International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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Depending on the observability of the inputs used, fair value measurements of over-
the-counter derivatives that are not centrally cleared would likely be within either
Level 2 or Level 3 of the fair value hierarchy.
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Although these instruments may initially be executed in active markets, quoted
prices for the identical asset or liability will often not be available when measuring
fair value subsequently. For example, consider a 10-year plain vanilla interest-rate
swap entered into on 1 January 20X9 that is not centrally cleared. While there may
be quoted prices for 10-year swaps, when measuring the fair value of the swap on
31 March 20X9, the subject instrument would represent a 9.75 year swap for which
quoted prices are generally not available. As a result, most over-the-counter
derivative contracts that are not centrally cleared are valued based on inputs used
in pricing models.
In addition, centrally cleared derivatives would not be categorised within Level 1
unless their fair value was determined based on an unadjusted quoted price in active
markets for an identical instrument. Some constituents have questioned whether a
‘value mark’, periodically provided by a central clearing organisation for variation
margin purposes, represents a Level 1 measurement. As discussed at 15.5.1 above, a
reporting entity should not presume that the value provided by a central clearing
organisation for margin purposes represents fair value in accordance with IFRS 13.
Instead, entities need to understand the source and nature of the information
provided by the central clearing organisation and assess whether the value
indication represents fair value in accordance with IFRS 13 or whether an
adjustment may be needed.
Even in those circumstances where an entity determines that the information received
from the central clearing organisation is representative of fair value and does not require
adjustment, it is our understanding that the ‘value marks’ provided typically do not
represent actual trades of the identical instrument and therefore would not be a Level 1
measurement. See 15.5.1 above for additional discussion on the consideration of values
provided by central clearing organisations when determining the fair value.
17 LEVEL
1
INPUTS
‘Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or
liabilities that the entity can access at the measurement date’. [IFRS 13.76]. According to
IFRS 13, this price represents the most reliable evidence of fair value. If a quoted price
in an active market is available, an entity must use this price to measure fair value
without adjustment; although adjustments are permitted in limited circumstances
(see 17.3 below). [IFRS 13.77].
Fair value measurement 1057
17.1 Use of Level 1 inputs
As a general principle, IFRS 13 mandates the use of quoted prices in active markets for
identical assets and liabilities whenever available. With limited exceptions, quoted
prices in active markets should not be adjusted when determining the fair value of
identical assets and liabilities, as the IASB believes these prices provide the most reliable
evidence of fair value.
Adjustments can only be made to a quoted price in an active market (a Level 1 input) in
the following circumstances:
(a) when an entity holds a large number of similar (but not identical) assets or liabilities
(e.g. debt securities) that are measured at fair value and a quoted price in an active
market is available but is not readily accessible for each of those assets or liabilities
individually. That is, since the assets or liabilities are not identical and given the large
number of similar assets or liabilities held by the entity, it would be difficult to obtain
pricing information for each individual asset or liability at the measurement date.
In this situation, IFRS 13 provides a practical expedient; an entity may measure fair
value using an alternative pricing method that does not rely exclusively on quoted
prices (e.g. matrix pricing);
(b) when a quoted price in an active market does not represent fair value at the
measurement date.
This may be the case, for example, if significant events, such as transactions in a
principal-to-principal market, trades in a brokered market or announcements, take
place after the close of a market but before the measurement date. An entity must
establish and consistently apply a policy for identifying those events that might
affect fair value measurements; or
(c) when measuring the fair value of a liability or an entity’s own equity instrument using
the quoted price for the identical item traded as an asset in an active market and that
price needs to be adjusted for factors specific to the item or the asset. [IFRS 13.79].
These exceptions are discussed further at 17.1.1, 17.2 and 17.3 below. Level 1 inputs are
most commonly associated with financial instruments, for example, shares that are
actively traded on a stock exchange. It may be that an asset or liability is traded in
multiple active markets, for example, shares that are listed on more than one stock
exchange. In light of this, the standard emphasises the need within Level 1 to determine
both, the principal (or most advantageous) market (see 6 above) and whether the entity
can enter into a transaction for the asset or liability at the price in that market at the
measurement date (see 8 above). [IFRS 13.78].
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As discussed at 16.2 above, if no adjustment is made to a Level 1 input, the result is the
entire fair value measurement being categorised within Level 1 of the fair value
hierarchy. However, any adjustment made to a Level 1 input or use of the practical
expedient in (a) above would result in categorisation within a lower level of the fair
value hierarchy. If the adjustment uses significant unobservable inputs, it would need to
be categorised within Level 3. [IFRS 13.75].
17.1.1
Level 1 liabilities and instruments classified in an entity’s own equity
Quoted prices in active markets for identical liabilities and instruments classified as an
entity’s own equity are Level 1 measurements. These instruments would likewise be
categorised within Level 1 when a quoted price exists for the identical instrument traded
as an asset in an active market, provided no adjustment to the quoted price is required.
The fair value of corporate debt issued by a reporting entity, for example, would be a Level 1
measurement if the asset corresponding to the issuer’s liability (i.e. the corporate bond)
trades in an active market and no adjustment is made to the quoted price. While the liability
itself is not transferred in an active market, the IASB concluded that Level 1 categorisation
is appropriate when the identical instrument trades as an asset in an active market.
If an adjustment to the corresponding asset’s price is required to address differences
between the asset and the liability or equity instrument (as discussed at 11 above),
[IFRS 13.79(c)], the adjusted price would not be a Level 1 measurement. For example, an
adjustment to the quoted price of an asset that includes the effect of
a third-party credit
enhancement would be warranted when measuring the fair value of the liability. In this
case, the corresponding asset and the liability would have different units of account (as
discussed at 11.3.1 above).
17.2 Alternative
pricing
methods
When an entity holds a large number of similar assets and liabilities for which quoted
prices exist, but are not easily accessible, IFRS 13 allows for the use of alternative pricing
methods (e.g. matrix pricing) as a practical expedient. [IFRS 13.79(a)]. The IASB provided this
practical expedient to ease the administrative burden associated with obtaining quoted
prices for each individual instrument. However, if the practical expedient is used, the
resulting fair value measurement would not be considered a Level 1 measurement.
17.3 Quoted prices in active markets that are not representative of
fair value
IFRS 13 recognises that in certain situations a quoted price in an active market might
not represent the fair value of an asset or liability, such as when significant events occur
on the measurement date, but after the close of trading. In these situations, entities
would adjust the quoted price to incorporate this new information into the fair value
measurement. [IFRS 13.79(b)]. However, if the quoted price is adjusted, the resulting fair
value measurement would no longer be considered a Level 1 measurement.
An entity’s valuation policies and procedures should address how these ‘after-hour’
events will be identified and assessed. Controls should be put in place to ensure that any
adjustments made to quoted prices are appropriate under IFRS 13 and are applied in a
consistent manner.
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17.4 Unit of account
Although the unit of account is generally determined in accordance with other
IFRSs, IFRS 13 addresses the unit of account for Level 1 assets and liabilities.
Paragraph 80 of IFRS 13 states that ‘if an entity holds a position in a single asset or
liability (including a position comprising a large number of identical assets or
liabilities, such as a holding of financial instruments) and the asset or liability is
traded in an active market, the fair value of the asset or liability shall be measured
within Level 1 as the product of the quoted price for the individual asset or liability
and the quantity held by the entity’. [IFRS 13.80]. By dictating that fair value be
determined based on P×Q, IFRS 13 effectively prescribes the unit of account as the
individual asset or liability in these situations.
This requirement is generally accepted when the asset or liability being measured is
a financial instrument in the scope of IFRS 9. However, when an entity holds an
investment in a listed subsidiary, joint venture or associate, some believe the fair
value should include an adjustment (e.g. a control premium) to reflect the value of
the investor’s control, joint control or significant influence over their investment as
a whole. In September 2014, the IASB issued an exposure draft that proposed
clarifying that the requirement in IFRS 13 to use P×Q, without adjustment, to
measure fair value would apply even in situations where the unit of account is the
entire investment. After considering the responses from constituents, the IASB had
directed its staff to perform additional research before they deliberated further.
Following that work the IASB has decided that further research would be fed into
the PIR of IFRS 13.In 2017, the IASB had issued a RFI as part of its PIR of IFRS 13,
which asked for feedback on prioritising level 1 inputs. At the time of writing, the
IASB was concluding its PIR and had decided not to do further work on this topic.
This is discussed further at 5.1.1 above.
18 LEVEL
2
INPUTS
18.1 Level
2
inputs
Level 2 inputs include quoted prices (in non-active markets or in active markets for
similar assets or liabilities), observable inputs other than quoted prices and inputs that
are not directly observable, but are corroborated by observable market data. [IFRS 13.82].
The inclusion of market-corroborated inputs is significant because it expands the scope
of Level 2 inputs beyond those directly observable for the asset or liability. Inputs
determined through mathematical or statistical techniques, such as correlation or
regression, may be categorised as Level 2 if the inputs into, and/(or) the results from,
these techniques can be corroborated with observable market data.
IFRS 13 requires that a Level 2 input be observable (either directly or indirectly through
corroboration with market data) for substantially the full contractual term of the asset
or liability being measured. [IFRS 13.81]. Therefore, a long-term input extrapolated from
short-term observable market data (e.g. a 30-year yield extrapolated from the
observable 5-, 10- and 15-year points on the yield curve) would generally not be
considered a Level 2 input.
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18.2 Examples of Level 2 inputs
IFRS 13’s application guidance provides a number of examples of Level 2 inputs for
specific assets or liabilities. These examples are included in Figure 14.9 below.
Figure 14.9:
Examples of Level 2 inputs [IFRS 13.B35]
Asset or Liability
Example of a Level 2 Input
Receive-fixed, pay-variable The LIBOR swap rate if that rate is observable at commonly quoted
interest rate swap based on
intervals for substantially the full term of the swap.
the London Interbank
Offered Rate (LIBOR)
swap rate
Receive-fixed, pay-
The swap rate based on a yield curve denominated in a foreign currency
variable interest rate
that is observable at commonly quoted intervals for substantially the full
swap based on a yield
term of the swap. This would be a Level 2 input if the term of the swap is
curve denominated in a
10 years and that rate is observable at commonly quoted intervals for
foreign currency
9 years, provided that any reasonable extrapolation of the yield curve for
year 10 would not be significant to the fair value measurement of the
swap in its entirety.
Receive-fixed, pay-
The bank’s prime rate derived through extrapolation if the extrapolated
variable interest rate swap
values are corroborated by observable market data, for example, by
based on a specific bank’s
correlation with an interest rate that is observable over substantially the
prime rate
full term of the swap.
Three-year option on
The implied volatility for the shares derived through extrapolation to
exchange-traded shares
year 3 if both of the following conditions exist:
(i) Prices for one-year and two-year options on the shares are observable.
(ii) The extrapolated implied volatility of a three-year option is corroborated
by observable market data for substantially the full term of the option.
In this situation, the implied volatility could be derived by extrapolating
from the implied vola
tility of the one-year and two-year options on the
shares and corroborated by the implied volatility for three-year options on
comparable entities’ shares, provided that correlation with the one-year
and two-year implied volatilities is established.
Licensing arrangement
For a licensing arrangement that is acquired in a business combination and
was recently negotiated with an unrelated party by the acquired entity (the
party to the licensing arrangement), a Level 2 input would be the royalty
rate in the contract with the unrelated party at inception of the arrangement.
Cash-generating unit
A valuation multiple (e.g. a multiple of earnings or revenue or a similar
performance measure) derived from observable market data, e.g. multiples
derived from prices in observed transactions involving comparable (i.e.
similar) businesses, taking into account operational, market, financial and
non-financial factors.
Finished goods inventory
For finished goods inventory that is acquired in a business combination, a
at a retail outlet
Level 2 input would be either a price to customers in a retail market or a
price to retailers in a wholesale market, adjusted for differences between
the condition and location of the inventory item and the comparable (i.e.
similar) inventory items so that the fair value measurement reflects the
price that would be received in a transaction to sell the inventory to
another retailer that would complete the requisite selling efforts.
Fair value measurement 1061
Conceptually, the fair value measurement will be the same, whether
adjustments are made to a retail price (downward) or to a wholesale price
(upward). Generally, the price that requires the least amount of subjective
adjustments should be used for the fair value measurement.
Building held and used
The price per square metre for the building (a valuation multiple) derived
from observable market data, e.g. multiples derived from prices in observed
transactions involving comparable (i.e. similar) buildings in similar locations.