Fair value is a market-based measurement that estimates the price at which an orderly transaction to sell an asset or transfer a liability would take place between market participants at the measurement date under the current market conditions.
Compared to historical cost, fair value is a current measure and also an estimate that is derived, and as a result, users of financial statements are interested not only in fair values but in understanding the key drivers of those values.
Organisations usually measure assets and liabilities on their balance sheet using a mix of historical cost and fair value. Historical costs involve the reporting of assets at their original acquisition cost.
Fair value is a market-based measurement that estimates the price at which an orderly transaction to sell an asset or transfer a liability would take place between market participants at the measurement date under the current market conditions.
Compared to historical cost, fair value is a current measure and also an estimate that is derived, and as a result, users of financial statements are interested not only in fair values but in understanding the key drivers of those values.
Today, organisations are grappling with unprecedented levels of uncertainty and should take advantage of the disclosure requirements in financial reporting standards to provide stakeholders with relevant information for decision making.
The IFRS (International Financial Reporting Standard) on fair value measurement and disclosure is IFRS 13. This standard sets out the framework for measuring fair value and the required disclosures. Once fair value measurements have been derived, we will see why the accompanying disclosures are vital.
While each organisation decides on the level of detail necessary to satisfy the disclosure requirements in IFRS 13, organisations should appreciate how the nature of inputs used in the fair value measurements impacts the level of disclosure provided.
There are three different levels of inputs for fair value measurement. Level 1 inputs are quoted prices in an active market, that is readily available and are considered the most reliable evidence of fair value.
An illustration is valuing a portfolio of listed shares on the stock exchange. Level 2 inputs are those other than quoted prices within level 1 that are observable, for example, a valuation multiple of earnings or revenue derived from observable market data.
They could be multiples from prices in observed transactions involving comparable companies. Level 3 inputs are unobservable inputs used in measuring the fair value of an asset or liability, for example, applying the financial forecasts (for example, cash flows or profit or loss) developed using an entity’s data.
From an investor’s perspective, the level of reliance placed on a fair value measurement reduces as organisations move from inputs in level 1 to those in level 3, just as the inputs move from being observable to unobservable.
This is where fair value disclosures become critical. It is expected that the level of disclosure or detail provided by an organisation would increase as the inputs move from level 1 to 3 also.
Information on the valuation technique and the description of the inputs for fair value measurements are required disclosures among others. There are three valuation techniques — the market, income and cost approaches.
Organisations should realise the disservice to their stakeholders by failing to provide adequate fair value disclosures to support their fair value measurements. It will boost the confidence and reliance of stakeholders on the fair value of the assets and liabilities on the balance sheet, which should be the goal of every organisation.
Looking through the eyes of investors, organisations should understand that when fair value measurements are derived using unobservable inputs such as internal management cash flow forecasts that cannot be readily verified, it is critical to provide investors with disclosures on those forecasts and the underlying assumptions.
Unlike observable inputs such as the listed share price on a stock exchange that is easily verifiable by investors, the disclosure requirements for fair value measurements with unobservable level 3 inputs are more when compared to those with observable inputs in levels 1 and 2.
