Fair value measurement (IFRS 13) - Valuation techniques and ...

Learning Outcomes

After reading this article, you will be able to explain how fair value is determined under IFRS 13 using appropriate valuation techniques and hierarchy inputs. You will understand the three main approaches to valuation, the types of inputs used, and how to assess the reliability of fair value measurements for ACCA Financial Reporting (FR). You will also be able to recognise exam pitfalls and apply these concepts in practical scenarios.

ACCA Financial Reporting (FR) Syllabus

For ACCA Financial Reporting (FR), you are required to understand how to measure assets and liabilities at fair value. Specifically, this article will help you prepare for questions on:

• The objective and definition of fair value measurement under IFRS 13
• Selection and application of valuation techniques (market, income, and cost approaches)
• The fair value hierarchy: Levels 1, 2, and 3 inputs
• Classification of inputs as observable or unobservable
• Assessing whether the chosen methods and inputs provide the most reliable measure of fair value

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the main principle behind the fair value hierarchy in IFRS 13?
   1. Preference for inputs based on management estimates
   2. Using prices from active markets for identical items
   3. Always using historical cost unless impractical
   4. Measuring all non-current assets at cost
2. Which of the following is an example of a Level 2 input under IFRS 13?
   1. Quoted price for identical asset in an active market
   2. Quoted price for similar asset in an inactive market
   3. Management forecast of sales
   4. Historical purchase price

3. True or False? Valuation techniques under IFRS 13 must maximise the use of observable market data.

4. Name the three main valuation techniques prescribed by IFRS 13.

Introduction

Fair value is widely used in IFRS Accounting Standards to report the value of assets and liabilities based on current market conditions rather than historical cost. IFRS 13 Fair Value Measurement establishes a framework for measuring fair value, providing guidance on valuation techniques, the use of market inputs, and the prioritisation of evidence based on reliability.

Under IFRS 13, fair value is not a random estimate—it is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date.

Key Term: fair value
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.

Fair Value Measurement: Core Requirements

The Fair Value Objective

IFRS 13 requires entities to measure fair value using assumptions that market participants would use. This standard applies whenever another IFRS states that fair value measurement or disclosure is required.

Valuation techniques must use the best available information and seek to maximise observable data while minimising unobservable information.

Key Term: observable inputs
Inputs developed using market data from independent sources, such as prices or interest rates published for identical or similar assets.

Key Term: unobservable inputs
Inputs that reflect the entity’s own assumptions about what market participants would use, based on the best information available.

Valuation Techniques under IFRS 13

Entities must use one or more of the following techniques, choosing the method(s) most appropriate for the asset or liability and available inputs:

• Market approach: Uses prices from actual market transactions involving identical or comparable assets or liabilities.
• Income approach: Converts future cash flows or income/expenses to a single present value using appropriate discount rates.
• Cost approach: Estimates the amount that would be required to replace the service capacity of an asset (current replacement cost, less obsolescence).

Key Term: market approach
A valuation technique that uses prices and other relevant data from market transactions involving identical or comparable assets or liabilities.

Key Term: income approach
A technique converting future amounts (for example, cash flows or earnings) to a single present value, using discounting.

Key Term: cost approach
A technique estimating the price that would be required to replace the service capacity of an asset (current replacement cost).

Choosing a Technique

The selected technique must result in the most reliable measure of fair value in the circumstances. Entities should use price quotations from orderly transactions, not forced sales or distressed pricing.

Worked Example 1.1

A company owns a piece of specialist equipment. There is no active quoted market for this asset. It could estimate fair value by:

• Adjusting prices of similar equipment sold in a recent, inactive market (market approach)
• Discounting expected cash flows from use and future resale (income approach)
• Estimating the current cost to replace it, less depreciation and obsolescence (cost approach)

Answer:
Any of these approaches can be used, depending on available market data. IFRS 13 requires maximising observable inputs (such as prices of similar assets) and minimising the use of purely internal estimates.

The Fair Value Hierarchy: Inputs and Reliability

A central feature of IFRS 13 is the fair value hierarchy, which ranks inputs into three levels based on observability and reliability:

• Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities at the measurement date.
• Level 2: Inputs other than quoted Level 1 prices that are observable for the asset or liability, either directly or indirectly (e.g., quoted prices for similar items, observable interest rates, yield curves).
• Level 3: Unobservable inputs, used when observable inputs are not available (e.g., internal company data, discounted cash flow projections using unobservable assumptions).

Key Term: Level 1 inputs
Quoted prices (unadjusted) in active markets for identical assets or liabilities, providing the most reliable evidence of fair value.

Key Term: Level 2 inputs
Inputs other than quoted prices included in Level 1 that are observable, such as prices for similar assets or liabilities.

Key Term: Level 3 inputs
Unobservable inputs reflecting the entity's own assumptions about market participant behaviour.

Application and Disclosure

Entities must:

• Prioritise Level 1 inputs wherever possible.
• Use Level 2 for similar assets/liabilities if identical quoted prices are unavailable.
• Only rely on Level 3 inputs when no observable market data is practical to obtain.

Exam Warning A common exam error is to confuse Level 2 and Level 3 inputs. Remember, Level 2 inputs come from observable market data (even if the data is for similar, not identical, items), while Level 3 involves unobservable, entity-specific estimates.

Worked Example 1.2

Brave Ltd holds 200 shares in Tiger Co. Tiger Co's shares are quoted on an active exchange at $5 each.

• What is the fair value and the level of input?

Answer:
Fair value is $1,000 (200 x $5). This is a Level 1 input—the quoted price in an active market for identical items.

Now suppose Brave Ltd also owns a similar unquoted shareholding in Lion Co. The most recent sale of Lion Co shares was at $4.50, in an inactive market. Management adjusts for differences and estimates $4.70 as fair value.

• What level input is this?

Answer:
This is a Level 2 input—it uses observable market data, but not for identical assets, and requires adjustment.

Selecting and Disclosing Inputs

IFRS 13 requires clear documentation and disclosure of:

• The valuation technique(s) applied
• The level of the hierarchy for each input used
• Any changes in technique or inputs compared to previous measurements

If significant unobservable (Level 3) inputs are used, the entity must disclose information about sensitivity to changes in those assumptions.

Worked Example 1.3

Monkey Co values a rare artwork. No quoted market price is available. It uses a discounted cash flow model, assuming annual appreciation and risk based on internal assessment.

• Which level of input and what disclosure is required?

Answer:
This is a Level 3 input—unobservable, entity-specific. Monkey Co must disclose the valuation technique, key assumptions, and the effect of changes in assumptions on the reported value.

Summary

IFRS 13 establishes a consistent, market-based approach for measuring fair value. Valuation techniques should maximise observable inputs and minimise reliance on unobservable ones. The fair value hierarchy ensures that users understand the reliability of reported measurements by classifying inputs as Level 1, 2, or 3.

Key Point Checklist

This article has covered the following key knowledge points:

• Define fair value and explain when IFRS 13 applies
• Identify and describe the three main valuation techniques
• Explain the fair value hierarchy (Levels 1, 2, 3) and classify typical inputs
• State that measurement should maximise observable inputs
• Describe required fair value disclosures regarding techniques and input levels

Key Terms and Concepts

• fair value
• observable inputs
• unobservable inputs
• market approach
• income approach
• cost approach
• Level 1 inputs
• Level 2 inputs
• Level 3 inputs