and the compensation market participants would require for this uncertainty.
21.2.2
Risk and uncertainty in a present value technique
At its core, the concept of value measures expected rewards against the risks of realising
those rewards. Present value techniques implicitly contain uncertainty as they generally
deal with estimates rather than known amounts. In many cases, both the amount and
timing of the cash flows are uncertain. The standard notes that even contractually fixed
amounts are uncertain if there is risk of default. [IFRS 13.B15].
Market participants generally require compensation for taking on the uncertainty inherent
in the cash flows of an asset or a liability. This compensation is known as a risk premium.
IFRS 13 states that in order to faithfully represent fair value, a present value technique should
include a risk premium. The standard acknowledges that determining the appropriate risk
premium might be difficult. However, the degree of difficulty alone is not a sufficient reason
to exclude a risk premium if market participants would demand one. [IFRS 13.B16].
Depending on the present value technique used, risk may be incorporated in the cash
flows or in the discount rate. However, identical risks should not be captured in both
the cash flows and the discount rate in the same valuation analysis. For example, if the
probability of default and loss given default for a liability are already incorporated in the
discount rate (i.e. a risk-adjusted discount rate), the projected cash flows should not be
further adjusted for the expected losses.
The present value techniques discussed in the application guidance to IFRS 13 differ in
how they adjust for risk and in the type of cash flows they use.
• The discount rate adjustment technique uses a risk-adjusted discount rate and
contractual, promised or most likely cash flows (see 21.3 below).
• Method 1 of the expected present value technique uses cash certain equivalent
cash flows and a risk-free rate (see 21.4 below).
• Method 2 of the expected present value technique uses expected cash flows that
are not risk-adjusted and a discount rate adjusted to include the risk premium that
market participants require. That rate is different from the rate used in the discount
rate adjustment technique (see 21.4 below). [IFRS 13.B17].
Fair value measurement 1093
If the risks are accounted for fully and appropriately, the three present value techniques
noted above should all produce an identical fair value measurement, regardless of
whether risk is captured in the cash flows or the discount rate (see 21.4.1 below for a
numerical example illustrating this point).
21.3 Discount rate adjustment technique
The discount rate adjustment technique attempts to capture all of the risk associated with
the item being measured in the discount rate and is most commonly used to value assets
and liabilities with contractual payments, such as debt instruments. This technique uses a
single set of cash flows from the range of possible estimated amounts and discounts those
cash flows using a rate that reflects all of the risk related to the cash flows.
According to the standard, the cash flows may be contractual or promised or the most
likely cash flows. In all cases, those cash flows are conditional upon the occurrence of
specified events. For example, contractual or promised cash flows for a bond are
conditional on the event of no default by the debtor. [IFRS 13.B18].
The discount rate is derived from observable rates of return for comparable assets and
liabilities that are traded in the market and incorporates the following:
• the risk-free interest rate;
• market participants’ expectations about possible variations in the amount or timing
of the cash flows;
• the price for bearing the uncertainty inherent in these cash flows (or risk premium);
and
• other risk factors specific to the asset or liability.
As such, under this technique the cash flows are discounted at an observed or estimated
market rate appropriate for such conditional cash flows (that is, a market rate of return).
The discount rate adjustment technique requires an analysis of market data for
comparable assets or liabilities. Comparability is established by considering:
• the nature of the cash flows – for example, whether the cash flows are contractual
or non-contractual and whether the cash flows are likely to respond similarly to
changes in economic conditions; and
• other factors, such as credit standing, collateral, duration, restrictive covenants and
liquidity. [IFRS 13.B19].
Alternatively, if a single comparable asset or liability does not fairly reflect the risk
inherent in the cash flows of the asset or liability being measured, it may be possible to
derive a discount rate using a ‘build-up’ approach. That is, the entity should use data for
several comparable assets or liabilities in conjunction with the risk-free yield curve.
Example 14.31 at 21.3.1 below illustrates this further.
If the discount rate adjustment technique is applied to fixed receipts or payments, the
adjustment for any risk inherent in the cash flows is included in the discount rate. In
some applications of the discount rate adjustment technique to cash flows that are not
fixed receipts or payments, an entity may need to make an adjustment to the cash flows
to achieve comparability with the observed asset or liability from which the discount
rate is derived. [IFRS 13.B22].
1094 Chapter 14
Although IFRS 13 does not prescribe when a particular present value technique should
be used, the extent of market data available for a particular type of asset or liability will
influence when use of the discount rate adjustment technique is appropriate.
Paragraph B19 of IFRS 13 states that the ‘discount rate adjustment technique requires an
analysis of market data for comparable assets or liabilities’. [IFRS 13.B19]. Therefore,
certain assets and liabilities may not lend themselves to the use of the discount rate
adjustment technique, even though it may be possible to derive discount rates using
market data from several comparable items when no single observable rate of return
reflects the risk inherent in the item being measured.
The most challenging aspect of applying this technique is the identification of market
observable rates of return that appropriately capture the risk inherent in the asset or
liability being measured. Understanding the various risk factors associated with certain
types of assets and liabilities is not always easy, and quantifying the effect of these
factors is even more difficult. However, it may be helpful to deconstruct a discount rate
into its component parts to understand what risks are being considered; beginning with
the risk-free rate, which represents the time value of money. In addition to the risk-free
rate, entities should consider credit or non-performance risk, if the subject asset or
liability requires performance in the future (including, but not limited to, a cash
payment). For example, in the case of a financial asset, the discount rate would include
compensation required by market participants to assume the risk that the counterparty
will be unable to fulfil its obligation. Not all discount rates require an explicit adjustment
for credit (or non-performance) risk. Equity interests, for example, may assume
perpetual residual cash flows from the operations of a business, rather than a contractual
future payment. In this case, an additional component of risk is captured through an
equity risk premium, instead of a credit risk adjustment. The long-term incremental rate
of return of equity interests over long-term risk-free interest rates may generally
represent an identifiable component of risk.
When applying the discount rate adjustment technique, the credit spread (above the
risk-free rate) will implicitly include assumptions about probabilities of default and
losses given default without requiring an adjustment to the projected cash flows used in
the analysis. However, a credit adjusted risk-free rate may not sufficiently capture all
the risk related to the subject asset or liability. Depending on facts and circumstances of
the item being measured, the observable rate of return should also capture other
potential variability with respect to the timing and amount of the cash flows (e.g.
potential variability due to prepayment risk for financial instruments such as mortgage
backed securities) and the price for bearing such uncertainty (risk premium).
In addition, when assessing discount rates, it is important to keep in mind the exit price
objective of a fair value measurement in IFRS 13. Because the discount rate represents the
rate of return required by market participants in the current market, it should also
incorporate factors such as illiquidity and the current risk appetite of market participants.
21.3.1
Illustrative example of the discount rate adjustment technique
The following example from IFRS 13 illustrates how a build-up approach is applied
when using the discount rate adjustment technique. [IFRS 13.B20-21].
Fair value measurement 1095
Example 14.31: Discount rate adjustment technique
Assume that Asset A is a contractual right to receive CU 800 in one year (i.e. there is no timing uncertainty).
There is an established market for comparable assets, and information about those assets, including price
information, is available. Of those comparable assets:
Asset B is a contractual right to receive CU 1,200 in one year and has a market price of CU 1,083. Therefore,
the implied annual rate of return (i.e. a one-year market rate of return) is 10.8% [(CU 1,200/CU1,083) – 1].
Asset C is a contractual right to receive CU 700 in two years and has a market price of CU 566. Therefore,
the implied annual rate of return (i.e. a two-year market rate of return) is 11.2% [(CU 700/CU 566)^0.5 – 1].
All three assets are comparable with respect to risk (i.e. dispersion of possible pay-offs and credit).
(i) Comparability based nature of the cash flows and other factors
On the basis of the timing of the contractual payments to be received for Asset A relative to the timing for
Asset B and Asset C (i.e. one year for Asset B versus two years for Asset C), Asset B is deemed more
comparable to Asset A. Using the contractual payment to be received for Asset A (CU 800) and the one-
year market rate derived from Asset B (10.8%), the fair value of Asset A is CU 722 (CU 800/1.108).
(ii) Using the build-up approach
In the absence of available market information for Asset B, the one-year market rate could be derived
from Asset C using the build-up approach. In that case the two-year market rate indicated by Asset C
(11.2%) would be adjusted to a one-year market rate using the term structure of the risk-free yield curve.
Additional information and analysis might be required to determine whether the risk premiums for one-
year and two-year assets are the same. If it is determined that the risk premiums for one-year and two-
year assets are not the same, the two-year market rate of return would be further adjusted for that effect.
As evidenced in the example above, using a build-up approach requires that market data
for comparable assets be available. In addition, when applying the build-up approach,
significant judgement may be required in determining comparability between the item
being measured and the available benchmarks, as well as quantifying the appropriate
adjustments necessary to account for any differences that may exist between the item
being measured and the applicable benchmark (e.g. differences in credit risks, nature
and timing of the cash flows, etc.).
21.4 Expected present value technique
The expected present value technique is typically used in the valuation of business
entities, assets and liabilities with contingent or conditional payouts and items for which
discount rates cannot be readily implied from observable transactions.
This technique uses, as a starting point, a set of cash flows that represent the probability-
weighted average of all possible future cash flows (i.e. the expected cash flows). Unlike
the cash flows used in the discount rate adjustment technique (i.e. contractual, promised
or most likely amounts), expectations about possible variations in the amount and/or
timing of the cash flows are explicitly incorporated in the projection of the expected
cash flows themselves, rather than solely in the discount rate. [IFRS 13.B23].
The application guidance in IFRS 13 identifies two types of risk, based on portfolio theory:
(a) unsystematic (diversifiable) risk – the risk specific to a particular asset or liability;
and
(b) systematic (non-diversifiable) risk – the common risk shared by an asset or a
liability with the other items in a diversified portfolio (i.e. market risk). [IFRS 13.B24].
1096 Chapter 14
According to portfolio theory, in a market in equilibrium, market participants will be
compensated only for bearing the systematic risk inherent in the cash flows. If the
market is inefficient or is out of equilibrium, other forms of return or compensation
might be available.
While, in theory, all possible future cash flows are meant to be considered, in practice,
a discrete number of scenarios are often used to capture the probability distribution of
potential cash flows.
• The number of possible outcomes to be considered will generally depend on the
characteristics of the specific asset or liability being measured. For example, the
outcome of a contingency may be binary, therefore, only two possible outcomes
need be considered. In contrast, certain complex financial instruments are valued
using option pricing models, such as Monte Carlo simulations, that generate
thousands of possible outcomes.
• Estimating the probability distribution of potential outcomes requires judgement
and will depend on the nature of the item being measured.
Assuming the entity’s use of the asset is consistent with that of market participants, an
entity might look to its own historical performance, current and expected market
environments (including expectations of volatility) and budgetary considerations to
develop expectations about future cash flows and appropriate weightings. However, as
discussed at 19.1 above, the use of an entity’s own data can only be a starting point when
measuring fair value. Adjustments may be needed to ensure that the measurement is
consistent wi
th market participant assumptions. For example, synergies that can be
realised by the entity should not be considered unless they would similarly be realised
by market participants.
The concept of a risk premium is just as important under an expected present value
technique as it is under the discount rate adjustment technique. The use of
probability-weighted cash flows under an expected present value technique does
not remove the need to consider a market risk premium when estimating fair value.
While ‘expected cash flows’ capture the uncertainty in the amount and timing of the
future cash flows, the probability weighting does not include the compensation
market participants would demand for bearing this uncertainty. For example,
assume Asset A is a contractual right to receive CU 10,000. Asset B has a payout that
is conditional upon the toss of a coin: if ‘heads’, Asset B pays CU 20,000; and if ‘tails’
it pays nothing. Assuming no risk of default, both assets have an expected value of
CU 10,000 (i.e. CU 10,000 × 100% for Asset A, and CU 20,000 × 50% + CU 0 × 50%
for Asset B). However, risk-averse market participants would find Asset A more
valuable than Asset B, as the cash-certain payout of CU 10,000 for Asset A is less
risky than the expected cash flow of CU 10,000 for Asset B.
Although the variability in the cash flows of Asset B has been appropriately captured by
probability-weighting all the possible cash flows (i.e. there is no subjectivity involved in
the determination of the probability weighting in the simplified example since the
payout is based on a coin toss), Asset B’s expected value does not capture the
compensation market participants would require for bearing the uncertainty in the cash
flows. As such, all else being equal, the price for Asset B would be lower than the price
Fair value measurement 1097
for Asset A. That is, the required rate of return for Asset B would be higher than that for
Asset A, in order to compensate the holder for the incremental risk in Asset B’s cash
flows (relative to Asset A).
21.4.1
Expected present value technique – method 1 and method 2
The standard describes two methods of the expected present value technique. The
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 216
