participant might require for compensation for assuming the liability. Because Entity C’s obligation is a
financial liability, Entity C concludes that the interest rate already captures the risk or profit that a market
participant would require as compensation for assuming the liability. Furthermore, Entity C does not adjust
its present value technique for the existence of a restriction preventing it from transferring the liability.
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,
Fair value measurement 1003
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:
(a) 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
(b) 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].
11.2.2.A
Use of present value techniques to measure fair value for liabilities and
an entity’s own equity instruments not held by other parties as assets
If an entity uses a present value technique to measure the fair value of a liability or its
own equity not held by other parties as assets, IFRS 13 requires the entity to estimate
the future cash outflows that a market participant would expect to incur in fulfilling the
obligation, among other things. The estimated cash flows include:
• market participants’ expectations about the costs of fulfilling the obligation; and
• compensation that a market participant would require for taking on the obligation.
This compensation includes the return that a market participant would require for
the following:
(i) undertaking the activity (i.e. the value of fulfilling the obligation) – for
example, by using resources that could be used for other activities; and
(ii) assuming the risk associated with the obligation (i.e. a risk premium that
reflects the risk that the actual cash outflows might differ from the expected
cash outflows). [IFRS 13.B31].
1004 Chapter 14
In some cases, the components of the return a market participant would require will be
indistinguishable from one another. In other cases, an entity will need to estimate those
components separately. For example, assume an entity uses the price a third-party
contractor would charge as part of the discounted cash flows. If the contract is priced
on a fixed fee basis, both the return for undertaking the activity and the risk premium
would be indistinguishable. However, as is shown in Example 14.16 below, if the
contractor would charge on a cost plus basis, an entity would need to estimate the
components separately, because the contractor in that case would not bear the risk of
future changes in costs. [IFRS 13.B32].
A risk premium can be included in such fair value measurements, either by:
(a) adjusting the cash flows (i.e. as an increase in the amount of cash outflows); or
(b) adjusting the rate used to discount the future cash flows to their present values (i.e.
as a reduction in the discount rate).
However, an entity must ensure adjustments for risk are not double-counted or omitted.
[IFRS 13.B33].
IFRS 13 provides the following example, which illustrates how these considerations
would be captured when using a valuation technique to measure the fair value of a
liability not held by another party as an asset. [IFRS 13.IE35-39].
Example 14.16: Decommissioning liability
On 1 January 20X1 Entity A assumes a decommissioning liability in a business combination. The entity is
legally required to dismantle and remove an offshore oil platform at the end of its useful life, which is
estimated to be 10 years. Entity A uses the expected present value technique to measure the fair value of the
decommissioning liability.
If Entity A were contractually allowed to transfer its decommissioning liability to a market participant,
&n
bsp; Entity A would conclude that a market participant would use all the following inputs, probability-weighted
as appropriate, when estimating the price it would expect to receive:
(a) labour
costs;
(b) allocation of overhead costs;
(c) the compensation that a market participant would require for undertaking the activity and for assuming
the risk associated with the obligation to dismantle and remove the asset. Such compensation includes
both of the following:
(i) profit on labour and overhead costs; and
(ii) the risk that the actual cash outflows might differ from those expected, excluding inflation;
(d) effect of inflation on estimated costs and profits;
(e) time value of money, represented by the risk-free rate; and
(f) non-performance risk relating to the risk that Entity A will not fulfil the obligation, including Entity A’s
own credit risk.
The significant assumptions used by Entity A to measure fair value are as follows:
(a) Labour costs are developed on the basis of current marketplace wages, adjusted for expectations of future
wage increases and a requirement to hire contractors to dismantle and remove offshore oil platforms.
Entity A assigns probability assessments to a range of cash flow estimates as follows:
Fair value measurement 1005
Cash flow estimate
Probability assessment
Expected cash flows
CU CU
100,000 25%
25,000
125,000 50%
62,500
175,000 25%
43,750
131,250
The probability assessments are developed on the basis of Entity A’s experience with fulfilling
obligations of this type and its knowledge of the market.
(b) Entity A estimates allocated overhead and equipment operating costs using the rate it applies to labour
costs (80% of expected labour costs). This is consistent with the cost structure of market participants.
(c) Entity A estimates the compensation that a market participant would require for undertaking the activity
and for assuming the risk associated with the obligation to dismantle and remove the asset as follows:
(i) A third-party contractor typically adds a mark-up on labour and allocated internal costs to provide
a profit margin on the job. The profit margin used (20%) represents Entity A’s understanding of the
operating profit that contractors in the industry generally earn to dismantle and remove offshore oil
platforms. Entity A concludes that this rate is consistent with the rate that a market participant
would require as compensation for undertaking the activity.
(ii) A contractor would typically require compensation for the risk that the actual cash outflows might
differ from those expected because of the uncertainty inherent in locking in today’s price for a
project that will not occur for 10 years. Entity A estimates the amount of that premium to be 5% of
the expected cash flows, including the effect of inflation.
(d) Entity A assumes a rate of inflation of 4% over the 10-year period on the basis of available market data.
(e) The risk-free rate of interest for a 10-year maturity on 1 January 20X1 is 5%. Entity A adjusts that rate
by 3.5% to reflect its risk of non-performance (i.e. the risk that it will not fulfil the obligation), including
its credit risk. Therefore, the discount rate used to compute the present value of the cash flows is 8.5%.
Entity A concludes that its assumptions would be used by market participants. In addition, Entity A does not
adjust its fair value measurement for the existence of a restriction preventing it from transferring the liability
even if such a restriction exists. As illustrated in the following table, Entity A measures the fair value of its
decommissioning liability as CU 194,879.
Expected cash flows
CU
Expected labour costs
131,250
Allocated overhead and equipment costs (0.80 × CU 131,250)
105,000
Contractor’s profit mark-up
[0.20 × (CU 131,250 + CU 105,000)]
47,250
Expected cash flows before inflation adjustment
283,500
Inflation factor (4% for 10 years)
1.4802
Expected cash flows adjusted for inflation
419,637
Market risk premium (0.05 × CU 419,637)
20,982
Expected cash flows adjusted for market risk
440,619
Expected present value using discount rate of 8.5% for 10 years
194,879
In practice, estimating the risk premium for a decommissioning liability, such as in the
example above, requires significant judgement, particularly in circumstances where the
decommissioning activities will be performed many years in the future. Information
about the compensation market participants would demand to assume
decommissioning liability may be limited, because very few decommissioning liabilities
are transferred in the manner contemplated by IFRS 13.
1006 Chapter 14
Because of these data limitations, entities might look to risk premiums observed from
business combinations where decommissioning liabilities are assumed, including their
own business combination transactions. IFRS
13 indicates that when market
information is not reasonably available, an entity may consider its own data in
developing assumptions related to the market risk premium (see 19 below for additional
discussion on the use of an entity’s own data to determine unobservable inputs).
Alternatively, as noted above, the market risk premium might be estimated by considering
the difference between a fixed-price arrangement and a cost-plus arrangement with a
third party to complete the remediation and monitor the site. The difference between the
fixed-price arrangement and the cost-plus arrangement may provide insight into the risk
premium market participants would demand to fulfil the obligation.
While all available evidence about market participant assumptions regarding the market
risk premium should be considered, circumstances may exist when an explicit
assumption cannot be determined. In such cases, based on the specific guidance in
IFRS 13 – which acknowledges that explicit assumptions in some cases may not be able
to be incorporated into the measurement of decommissioning liability – we believe the
market risk premium may be incorporated into the fair value measurement on an
implicit basis.
11.2.2.B
Consideration of an entry price in measuring a liability or entity’s own
equity not held as an asset
Although fair value represents an exit price, IFRS 13 indicates that in certain situations
an entry price may be considered in estimating the fair value of a liability or an entity’s
own equity instrument. This approach uses assumptions that market participants would
use when pricing the identical item (e.g. having the same credit characteristics) in the
principal (or most advantageous) market – that is, the principal (or most advantageous)
market for issuing a liability or equity instrument with the same contractual terms.
The standard allows for entry prices to be considered in estimating the fair value of a
liability because the IASB believes that a liability’s entry and exit prices will be identical
i
n many instances. As a result, the price at which a market participant could enter into
the identical liability on the measurement date (e.g. an obligation having the same credit
characteristics) may be indicative of its fair value.
However, an entry price may differ from the exit price for a liability for a number of
reasons. For example, an entity may transfer the liability in a different market from that
in which the obligation was incurred. When entry and exit prices differ, IFRS 13 is clear
that the objective of the measurement remains an exit price.
11.3 Non-performance
risk
IFRS 13 requires a fair value measurement of a liability to incorporate non-performance
risk (i.e. the risk that an obligation will not be fulfilled). Conceptually, non-performance
risk encompasses more than just an entity’s credit risk. It may also include other risks,
such as settlement risk. In the case of non-financial instruments, such as commodity
contracts, non-performance risk could represent the risk associated with physically
extracting and transferring an asset to the point of delivery. When measuring the fair
value of a liability, an entity must:
Fair value measurement 1007
• Take into account the effect of its credit risk (credit standing) and any other factors
that could influence the likelihood whether or not the obligation will be fulfilled.
• Assume that non-performance risk will be the same before and after the transfer
of a liability.
• Ensure the effect of non-performance risk on the fair value of the liability is
consistent with its unit of account for financial reporting purposes.
If a liability is issued with a third-party credit enhancement that the issuer accounts
for separately from the liability, the fair value of the liability does not include the
effect of the credit enhancement (e.g. a third-party guarantee of debt). That is, the
issuer would take into account its own credit standing and not that of the third-
party guarantor when measuring the fair value of the liability (see 11.3.1 below).
[IFRS 13.42-44].
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 198
