IFRS 13: Fair Value Measurement#

Definition#

Fair value is 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.

Three ideas in the definition matter:

Exit price: it is the price at which the firm would sell the asset or transfer the liability, not the price at which it bought it or would buy it. The transaction price at inception is often the best evidence of fair value, but it is not by definition the fair value.
Market participants: the assumptions are those that market participants would use, acting in their economic best interest, and not the firm’s own intentions or its own view of the asset.
Orderly transaction: the transaction is not forced or distressed. It is assumed that there is enough time for normal marketing of the asset.

The market#

The measurement assumes a transaction in the principal market for the asset or liability, which is the market with the greatest volume and level of activity. If there is no principal market, it is the most advantageous market, the one that maximises the amount received or minimises the amount paid, after transaction and transport costs. A firm does not have to search every market, and it is presumed that the market it normally uses is the principal one.

Transaction costs are not part of the fair value, but they are taken into account when deciding which market is the most advantageous.

Unit of account#

The unit of account is the level at which the asset or liability is aggregated for recognition, and it comes from the standard that requires the measurement. For a financial instrument, this is generally the individual instrument. IFRS 13 does not allow a block discount, or a premium, for the size of a holding in a Level 1 asset: the price is multiplied by the quantity.

Valuation techniques#

The firm uses the technique that is appropriate in the circumstances and for which enough data is available, and it maximises the use of relevant observable inputs and minimises the use of unobservable ones. There are three approaches:

Valuation approaches#
Approach	Idea	Typical use
Market approach	Uses prices and other information from market transactions in identical or comparable assets.	Quoted securities, matrix pricing of bonds, and comparable company multiples.
Income approach	Converts future amounts, such as cash flows, into a single discounted present value.	Discounted cash flow models, option pricing models and the Monte Carlo methods used for XVA.
Cost approach	The amount that would be required to replace the service capacity of the asset.	Mainly for physical assets, rarely for financial instruments.

The ranking of the inputs to these techniques is the fair-value hierarchy, described in Fair-value hierarchy: Levels 1, 2 and 3.

Points that matter for financial instruments#

High-level valuation bridge#

As a high-level way to think about the measurement, fair value can be presented as a desk mark plus the valuation adjustments needed to arrive at an exit price:

\[\text{Fair value} \approx \text{Desk MTM} + \sum_i \text{recognised valuation adjustment}_i\]

The adjustments are signed: some increase the value and others reduce it. Depending on the instrument and the firm’s valuation policy, they may include a bid-offer or close-out reserve when the desk mark is at mid, model reserves for relevant valuation uncertainty, and XVA such as CVA or DVA. The treatment of funding and capital adjustments, including FVA and KVA, varies.

This is a conceptual bridge, not a universal accounting formula or a prescribed list of reserves. An IPV difference is evidence from a control process, not automatically an adjustment; it may lead to an adjustment when it shows that the mark does not represent fair value. Include only adjustments that are appropriate to the fair-value measurement, avoid double-counting effects already in the desk mark or another adjustment, and apply the relevant accounting policy.

Bid, offer and mid#

Where an input has a bid and an offer price, the fair value is the price within the bid-offer spread that is most representative of fair value in the circumstances. IFRS 13 allows the use of mid-market pricing as a practical expedient, and does not require it. Many firms do take a bid-offer reserve to bring the mid value to the exit price.

Non-performance risk and credit adjustments#

The fair value of a liability assumes it is transferred to a market participant, so it reflects the risk that the obligation will not be fulfilled, including the firm’s own credit risk. The fair value of a derivative asset likewise reflects the counterparty’s credit risk. This is the basis for including CVA and DVA in the fair value of OTC derivatives, as covered in CVA: Credit Valuation Adjustment. IFRS 13 does not mention funding or capital adjustments by name, which is why the treatment of FVA and KVA varies. See FVA: Funding Valuation Adjustment and KVA: Capital Valuation Adjustment.

Portfolio exception#

A firm that manages a group of financial assets and liabilities on the basis of its net exposure to market risk or to credit risk of a counterparty may measure the fair value of the group on a net basis. This is the reason that CVA is calculated at the netting-set level, and not trade by trade. The firm must apply this consistently and must be able to show that it manages the risk this way.

Fair value at initial recognition#

The transaction price is normally the fair value at inception, but where it is not, for example because the deal was done between related parties or under duress, the difference has to be dealt with under the relevant standard. For financial instruments this is the day-one profit or loss rule in IFRS 9: Financial Instruments.

Disclosures#

The disclosure requirements are extensive and scale with the level of the hierarchy. They include:

the fair value measurement at the reporting date, and the level in which it falls
a description of the valuation techniques and the inputs for Level 2 and Level 3
for Level 3, a reconciliation of the opening to the closing balance, and quantitative information about the significant unobservable inputs
a narrative description of the sensitivity of the measurement to the unobservable inputs
the amounts of any transfers between levels, with the reasons and the policy for deciding when they have occurred
for items that are not measured at fair value but for which fair value is disclosed, the level at which it falls

A valuation control view#

IFRS 13 is the standard behind most of the work of the valuation control function:

Exit price and independence: independent price verification tests whether the book value is in line with the price that could be achieved in the market, using independent data and not the desk’s own marks.
Principal market and bid-offer: the choice of market and the use of mid-market pricing are policy decisions that need to be documented and applied consistently. Where mid is used, the bid-offer reserve should reflect the exit price.
Valuation adjustments: CVA, DVA, funding and model adjustments are part of the fair value and are subject to the same governance as the rest of the valuation.
Hierarchy and disclosure: the control framework supplies the evidence for the level of each position and for the Level 3 reconciliations and sensitivities.
Consistency with US GAAP: ASC 820 is largely converged with IFRS 13, so the same IPV framework generally supports both. See US GAAP: How It Differs from IFRS.