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This article was first published in the July/August 2019 International edition of Accounting and Business magazine.

In previous editions, AB has looked at how accounting standards such as IAS 38, Intangible Assets, have failed to adapt to the world of fair value measurement, where they state that intangible assets can only be revalued with reference to an active market.

An active market is one in which transactions take place with sufficient frequency and volume to provide pricing on an ongoing basis, but such markets are uncommon for intangible assets. This means that intangible items are often held at historical cost, with no reflection of a more ‘up-to-date’ value included.

The result of this is that many entities’ internally generated assets go unrecorded, shown as valueless. In the eternal Messi-Ronaldo debate, accountants have long known who is the most valuable. Cristiano Ronaldo is shown at the cost of €115m in the books of Juventus, whereas Lionel Messi is valued at €0 in the books of Barcelona. That may not settle many debates on radio phone-in shows, but it is enough to satisfy the auditors.

The use of fair values has always been contentious in the accounting world. There are some who firmly believe that such figures can be unreliable and even dangerous. Extreme examples such as the 2007 US housing bubble only serve to further this argument.

In 2011, IFRS 13, Fair Value Measurement, was introduced in an attempt to provide further guidance for holding items at fair value. It does not determine when an item is measured at fair value, as this is covered by the applicable rules outlined in other standards, as shown in our Messi-Ronaldo comparison.

IFRS 13 seeks to provide preparers with guidance by defining fair value. If you ask most people what an item’s fair value is, they will probably conclude something along the lines of it being what another party is willing to pay for it. While that is a seemingly sensible response, realistically it falls some way short of the practicalities of how values should be derived in respect of some of the modern, complex instruments held by entities today.

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. In addition, IFRS 13 sets out a framework for measuring fair value and provides guidance on the required disclosures about fair value measurements.

One of the key aspects of IFRS 13 is that it utilises a fair value hierarchy across three levels, as follows:

  • Level 1 inputs. These are the most reliable way to measure fair value. Level 1 inputs are quoted prices in active markets for identical assets or liabilities.
  • Level 2 inputs. These are inputs that can be observed directly or indirectly but are not quoted prices on an active market. This can include quoted prices for similar assets or liabilities, or other inputs that are observable such as interest rates and yield curves.
  • Level 3 inputs. These are unobservable inputs and are therefore the least reliable measurement of fair value. They use the best information available, often utilising valuation techniques or the entity’s own data.

The International Accounting Standards Board (IASB) is in the process of constructing guidance for the development and drafting of future disclosure requirements. As we have written numerous times in the past year, the central theme to the work of the IASB is ‘better communication in financial reporting’. A key part of this is the disclosure project, looking at the problems communicating information in financial statements to users. Part of this process involves testing ideas for guidance on two existing IFRS Standards, one of which is IFRS 13.

Which disclosures to value?

According to IFRS 13, entities must disclose the valuation techniques and inputs used in calculating fair value, which level in the hierarchy the measurements are categorised in and any transfers made between levels. As level 3 inputs carry more subjectivity, much greater disclosures are required with these. This can include amounts recorded in profit or loss (or other comprehensive income), the valuation processes used and an element of sensitivity analysis, particularly regarding the unobservable inputs.

Most users who responded to the IASB were broadly happy with the information they receive, and said that the improvements suggested were not critical. While disclosures could often be lengthy – and a number of users stated that they did not actually examine closely the disclosures – some respondents were nervous about eliminating some of them.

The IASB is finding this a common theme in its testing. While users accept that there is probably a lot of information disclosed that they don’t need, they still often prefer to have the information available. They would support better application of judgment in eliminating information that is not material from the financial statements.

The most common finding among users was that detailed disclosures were only provided for level 3 assets and liabilities. Some users believe that standard-setting could help by requiring additional disclosures for level 2 items similar to those needed in level 3.

Some feel that level 2 is currently a ‘black box’, and that additional information about the inputs, techniques and amounts underlying level 2 would be very useful. Some users noted that level 2 items are often significant for banks. A similar request for additional disclosures in level 2 has arisen in the US, but the Financial Accounting Standards Board heard that such additional disclosures would be extremely costly to prepare.

Almost all users said that a tabular breakdown of specific items within each level of the fair value hierarchy would be useful. This would help them understand the nature and characteristics of items measured at fair value, and provide more information such as a breakdown of which specific types of derivative the entity holds. Many users also said they found it difficult to understand how the entity has assessed which level items belong in, particularly in relation to differentiating between level 2 and level 3 items.

While information is provided about this, it is often a simple duplication of the definitions in IFRS 13. Users believe that an entity-specific explanation, together with the above tabular breakdown, would allow them to better understand the nature and characteristics of the items measured at fair value. It is unlikely that such information would be costly for preparers and users.

The IFRS taxonomy team undertook a comprehensive common practice review of IFRS 13 in 2018. It found a diversity in whether the reported effect is before or after tax. It also found that some entities report absolute changes in inputs and others report relative changes in terms of the sensitivity analysis.

This neatly brings us to the topic of sensitivity analysis, which appears to be a constant theme in relation to the disclosure project. A number of users would like to see a sensitivity analysis that shows the effect on fair value of changing multiple inputs simultaneously.  

Preparers commented that the current level of sensitivity analysis required by IFRS 13 was already costly to prepare and that the provision of further such analyses would require even more effort. Given the lack of appetite previously shown by the IASB for increasing the disclosures around sensitivity analysis, it’s unlikely this will be taken any further.

So in this project, there will not be any changes to whether items can be recognised at fair value or not, meaning Ronaldo is still worth more than Messi.

It appears that the next step will be for the IASB to develop specific disclosure objectives, focusing on what the aims of providing specific information would be.  The IASB will review any information required by either of these standards that cannot be linked to a specific objective, in addition to areas identified through the feedback process, which is not currently covered by existing requirements.

One of the IASB’s concerns is that financial statements contain too much irrelevant information. Part of the disclosure project was to see if the clutter could be reduced. In fact, from the initial feedback, it seems users would like more entity-specific information. The project may not take the direction initially expected.

Adam Deller is a financial reporting specialist and lecturer.