk-adjusted interest rates. These estimations might impede reliability and comparability. On the other hand, a comprehensive discussion should also look at alternatives. Coming back to the example in Section I.2 and the two items of investment property, we note that both amounts are reliable, but certainly not comparable. The illustration is of course a very simple one. However, it should be noted that questions related to comparability are raised very rarely in connection to a cost-based measurement concept, but they should be raised.
Figure VI.3. IAS 40 Fair Value Measurement Guidance
L e v e l 1 : C u rre n t p ric e in a n a c tiv e m a rk e t
L e v e l 2 : A d ju s te d c u rre n t p ric e s fo r d iffe re n t p ro p e rtie s in a n a c tiv e m a rk e t
L e v e l 3 : R e c e n t p ric e s o f s im ila r p ro p e rtie s o n le s s a c tiv e m a rk e ts
L e v e l 4 : D is c o u n te d c a s h flo w p ro je c tio n s b a s e d o n re lia b le e s tim a te s o f fu tu re c a s h flo w s
? R e lia b ility C o m p a ra b ility
? R e lia b ility C o m p a ra b ility
R e lia b ility C o m p a ra b ility
R e lia b ility C o m p a ra b ility
An interesting aspect of the IAS 41 fair value measurement hierarchy35 is the difference between levels 1 and 2: As already mentioned above, there might be a difference between a price observed in an active market and a transaction price. A single transaction does not constitute a market, albeit an active one. This is also the reason for a transaction price (the consideration given to acquire an asset) used in a cost-based measurement conceptnot necessarily being a fair value.
34 See IAS 40.45 (current price in an active market as fair value) and IAS 40.46 (other sources, level 2-4 in figure VI.3).
35 See IAS 41.17 (the quoted price in an active market as fair value) and IAS 41.18 (other sources, level 2-4 in figure VI.4).
Figure VI.4. IAS 41 Fair Value Measurement Guidance
L e v e l 1 : Q u o te d p ric e in a n a c tiv e m a rk e t
L e v e l 2 : R e c e n t m a rk e t tra n s a c tio n p ric e
(if n o s ig n ific a n t c h a n g e in th e e c o n o m ic c irc u m s ta n c e s o c c u re d )
L e v e l 3 : A d ju s te d m a rk e t p ric e s fo r d iffe re n t a s s e ts
L e v e l 4 : S e c to r b e n c h m a rk s (e .g . v a lu e p e r b u s h e l o r h e c ta r)
? R e lia b ility C o m p a ra b ility
? R e lia b ility C o m p a ra b ility
R e lia b ility C o m p a ra b ility
R e lia b ility C o m p a ra b ility
One of the major problems connected with fair value measurement might be a misconception of what a fair value actually is. The fair value does not “claim” to be the only true and real amount at which any given item may be realized (liquidated) at any given point in time. This would only be the case with a fair value determined by observation of a transaction price in an active market. If the fair value is determined by a valuation technique, the amount might not be realized at any given point in time as there is no active market. If there was an active market, there would be no need for a valuation technique. In this situation the fair value is a hypothetical amount – the transaction price two parties would agree on. This could almost be called an
“expectation gap” as there is the danger that users of financial statements might mistake the fair value determined by a valuation technique for a market price.