In contrast, the unit of account for Bank Y’s 100 derivative contracts is the individual OTC contracts, not the
aggregate gross exposure stemming from the 100 contracts (i.e. the block). In pricing the individual contracts,
market participants would likely not consider a discount associated with the size of the contracts, since the
notional amount for each contract is consistent with the market norm. In accordance with IFRS 13, Bank Y
would be prohibited from applying a discount based on the size of its entire holding (i.e. the 100 contracts)
as this would represent a block discount that cannot be considered in a fair value measurement.
As discussed at 5.1 above, the unit of account is determined by the relevant IFRS that
permits or requires an asset or liability to be measured at fair value, unless IFRS 13 states
otherwise. In some cases, the unit of account may be clear, for example, the unit of
account for financial instruments in the scope of IFRS 9 is typically the individual
instrument. However, it may be less clear in other standards, for example, the unit of
account for a cash-generating unit when testing non-financial assets for impairment in
1046 Chapter 14
accordance with IAS 36. At the time of writing, the IASB was concluding its PIR of
IFRS 13, in which it had considered issues relating to prioritising Level 1 inputs or the
unit of account. This is discussed further at 5.1.1 above.
15.3 Pricing within the bid-ask spread
The ‘bid price’ represents the price at which a dealer or market maker is willing to buy
an asset (or dispose of a liability). The ‘ask price’ (or offer price) represents the price at
which a dealer or market maker is willing to sell an asset (or assume a liability). The
spread between these two prices represents the profit a dealer requires for making a
market in a particular security (i.e. providing two-way liquidity).
The use of bid prices to measure assets and ask prices to measure liabilities is permitted,
but not required. Instead, for assets and liabilities that are bought and sold in markets
where prices are quoted using a bid-ask spread (e.g. over-the-counter markets), the
entity must use the price within the bid-ask spread that is most representative of fair
value in the circumstances to measure fair value. In making this assessment, entities
should evaluate their recent transaction history to support where in the bid-ask spread
they are able to exit their positions. For some entities this could result in valuing assets
at the bid price and liabilities at the ask price, but in other instances judgement is
required to determine the point in the bid-ask spread that is most indicative of fair value.
The use of the price within the bid-ask spread that is most representative of fair value
applies regardless of whether the input (i.e. the bid or ask price) is observable or not (i.e.
regardless of its categorisation in the fair value hierarchy – see 16 below for further
discussion). [IFRS 13.70].
Entities need to be consistent in their application of this concept. It would not be
appropriate for an entity to measure similar assets at different prices within the bid-ask
spread, without evidence indicating that the exit prices for those assets would be at
different points within the bid-ask spread.
15.3.1 Mid-market
pricing
As a practical expedient, IFRS 13 allows the use of mid-market pricing, or other pricing
conventions that are used by market participants, when measuring fair value within the
bid-ask spread. [IFRS 13.71]. Use of a mid-market pricing convention results in a valuation
of an asset or liability at the mid-point of the bid-ask spread. Extract 14.1 at 20.2 below
illustrates use of mid-market pricing.
The guidance does not limit or restrict the use of mid-market pricing to specific types
of instruments or entities. However, as discussed at 14 above, valuation techniques used
to measure fair value should be consistently applied. [IFRS 13.65].
15.3.2
What does the bid-ask spread include?
The commentary in the Basis for Conclusions acknowledges that the previous guidance
in paragraph AG70 of IAS 39 only includes transaction costs in the bid-ask spread. The
Boards chose not to specify what is included in the bid-ask spread, except for
transaction costs. However, they did make it clear that, in their view, the bid-ask spread
does not include adjustments for counterparty credit risk. [IFRS 13.BC164].
Fair value measurement 1047
The IASB has not provided any clarity regarding the interaction between the
guidance in IFRS 13 on transaction costs (i.e. transaction costs are not considered an
attribute of the asset or liability and, accordingly, are excluded from fair value
measurements) and the guidance on the use of prices within the bid-ask spread. If
transaction costs are included in the bid-ask spread, measuring an asset at the bid
price would include certain future transaction costs in the fair value measurement
for the asset.
Given the lack of any specific guidance on this issue, there may be some diversity in
practice between entities with respect to how transaction costs are considered.
However, we would expect an entity to apply a consistent approach to all of its own fair
value measurements.
15.4 Risk
premiums
IFRS 13 defines a risk premium as ‘compensation sought by risk-averse market
participants for bearing the uncertainty inherent in the cash flows of an asset or a
liability’. [IFRS 13 Appendix A]. Regardless of the valuation technique(s) used, a fair value
measurement is intended to represent an exit price and, as such, should include a risk
premium that reflects the compensation market participants would demand for bearing
the uncertainty inherent in the cash flows of an asset or liability. [IFRS 13.B16, B39]. While
this risk premium should reflect compensation required in an orderly transaction (not a
forced or distressed sale), it should also capture market participant assumptions
regarding risk under current market conditions. Example 14.9 discussed at 8.3.2 above
illustrates that this risk adjustment may include assumptions about liquidity and
uncertainty based on relevant market data.
IFRS 13 explicitly states that ‘[a] fair value measurement should include a risk premium
reflecting the amount market participants would demand as compensation for the
uncertainty inherent in the cash flows. Otherwise, the measurement would not faithfully
represent fair value. In some cases, determining the appropriate risk premium might be
difficult. However, the degree of difficulty alone is not a sufficient reason to exclude a
risk premium’. [IFRS 13.B16].
The objective of a risk premium is often misunderstood. Many incorrectly assume
that a risk premium is unnecessary when fair value is determined using probability-
weighted cash flows. That is, they believe it is appropriate to discount probability-
weighted cash flows using a risk-free rate under the assumption that all uncertainty
is captured by probability-weighting the cash flows. While expected cash flows (i.e.
the probability-weighted average of possible future cash flows) incorporate the
uncertainty in the instrument’s cash flows, they do not incorporate the<
br />
compensation that market participants demand for bearing that uncertainty.
[IFRS 13.B25-B29]. In order to capture this required compensation in the measurement,
a market risk premium must be added (either as an adjustment to the discount rate
or to the expected cash flows). IFRS 13’s application guidance addresses this point
when discussing systematic and unsystematic risk and certainty-equivalent cash
flows (see 21 below for additional discussion on how risk premiums are applied in a
present value technique).
1048 Chapter 14
It is important to note that increased risk associated with an asset generally decreases the
fair value of that asset, whereas increased risk associated with a liability generally increases
the fair value of that liability (with the exception of non-performance risk). Uncertainty
associated with an asset reduces the amount a market participant would pay for the asset.
In contrast, all else being equal, compensation for an uncertainty related to a liability results
in an increase to the amount that the market participant would expect to receive for
assuming the obligation. If that compensation is accounted for in the discount rate, rather
than in the cash flows, it would result in an increase in the discount rate used to measure
the fair value of an asset. However, it would result in a reduction of the discount rate used
in the fair value measurement of the liability (i.e. the discount rate must be lower so that
the resulting fair value of the liability is higher). [IFRS 13.BC91]. This concept only applies
when measuring the fair value of a liability that does not have a corresponding asset using
an income approach. As discussed at 11.2.1 above, when a quoted price for the transfer of
an identical or similar liability or entity’s own equity instrument is held by another party as
an asset, the fair value of this liability or own equity instrument should be determined from
the perspective of the market participant that holds the identical item as an asset.
15.5 Broker quotes and pricing services
When quoted prices from brokers or pricing services are used to measure fair value, it
is the entity’s responsibility to understand the source and nature of this information to
accurately assess its relevance. When there has been a significant decrease in the
volume or level of activity for the asset or liability, management should evaluate
whether the prices received from brokers or pricing services are based on current
information from orderly transactions or valuation techniques that appropriately reflect
market participant assumptions regarding risk. IFRS 13 states that entities should place
less reliance on third-party quotes that are not based on transactions, compared to other
value indications that are based on market transactions. [IFRS 13.B46].
When information from brokers and pricing services is based on transaction data,
entities should assess whether, and to what extent, the observed prices are a result of
orderly transactions when determining the weight to place on these data points,
compared to other value indications (see 8.2 above for additional information on the
factors an entity may consider when assessing whether transactions are orderly). Facts
and circumstances will determine the weight that an entity should place on a transaction
price, including:
• the comparability of the transaction to the asset or liability being measured at fair
value;
• the proximity of the transaction to the measurement date;
• the size of the transaction; and
• the nature of the quote (e.g. binding versus indicative quote) and the number of
quotes received.
Fair value measurement 1049
See 16.2.3 below for additional discussion on fair value hierarchy considerations when
using quoted prices from brokers and pricing services.
15.5.1
How should values provided by central clearing organisations for
margin purposes be evaluated when determining the fair value of
centrally cleared derivatives for financial reporting?
For OTC derivatives that are centrally cleared, counterparties are typically required on
an ongoing basis to post collateral based on the change in value of the derivative
(sometimes referred to as ‘variation margin’). As a result, entities with centrally cleared
OTC derivatives will periodically receive a ‘value mark’ from a clearing organisation
that states the amount of variation margin to be posted or received.
However, this value should not be presumed to represent fair value (an exit price)
in accordance with IFRS 13. Different clearing organisations may have different
approaches for calculating variation margin requirements and while practice may
continue to evolve, it is our understanding that the ‘value marks’ provided generally
do not represent an actual transaction price (i.e. a price at which the reporting
entity could execute a trade to buy or sell the contract). Instead, this value may be
based on a clearing organisation’s analysis of information provided by clearing
members and certain of its own assumptions. While this value may potentially be
an appropriate estimate of fair value in certain instances, the reporting entity
should understand how this value is determined and evaluate whether it includes
only those factors that would be considered by market participants in an orderly
transaction to sell or transfer the derivative. For example, to provide themselves
with additional protection, some clearing organisations may include an incremental
amount in their variation margin requirement in excess of the ‘true’ change in the
value of the derivative.
As with pricing information provided by brokers or third-party pricing services,
reporting entities are responsible for understanding the source and nature of
information provided by central clearing organisations. An entity should assess whether
the value indication represents fair value in accordance with IFRS 13 or whether an
adjustment may be needed. See 16.2.4 below for a discussion of the classification of
centrally cleared OTC derivatives in the fair value hierarchy.
16
THE FAIR VALUE HIERARCHY
The fair value hierarchy is intended to increase consistency and comparability in
fair value measurements and the related disclosures. [IFRS 13.72]. Application of the
hierarchy requires an entity to prioritise observable inputs over those that are
unobservable when measuring fair value. In addition, for disclosures, it provides a
framework for users to consider the relative subjectivity of the fair value
measurements made by the reporting entity.
1050 Chapter 14
16.1 The fair value hierarchy
The fair value hierarchy classifies the inputs used to measure fair value into three levels,
which are described in Figure 14.8.
Figure 14.8:
Fair value hierarchy
Level 1
Level 2
Level 3
Definition
Quoted prices
Inputs other than quoted
Unobservable inputs for
[IFRS 13
(unadjusted) in active
prices included within
the asset or liability.
Appendix A]
markets for identical
level 1 that are observable
assets or liabilities that the
for the asset or liability,
entity can access at the
either directly or
measurement date.
indirectly.
Example
The price for a financial
Interest rates and yield
Projected cash flows
asset or financial liability
curves observable at
used in a discounted
for the identical asset is
commonly quoted
cash flow calculation.
traded on an active market
intervals, implied
(e.g. Tokyo Stock
volatilities, and credit
Exchange).
spreads.
Valuation techniques used to measure fair value must maximise the use of relevant
observable inputs and minimise the use of unobservable inputs. The best indication of
fair value is a quoted price in an active market (i.e. ‘a market in which transactions for
the asset or liability take place with sufficient frequency and volume to provide pricing
information on an ongoing basis’ [IFRS 13 Appendix A] ).
The fair value hierarchy focuses on prioritising the inputs used in valuation techniques,
not the techniques themselves. [IFRS 13.74]. While the availability of inputs might affect
the valuation technique(s) selected to measure fair value, as discussed at 14 above,
IFRS 13 does not prioritise the use of one technique over another (with the exception
of the requirement to measure identical financial instruments that trade in active
markets at P×Q). The determination of the valuation technique(s) to be used requires
significant judgement and will be dependent on the specific characteristics of the asset
or liability being measured and the principal (or most advantageous) market in which
market participants would transact for the asset or liability.
Although the valuation techniques themselves are not subject to the fair value hierarchy,
a risk adjustment that market participants would demand to compensate for a risk
inherent in a particular valuation technique (e.g. a model adjustment) is considered an
input that must be assessed within the fair value hierarchy. As discussed at 16.2 below,
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 207
