Comments from ACCA
ACCA (the Association of Chartered Certified Accountants) is pleased to have this opportunity to comment on the exposure draft (ED) on the above subject. The ED was considered by ACCA's Financial Reporting Committee and I am writing to give you their views.
Although the focus of the ED is very much on 'how' to measure fair values, we believe that the question of 'when' fair values should be used is as vital when dealing with the issue of fair value measurement. While this latter question is being addressed by the separate exposure draft, Financial Instruments: Classification and Measurement , many of our concerns raised in this response by their very nature relate back to this issue.
We generally believe that fair value measurement provides a good level of transparency and clarity for most financial transactions and therefore has significant advantages over other measurement bases. In this context we believe it is helpful to have consistent use of the term 'fair value' in IFRS. However, at the same time we do not believe that the proposed narrowing of the definition of fair value to current market exit value is appropriate for measuring the wide range of assets and liabilities where the term fair value is currently used in IFRS. We would prefer either the definition itself to be widened, or a revised, wider concept of current value to be used.
While the ED notes a number of areas where the proposed definition would not be appropriate, we believe that sufficient justification has not been made for a number of other areas in IFRS which currently require fair value measurement which is not based on an exit price. Examples of where the use of fair values in IFRS essentially equate to forms of entry values include
- IFRS3 - where the costs of an acquisition have to be allocated among acquired and recognised assets and liabilities using fair value
- IAS17 - in lease accounting the fair value of the leased asset may be used and this will often be the price if acquired for cash
- IAS16 - fair value is used for non-cash considerations to acquire property or other assets which is again an entry price. This is also the case for revaluations, where IAS16 refers to replacement and therefore entry value. This would mean that specialised plant for instance, being valued at depreciated replacement cost.
In these circumstances some level of flexibility is required to allow for different sorts of current value, appropriate to these different circumstances.
We also have concerns about the reliability of estimates of fair values, as based on Level 3 of the fair value hierarchy, where they are based on markets which are non-existent or thin, and are therefore derived from approximations and hypothetical assumptions. While such estimates are clearly an important mechanism at arriving at a value for such financial assets, we believe that the term fair value suggests a level of precision that is not warranted.
With regards fair value measurement of liabilities, we believe where applicable this should be based on a transfer value as proposed, rather than a settlement value. However, we very much believe that the use of fair values for measuring liabilities is only relevant in limited circumstances, and that the subsequent measurement should not include the effects of changes in own credit risk, again other than for certain types of financial instruments.
Specific questions raised in ED
Definition of fair value and related guidance
The exposure draft proposes defining 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' (an exit price) (see paragraph 1 of the draft IFRS and paragraphs BC15-BC18 of the Basis for Conclusions). This definition is relevant only when fair value is used in IFRSs.
Is this definition appropriate? Why or why not? If not, what would be a better definition and why?
We support the consistent use of the term 'fair value' in IFRS, and accept the proposed new definition of fair value in so far as it is applied to non-operating assets required to be measured at fair value. We agree that by measuring such assets at fair value, an entity should be using an exit price, based on that of a market participant in such circumstances.
In the case of measuring liabilities, if fair value is to represent a market value then it should be a transfer value (as opposed to a settlement value). That said we would expect transfer values to be of very restricted application to the measurement of liabilities. They would not seem appropriate for the measurement of most provisions under IAS37 for instance and may well not be suitable for many claims under insurance contracts either.
As such, we believe that the relevance of fair value measurements to liabilities in IFRS is limited, and therefore should be restricted to for example, traded financial liabilities and derivatives with negative values or contingent liabilities when acquired in a business combination - both of which potentially represent transfers of liabilities. The value, however, of contingent liabilities cannot generally be derived from market values as no such markets exist. In practice these have to be the subjective specific assessments made by the acquirer in the business combination.
Furthermore we have concerns about whether a current exit price model as defined in the ED is appropriate for all measures of fair value, especially many types of non-financial assets such as intangible assets and operating assets. Similarly, we believe it is more appropriate to value business combinations on an expected use basis rather than at market value.
We also believe that using the term fair value, implies a level of precision and therefore added reliability in a set of reported figures. We are not comfortable with the use of such a term, especially where those figures are often based on approximations and hypothetical assumptions, especially where there is not any 'active market'.
In three contexts, IFRSs use the term 'fair value' in a way that does not reflect the Board's intended measurement objective in those contexts:
(a) In two of those contexts, the exposure draft proposes to replace the term 'fair value' (the measurement of share-based payment transactions in IFRS 2 Share-based Payment and reacquired rights in IFRS 3 Business Combinations ) (see paragraph BC29 of the Basis for Conclusions).
(b) The third context is the requirement in paragraph 49 of IAS 39 Financial Instruments: Recognition and Measurement that the fair value of a financial liability with a demand feature is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid (see paragraph 2 of the draft IFRS and paragraph BC29 of the Basis for Conclusions). The exposure draft proposes not to replace that use of the term 'fair value', but instead proposes to exclude that requirement from the scope of the IFRS.
Is the proposed approach to these three issues appropriate? Why or why not?
Should the Board consider similar approaches in any other contexts? If so, in which context and why?
We agree that fair value measurement as defined by the Board in the ED, and the objectives laid out for it, is not suitable for all cases where 'fair value' is currently used in IFRS. In principle we support all the exemptions that are proposed in the ED, including the de-scoping of 'financial instruments with a demand feature' from the future standard.
However, we note that the ED does not give any clear rationale why the proposed fair value measurement and its objectives is appropriate for a number of areas in IFRS, which we believe might not be suitable for the proposed definition. For example, we believe that the narrow notion of fair value defined in the ED may not be appropriate for investment properties, agricultural assets and operating profits in business combinations, and further guidance may be needed in these areas.
The exposure draft proposes that a fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place in the most advantageous market to which the entity has access (see paragraphs 8-12 of the draft IFRS and paragraphs BC37-BC41 of the Basis for Conclusions).
Is this approach appropriate? Why or why not?
Clearly entities are likely (seek to) to use the most advantageous market, and therefore this would mean the market they usually use anyway. We welcome paragraph 10 of the ED, which makes that presumption, such that 'the market in which the entity would normally enter into a transaction for the asset or liability is presumed to be the most advantageous market'. We therefore see no reason why the ED does not explicitly make the 'normal' market for the entity's transactions as the reference market - this would make the identification far simpler.
The exposure draft proposes that an entity should determine fair value using the assumptions that market participants would use in pricing the asset or liability (see paragraphs 13 and 14 of the draft IFRS and paragraphs BC42-BC45 of the Basis for Conclusions).
Is the description of market participants adequately described in the context of the definition? Why or why not?
We agree that an entity should determine fair value using the assumptions that market participants would use in pricing the asset or liability. In principle, we believe that a fair value should represent an estimate of future cash flows that would be made by another market participant (other than the holder of the item), and would therefore not be entity-specific.
We believe it is important to assume that a market participant is 'knowledgeable', and that transactions occur between 'willing parties in an arm's length transaction'. While this was also included in the existing definition, we believe that the notion of a market participant is adequately described in the ED.
Application to assets: higher and BESE use and valuation premise
The exposure draft proposes that:
(a) the fair value of an asset should consider a market participant's ability to generate economic benefit by using the asset or by selling it to another market participant who will use the asset in its highest and best use (see paragraphs 17-19 of the draft IFRS and paragraph BC60 of the Basis for Conclusions).
(b) the highest and best use of an asset establishes the valuation premise, which may be either 'in use' or 'in exchange' (see paragraphs 22 and 23 of the draft IFRS and paragraphs BC56 and BC57 of the Basis for Conclusions).
(c) the notions of highest and best use and valuation premise are not used for financial assets and are not relevant for liabilities (see paragraph 24 of the draft IFRS and paragraphs BC51 and BC52 of the Basis for Conclusions).
Are these proposals appropriate? Why or why not?
We support the proposals, and also agree that the 'in use' valuation premise does not apply to financial assets or liabilities for the reasons stated in the ED.
However, were it still to be applied, we would support the pragmatic approach taken in the ED. Paragraph 18 is quite helpful from a practical perspective, allowing entities to presume that unless there is evidence to suggest otherwise, an entity's current use of an asset is the highest and best use. It could otherwise be quite burdensome and complicated to prove their own use was indeed the highest and best use from a list of alternatives, especially as they may need to consider hypothetical uses for the asset.
When an entity uses an asset together with other assets in a way that differs from the highest and best use of the asset, the exposure draft proposes that the entity should separate the fair value of the asset group into two components: (a) the value of the assets assuming their current use and (b) the amount by which that value differs from the fair value of the assets (ie their incremental value). The entity should recognise the incremental value together with the asset to which it relates (see paragraphs 20 and 21 of the draft IFRS and paragraphs BC54 and BC55 of the Basis for Conclusions).
Is the proposed guidance sufficient and appropriate? If not, why?
We do not believe that the fair value of the asset group should be separated into two components, as this adds complexity without providing useful decision-making information. We would prefer such amounts to be provided via disclosure so that users can understand that the assets are being used at the highest and best use.
We also believe that the guidance is based on an extreme example and do not consider this to be helpful for the majority of circumstances.
Application to liabilities: General principles
The exposure draft proposes that:
(a) a fair value measurement assumes that the liability is transferred to a market participant at the measurement date (see paragraph 25 of the draft IFRS and paragraphs BC67 and BC68 of the Basis for Conclusions).
(b) if there is an active market for transactions between parties who hold a financial instrument as an asset, the observed price in that market represents the fair value of the issuer's liability. An entity adjusts the observed price for the asset for features that are present in the asset but not present in the liability or vice versa (see paragraph 27 of the draft IFRS and paragraph BC72 of the Basis for Conclusions).
(c) if there is no corresponding asset for a liability (eg for a decommissioning liability assumed in a business combination), an entity estimates the price that market participants would demand to assume the liability using present value techniques or other valuation techniques. One of the main inputs to those techniques is an estimate of the cash flows that the entity would incur in fulfilling the obligation, adjusted for any differences between those cash flows and the cash flows that other market participants would incur (see paragraph 28 of the draft IFRS).
Are these proposals appropriate? Why or why not? Are you aware of any circumstances in which the fair value of a liability held by one party is not represented by the fair value of the financial instrument held as an asset by another party?
As mentioned in our response to Question 1, we agree that in those (limited) circumstances where a financial liability is measured using fair value, it should be based on its transfer value, rather than a settlement value.
Intuitively, it seems reasonable that the fair value of a liability should be the same from both the perspective of the holder of the corresponding asset and from the perspective of the issuer of the liability - ie if the entity can settle (perform) the liability simply by acquiring the corresponding asset, the fair value of the corresponding asset would equate to the fair value of the liability.
However, it could be argued that there could be a difference in what market participants' view as fair value depending on whether they hold an entity's liability as an asset, or whether they might assume an entity's liability by transfer - depending on non-performance risk. Indeed, as noted in paragraph BC75 that the fair value of a liability, unlike an asset, is not a function of marketability, but of performance - thus incorporating non-performance risk could mean two different 'fair values' depending on whether they hold a corresponding asset or whether they might take on the liability. Our concerns about using non-performance risk are outlined in our response to Question 8.
We also accept the proposal that present value techniques and similar techniques should be used to estimate the price market participants would demand to assume a liability for which there is no corresponding asset.
While we would also support the use of such techniques to estimate a value where there is a corresponding asset, but no active market for that asset, we again question whether the use of unobservable inputs into such a model, can produce a 'fair' value.
Application to liabilities: non-performance risk and restrictions
The exposure draft proposes that:
(a) the fair value of a liability reflects non-performance risk, ie the risk that an entity will not fulfil the obligation (see paragraphs 29 and 30 of the draft IFRS and paragraphs BC73 and BC74 of the Basis for Conclusions).
(b) the fair value of a liability is not affected by a restriction on an entity's ability to transfer the liability (see paragraph 31 of the draft IFRS and paragraph BC75 of the Basis for Conclusions).
Are these proposals appropriate? Why or why not?
In our comments to the IASB's discussion paper, Credit Risk in Liability Measurement dated 1 September, we accepted that in general, when a liability is first recognised it should be measured by incorporating the price of credit risk inherent in the liability. This reflects the transactions from which they originate as far as possible. Where these are contractual these transaction prices will inevitably reflect and incorporate the counterparty's assessment of the credit risk of entity or the particular instrument.
For other liabilities where there is no immediate transaction from which the consideration received can be derived (including non-contractual liabilities) initial measurement should be at the present value of expected future cash flows, examples being pension obligations and provisions. The discount rates should in principle include the effect of non-performance risk by its incorporation in an incremental borrowing rate for example (among other factors) on the rationale that the entity might have to borrow to pay the liability.
However, we strongly believe that subsequent measures of liabilities should not include any effects of changes in the non-performance risk, other than in the case of derivatives. Our preferred measure for most contractual liabilities is amortised transaction value or released according to the performance of the contract, and therefore including the original credit risk but not including the effect of changes in own credit risk.
Fair value at initial recognition
The exposure draft lists four cases in which the fair value of an asset or liability at initial recognition might differ from the transaction price. An entity would recognise any resulting gain or loss unless the relevant IFRS for the asset or liability requires otherwise. For example, as already required by IAS 39, on initial recognition of a financial instrument, an entity would recognise the difference between the transaction price and the fair value as a gain or loss only if that fair value is evidenced by observable market prices or, when using a valuation technique, solely by observable market data (see paragraphs 36 and 37 of the draft IFRS, paragraphs D27 and D32 of Appendix D and paragraphs BC76-BC79 of the Basis for Conclusions).
Is this proposal appropriate? In which situation(s) would it not be appropriate and why?
As a matter of principle, we have severe reservations about the recognition of profit at inception. However we understand that this gain or loss at issue is an intrinsic part of a current exit value model. We therefore support similar restrictions to those currently in IAS39, whereby the initial gains are limited to those verified by positive evidence (observable inputs) on available information.
The exposure draft proposes guidance on valuation techniques, including specific guidance on markets that are no longer active (see paragraphs 38-55 of the draft IFRS, paragraphs B5-B18 of Appendix B, paragraphs BC80-BC97 of the Basis for Conclusions and paragraphs IE10-IE21 and IE28-IE38 of the draft illustrative examples).
Is this proposed guidance appropriate and sufficient? Why or why not?
We generally support the guidance provided in the ED, as most of the techniques are commonly used in practice.
In terms of the specific guidance on markets that are no longer active, t he ED proposes to align the IASB's application guidance for illiquid markets and distressed transactions with the FASB Staff Position (FSP) issued earlier this year. We believe that the guidance in the ED and the final FSP is essentially in line with the previous guidance issued in the IASB's Expert Advisory Panel Report Using judgement to measure the fair value of financial instruments when markets are no longer active published (October 2008). Indeed, as we noted in our response to the FSP, we believe that the guidance in the IASB's Expert Advisory Panel Report was well laid out and preferable to the FSP approach, in that it took a more principles-based approach. The ED appears to have taken on the more stringent guidance in the FSP, which we fear could not only result in greater inconsistency, but drive preparers to conclude that a market is 'not active' and then use unobservable inputs in fair value measurements.
The exposure draft proposes disclosure requirements to enable users of financial statements to assess the methods and inputs used to develop fair value measurements and, for fair value measurements using significant unobservable inputs (Level 3), the effect of the measurements on profit or loss or other comprehensive income for the period (see paragraphs 56-61 of the draft IFRS and paragraphs BC98-BC106 of the Basis for Conclusions).
Are these proposals appropriate? Why or why not?
In light of the recent financial crisis, we recognise the need for enhanced disclosure requirements and for financial instruments in particular. We therefore generally support the proposals made in the ED, although we believe that they are quite extensive. As such, we believe it is important for preparers to be guided further in terms of only making additional disclosures for material and critical estimations.
Convergence with US GAP
The exposure draft differs from Statement of Financial Accounting Standards No. 157 Fair Value Measurements (SFAS 157) in some respects (see paragraph BC110 of the Basis for Conclusions). The Board believes that these differences result in improvements over SFAS 157.
Do you agree that the approach that the exposure draft proposes for those issues is more appropriate than the approach in SFAS 157? Why or why not? Are there other differences that have not been identified and could result in significant differences in practice?
We believe that overall, although there are differences in some respects from SFAS 157, the proposals in the ED are an improvement.