key difference between Method 1 and Method 2 is where the market risk premium
is captured. However, either method should provide the same fair value
measurement, i.e. where the risk premium is treated should have no effect on
relative fair values.
• Method 1 – the expected cash flows are adjusted for the systematic (market) risk
by subtracting a cash risk premium. This results in risk-adjusted expected cash
flows that represent a certainty-equivalent cash flow. The cash flows are then
discounted at a risk-free interest rate. [IFRS 13.B25].
Because all of the risk factors have been incorporated into the cash flows under
Method 1, the discount rate used would only capture the time value of money. That
is, use of a risk-free discount rate is appropriate when using this technique,
provided that credit risk considerations are not applicable or have already been
considered in the cash flows.
A certainty-equivalent cash flow is an expected cash flow adjusted for risk so that
a market participant is indifferent to trading a certain cash flow for an expected
cash flow. For example, if a market participant was willing to trade an expected
cash flow of CU 1,200 for a cash flow that the market participant is certain to
receive of CU 1,000, the CU 1,000 is the certainty-equivalent of the CU 1,200 (i.e.
the CU 200 would represent the cash risk premium). [IFRS 13.B25].
• Method 2 – adjusts for systematic (market) risk by applying a risk premium to the
risk-free interest rate (i.e. the risk premium is captured in the discount rate). As
such, the discount rate represents an expected rate of return (i.e. the expected rate
associated with probability-weighted cash flows). In Method 2, the expected cash
flows are discounted using this rate. [IFRS 13.B26].
The use of a risk-free discount rate is not appropriate under Method 2,
because the expected cash flows, while probability weighted, do not
represent a certainty-equivalent cash flow. The standard suggests that models
used for pricing risky assets, such as the capital asset pricing model, could be
used to estimate the expected rate of return. As discussed at 21.3 above, the
discount rate used in the discount rate adjustment technique also uses a rate
of return, but it is related to conditional cash flows. A discount rate
determined in accordance with the discount rate adjustment technique is
likely to be higher than the discount rate used in Method 2, which is an
expected rate of return relating to expected or probability-weighted cash
flows. [IFRS 13.B26].
Capturing the risk premium in the cash flows versus the discount rate has no effect on
relative fair values under each method. That is, Method 1 and Method 2 should result in
the same fair value measurement, all else being equal.
1098 Chapter 14
Example 14.32 below illustrates the application of Method 1 and Method 2 when
measuring fair value. [IFRS 13.B27-B29]. The selection of Method 1 or Method 2 will depend
on facts and circumstances specific to the asset or liability being measured, the extent
to which sufficient data are available and the judgements applied. [IFRS 13.B30]. However,
in practice, Method 1 is rarely used because in most cases, to mathematically estimate
the cash certainty adjustment, one must already know the market risk premium that
would be applied to the discount rate under Method 2.
Example 14.32: Expected present value techniques
An asset has expected cash flows of CU 780 in one year determined on the basis of the possible cash flows
and probabilities shown below. The applicable risk-free interest rate for cash flows with a one-year horizon
is 5% and the systematic risk premium for an asset with the same risk profile is 3%.
Probability-weighted
Possible cash flows
Probability
cash flows
CU CU
500 15%
75
800 60%
480
900 25%
225
Expected cash flows
780
In this simple example, the expected cash flows of CU 780 represent the probability-weighted average of the
three possible outcomes. In more realistic situations, there could be many possible outcomes. However, to
apply the expected present value technique, it is not always necessary to take into account distributions of all
possible cash flows using complex models and techniques. Rather, it might be possible to develop a limited
number of discrete scenarios and probabilities that capture the array of possible cash flows. For example, an
entity might use realised cash flows for some relevant past period, adjusted for changes in circumstances
occurring subsequently (e.g. changes in external factors, including economic or market conditions, industry
trends and competition as well as changes in internal factors affecting the entity more specifically), taking
into account the assumptions of market participants.
In theory, the present value (i.e. the fair value) of the asset’s cash flows is the same whether determined using
Method 1 or Method 2, as follows:
(a) Using Method 1, the expected cash flows are adjusted for systematic (i.e. market) risk. In the absence of
market data directly indicating the amount of the risk adjustment, such adjustment could be derived from
an asset pricing model using the concept of certainty equivalents. For example, the risk adjustment (i.e.
the cash risk premium of CU 22) could be determined using the systematic risk premium of 3% (CU 780
– [CU 780 × (1.05/1.08)]), which results in risk-adjusted expected cash flows of CU 758 (CU 780 –
CU 22). The CU 758 is the certainty equivalent of CU 780 and is discounted at the risk-free interest rate
(5%). The present value (i.e. the fair value) of the asset is CU 722 (CU 758/1.05).
(b) Using Method 2, the expected cash flows are not adjusted for systematic (i.e. market) risk. Rather, the
adjustment for that risk is included in the discount rate. Thus, the expected cash flows are discounted at
an expected rate of return of 8% (i.e. the 5% risk-free interest rate plus the 3% systematic risk premium).
The present value (i.e. the fair value) of the asset is CU 722 (CU 780/1.08).
In Example 14.33 below, we have expanded the example from IFRS 13 to include the
discount rate adjustment technique (described at 21.3 above). Example 14.33 shows how
all three techniques converge to the same fair value measurement, while highlighting
the difference in the discount rates applied under each approach.
Fair value measurement 1099
Example 14.33: Comparison of present value techniques
An entity is estimating the fair value of an asset that will expire in one year and has determined that the
probability distribution of the future cash flows is as follows.
Probability-weighted
Possible cash flows
Probability
cash flows
CU CU
500 15%
75
800 60%
480
900 25%
225
Expected cash flows
780
Assume that the risk-free interest rate is 5% and the risk premium is 3%. The table below shows that all three
present value techniques yield identical results:
Certainty-
Certainty-<
br />
Contractual Most likely
Expected equivalent equivalent Discount
Present
Method
cash flows cash flows cash flows adjustment cash flows
rate
value
Discount rate
adjustment
technique
N/A
CU 800
N/A
N/A
N/A
10.8%
CU 722
EPV Method 1 –
Adjust expected
cash flows for
risk premium
N/A
N/A
CU 780
CU (22)
CU 758
5.0%
CU 722
EPV Method 2 –
Adjust discount
rate for risk
premium N/A N/A
CU
780
N/A
N/A
8.0%
CU
722
Method Fair
value
Calculation
Discount rate
CU 722
= Most likely cash flow / (1 + risk-free rate + adjustment for
adjustment
cash flow uncertainty + risk premium)
technique
EPV Method 1
CU 722
= (Expected cash flow – certainty-equivalent adjustment(a)) /
(1 + risk-free rate)
EPV Method 2
CU 722
= Expected cash flow / (1 + risk-free rate + risk premium)
(a) Certainty-equivalent
adjustment
=
Expected cash flow – [Expected cash flow × (1 + risk-free rate) / (1 + risk-free rate + risk premium)]
The three techniques differ in the manner in which the risks in the cash flows are captured, but not the level
of the risk inherent in those cash flows. In the discount rate adjustment technique, the most likely cash flow
(CU 800) is discounted at a rate that reflects all the risk inherent in the investment (i.e. time value of money,
possible variations in the amount of cash flows, risk premium).
Method 1 of the expected present value technique incorporates asset-specific and systematic uncertainty
directly into the cash flows (certainty-equivalent cash flow of CU 758) and therefore uses the risk-free rate
for discounting, as all the risks associated with the investment are incorporated in the cash flows. The
adjustment to the cash flows for systematic risk is based on the 3% risk premium.
Instead of using the risk premium to estimate a certainty-equivalent cash flow, Method 2 of the expected
present value technique incorporates the risk premium in the discount rate. The difference between the
discount rate in Method 1 and Method 2 is the market risk premium.
1100 Chapter 14
22
EFFECTIVE DATE AND TRANSITION
IFRS 13 mandatorily applied to annual periods beginning on or after 1 January 2013.
Entities were permitted to early adopt the standard, provided that fact was disclosed.
[IFRS 13.C1-C2].
The standard applied prospectively from the beginning of the annual period in which it
was initially applied. Assuming an entity had a reporting date of 30 June and did not
early adopt the standard, the date of initial application would have been 1 July 2013. Any
fair value measurements and disclosures (and those based on fair value) that occurred
on or after 1 July 2013 would be measured in accordance with IFRS 13. Any changes to
fair value resulting from the initial application of IFRS 13 would be recognised during
the year to 30 June 2014 in the same way as a change in accounting estimate.
[IFRS 13.BC229].
In the first year of application, disclosures for comparative periods were not required.
Disclosures required by IFRS 13 must be provided for the periods after the date of initial
application. [IFRS 13.C3]. In our example, the entity would have provided the required
disclosures for the year ending 30 June 2014, but need not have disclosed the same
information for the comparative period to 30 June 2013.
23
CONVERGENCE WITH US GAAP
23.1 The development of IFRS 13
IFRS 13 was the result of a convergence project between the IASB and the US Financial
Accounting Standards Board (FASB). However, the Boards began developing their fair
value measurement standards separately. The FASB issued Statement of Financial
Accounting Standards No. 157 – Fair Value Measurements (SFAS 157, now ASC 820)
in 2006. The IASB’s initial discussion paper, issued in 2006, and subsequent exposure
draft, issued in 2009, were developed using the requirements of SFAS 157. However,
the proposed requirements were not wholly consistent with that guidance and
responses from constituents emphasised the need for a common set of requirements
regarding the determination of fair value measurements under both IFRS and US GAAP.
As a result, the Boards began joint discussions in 2010. From the IASB’s perspective, the
project had four main objectives:
• ‘to establish a single set of requirements for all fair value measurements required
or permitted by IFRSs to reduce complexity and improve consistency in their
application, thereby enhancing the comparability of information reported in
financial statements;
• to clarify the definition of fair value and related guidance to communicate the
measurement objective more clearly;
• to enhance disclosures about fair value measurements that will help users of
financial statements assess the valuation techniques and inputs used to develop fair
value measurements; and
• to increase the convergence’ of IFRSs and US GAAP. [IFRS 13.BC6].
Fair value measurement 1101
The Boards’ joint discussions resulted in the issuance of IFRS 13 and ASU 2011-04
(formerly SFAS 157) and created a generally uniform framework for applying fair value
measurement in both IFRS and US GAAP (refer to 23.2 below for further discussion).
IFRS 13 was also part of the IASB’s response to G20 requests in relation to the financial
crisis. Therefore, the disclosures required by the standard are intended to help users
assess the valuation techniques and inputs used to measure fair value. The IASB had
originally proposed to require entities to disclose a quantitative sensitivity analysis for
non-financial assets and liabilities measured at fair value. While the proposed
disclosures were favoured by users and were consistent with the recommendations
from the IASB’s Expert Advisory Panel, the proposals were heavily criticised by
preparers. Their concerns included the additional cost involved. Therefore, the Boards
decided not to include this requirement until additional outreach could be completed.
Until such time that this project is completed, sensitivity disclosures are only required
for financial assets and liabilities (this continues the current disclosure requirements in
IFRS 7). [IFRS 13.BC208]. As part of the PIR of 2017, the board received feedback that
maintaining convergence with US GAAP was important in that it leads to increased
comparability for financial statements globally. This increased comparability is
facilitating efficient capital markets, increased user confidence and reduced compliance
costs. It was also indicated that the convergence has led to more material to be av
ailable
for stakeholders around fair value measurements.25
23.2 US GAAP differences
As noted above, the Boards’ joint fair value measurement project resulted in both the
issuance of IFRS 13 and amendments to particular aspects of ASC 820. These standards
now have a consistent definition of fair value and represent converged guidance in
relation to how to measure fair value. However, some differences still remain. The main
differences are discussed at 23.2.1 to 23.2.4 below.
It is also worth noting that there continue to be differences between IFRS and US GAAP
as to what is measured at fair value, but those differences were outside the scope of the
joint project, which focused on how to measure fair value.
In 2014, the Financial Accounting Foundation issued its post-implementation review of
SFAS 157, concluding that the standard met its intended objectives.26 While agreeing
that a comprehensive review of the fair value guidance was not needed, the FASB noted
that it plans to potentially address more challenging aspects of the standard in the years
ahead.27 In addition, at the time of writing, the FASB was in the process of evaluating
existing fair value disclosure requirements as part of its broader Disclosure Framework
project. The FASB issued an exposure draft for changes to disclosure requirements, but
is currently redeliberating the comments received on exposure draft.28
23.2.1
Practical expedient for alternative investments
ASC 820 provides a practical expedient to measure the fair value of certain investments
in investment companies (e.g. investments in hedge funds or private equity funds that do
not have readily determinable fair values) using net asset value (NAV), without
adjustment.29 Furthermore, in May 2015, the FASB issued ASU 2015-07 – Fair Value
Measurement (Topic 820): Disclosures for Investments in Certain Entities That Calculate
1102 Chapter 14
Net Asset Value per Share (or Its Equivalent), which eliminates the requirement to
categorise in the fair value hierarchy investments measured using the NAV practical
expedient.30 This amendment was effective for public business entities for fiscal years
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 217
