IFRS 13 Fair Valuation Techniques Simplified

Welcome to the 10th Edition....

Let's keep going! Today's topic is about "Fair Value" Under Accounting Standards and specifically IFRS. So without further ado, let's deep dive into it.

I have also published 4 other articles on IFRS 9, you can check them out as well.

In today's newsletter, we will be discussing the fair valuation concept under IFRS 13. Fair value is a crucial component of financial reporting as it provides a reliable measure of the value of an asset or liability.

• IFRS 13 defines fair value as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date". This definition emphasizes the importance of market participants and assumes that the transaction would occur in an orderly manner.
• Under IFRS 9, fair value is used to measure financial assets and liabilities at initial recognition and subsequently for certain categories of financial assets. IFRS 9 classifies financial instruments into three categories: amortized cost, fair value through profit or loss (FVTPL), and fair value through other comprehensive income (FVOCI). The fair value of financial assets and liabilities is determined using relevant market prices, such as quoted market prices in active markets (Level 1), inputs other than quoted prices that are observable for the asset or liability (Level 2), or unobservable inputs (Level 3).
• IFRS 7 requires entities to disclose the fair value of financial instruments measured using either Level 1, Level 2, or Level 3 inputs. The level of fair value measurement is based on the inputs used in determining the fair value of the financial instrument. Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Level 2 inputs are inputs other than quoted prices that are observable for the asset or liability, such as market data from similar transactions. Level 3 inputs are unobservable inputs, such as internal models used by the entity.
• To determine the level of fair value measurement, entities must consider the nature of the financial instrument and the availability and reliability of inputs used in the valuation process. The use of internal models and unobservable inputs (Level 3) requires greater scrutiny and disclosure in financial statements.
• In order to determine the fair value of financial instruments, various valuation techniques can be used, such as discounted cash flow analysis, market approach, or income approach. The selection of the appropriate valuation technique depends on the nature of the financial instrument being valued and the availability of relevant market data.
• In conclusion, fair value is a crucial concept in financial reporting under IFRS 9, IFRS 7, and IFRS 13. It provides a reliable measure of the value of an asset or liability, and the level of fair value measurement is determined based on the inputs used in the valuation process. Entities must carefully consider the nature of the financial instrument and the availability and reliability of inputs used in the valuation process to ensure the fair value is accurately reported in financial statements.

Example Of How To Fair Value An Interest Rate Swap

Let's say that Company A has entered into an interest rate swap agreement with Company B. The interest rate swap agreement stipulates that Company A will pay Company B a fixed interest rate of 3% per annum on a notional amount of $10 million, while Company B will pay Company A a floating interest rate based on the 3-month USD-LIBOR rate. The interest rate swap has a remaining term of 2 years.

To determine the fair value of the interest rate swap, Company A would need to follow the fair value hierarchy under IFRS 13, which involves three levels of inputs:

Level 1 inputs: These are quoted prices for identical assets or liabilities in active markets. In this case, there is no active market for the interest rate swap, so level 1 inputs are not applicable.

Level 2 inputs: These are inputs other than quoted prices included within level 1 that are observable for the asset or liability, either directly or indirectly. In this case, the 3-month USD-LIBOR rate is an observable input that can be used to value the floating leg of the interest rate swap. Company A would need to obtain the latest 3-month USD-LIBOR rate from a reputable financial data provider and use this rate to calculate the present value of the floating leg cash flows.

Level 3 inputs: These are inputs for the asset or liability that are unobservable, such as assumptions about future cash flows or discount rates. In this case, the fixed interest rate of 3% per annum is unobservable and would need to be estimated based on market data for similar instruments. Company A could use information from broker quotes or other sources to estimate the fair value of the fixed leg of the interest rate swap. Where there is a trade confirmation for the swap, the confirmation would already have it written the fixed rate that is part of the transaction.

Once Company A has gathered all the necessary inputs, it can calculate the fair value of the interest rate swap by discounting the expected future cash flows using the appropriate discount rate. For example, if the estimated fair value of the fixed leg of the swap is $8 million and the present value of the floating leg cash flows is $7 million, the fair value of the interest rate swap would be $1 million.

It's important to note that the fair value of the interest rate swap may fluctuate over time due to changes in market conditions, such as changes in interest rates. Therefore, it's important for Company A to regularly monitor and update the fair value of the interest rate swap in accordance with IFRS 13.

Thank you for reading today's newsletter. See you in the next newsletter :)

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