An overview of the key concepts and practical guidance for SFRS 113 Fair Value Measurement including valuation techniques
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For many years, preparers of financial statements have grappled with the issues associated with measuring fair value because several financial reporting standards require (or permit) reporting entities to measure (or disclose) assets or liabilities at fair value. Singapore FRS 113 Fair Value Measurement (SFRS 113) was issued to provide guidance about how to measure fair value and information to be disclosed.
As this standard is to be applied prospectively for annual periods on or after 1 January 2013, Singapore entities presenting financial statements from 2014 onwards will be affected.
SFRS 113 establishes how to measure fair value. It does not address which assets or liabilities to measure at fair value, or when it must be performed.
The reporting entity must look to other financial standards in this regard.
This article is not intended to address comprehensively all of the detailed requirements of this standard, but rather to provide an overview of the key concepts and practical guidance.
SFRS 113 applies whenever another financial reporting standard requires (or permits) the measurement of fair value, including a measure that is based on fair value, i.e. fair value less cost.
For example, SFRS 103 Business Combinations requires identifiable assets acquired and liabilities assumed to be measured at fair value for purchase price allocation. Investment properties are to be measured at fair value at each reporting date under SFRS 40 Investment Property.
However, this standard does not apply to share-based payment and leasing transactions. Also, measurements that are similar to fair value, but are not fair value (such as net realisable value in SFRS 2 Inventories or value in use in SFRS 36 Impairment of Assets) are not applicable.
The term ‘fair value’ is used throughout FRS. Given that there are few scope exclusions, this standard is pervasive.
Definition of fair value
Fair value is defined 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’.
Fair value is a current exit price, not an entry price (see diagram, above).
The exit price for an asset (or liability) is conceptually different from its transaction price (or entry price). While the exit and entry price may be identical in many situations, the transaction price is not presumed to represent fair value. For example, the last transacted price for a thinly traded quoted investment may not reflect fair value.
The exit price objective of a fair value measurement applies regardless of the reporting entity’s intent and/or ability to sell the asset (or transfer the liability). Fair value is the exit price in the principal market, or in the absence, the most advantageous market.
Fair value is not based on how much an entity has to pay to settle a liability.
Instead, it should be based on how much the reporting entity has to pay a market participant who is willing to take over the liability.
The transaction to sell the asset (or transfer the liability) is assumed to be orderly between market participants under normal current market conditions. Information that becomes known after measurement date is not normally taken into account.
Market participants are buyers and sellers in the principal (or most advantageous) market who are: (i) independent of each other; (ii) knowledgeable about the asset or liability; and (iii) able and willing to enter into a transaction for the asset or liability.
In other words, fair value is a market-based measurement, not an entity-specific measurement. For example, synergies available to a specific buyer are not considered in the valuation of an interest in an unquoted investment.
Fair value framework
Many of the key components used in the fair value framework are interrelated and their interaction should be considered holistically. The overall process for determining fair value under SFRS 113 may be illustrated by the diagram above.
In practice, navigating the fair value framework may be more straightforward for certain types of assets (e.g. quoted investments) than for others (e.g. intangible assets).
The unit of account defines what is being measured for financial reporting and this is normally determined by the applicable financial reporting standard. Fair value may need to be measured for either a standalone asset (or liability) or a group of assets (or liabilities), i.e. a cash-generating unit.
For example, a reporting entity that manages a group of financial assets and financial liabilities with offsetting risks on the basis of its net exposure to market may elect to measure the group based on the price that would be received to sell its net long position.
The principal market is the market for the asset (or liability) that has the greatest volume or level of activity. To determine the principal market, management needs to evaluate the level of activity in various markets. The market in which an entity normally transacts is presumed to be the principal market.
In the absence of a principal market, management needs to identity the most advantageous market, which is one that maximises the amount that would be received to sell the asset, after taking into account transaction costs and transport costs.
The standard is clear that, if there is a principal market for the asset (or liability), the price in that market represents fair value. The standard prohibits adjusting fair value for transaction costs incurred, but it does require such transaction costs to be considered in determining the most advantageous market. For example, agent’s commission, legal fees and stamp duty are not deducted from the price used to fair value real estate.
There may be no known or observable market for an asset or liability. For example, there may be no specific market for the sale of a CGU or intangible asset. In such cases, management needs to develop a hypothetical market and identify potential market participants.
The concepts of ‘highest and best use’ and ‘valuation premise’ are only applicable when determining the fair value of non-financial assets e.g. property, plant and equipment.
The fair value hierarchy categorises the inputs used into three levels. A reporting entity is required to maximise the use of Level 1 inputs (i.e. unadjusted prices in active markets, like stock price quoted on SGX) and minimise the use of Level 3 inputs (i.e. unobservable assumptions like projected cashflows). The best indication of fair value is a quoted price in an active market. This categorisation is relevant for disclosure purposes.
While the availability of inputs might affect the valuation techniques selected to measure fair value, the standard does
not prioritise the use of one valuation approach over another.
Three valuation approaches are widely used to measure fair value, namely the market approach, the income approach and the cost approach.
Market approach: The market approach is a widely used valuation technique and is defined as ‘uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities’.
Valuation techniques consistent with the market approach use prices from observed transactions for the same or similar assets e.g. P/E and P/EBIDTA multiples. Another example of a market approach is matrix pricing, which is normally used to value certain types of financial instruments e.g. debt securities estimated using transaction prices and other relevant market information like coupon, maturity and credit rating.
Income approach: The income approach converts future cashflows or income and expenses to a discounted amount. A fair value using this approach will reflect current market expectations about future cashflows or income and expenses.
Valuation techniques include:
- Present value techniques e.g. discount rate adjustment rate technique and expected present value technique
- Options pricing models e.g. Black-Scholes-Merton
- Multi-period excess earnings method
- Relief from royalties method
The standard does not limit the valuation techniques that are consistent with the income approaches. It provides some application guidance, but only in relation to present value techniques.
Cost approach: The cost approach reflects the amount that would be required currently to replace the service capacity of an asset. This approach is often referred to as current replacement cost and is typically used to measure the fair value of tangible assets such as plant and equipment.
From the perspective of a market participant seller, the price that would be received for the asset is based on the cost to a market participant buyer to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence.
Obsolescence is broader than depreciation and encompasses:
- Physical deterioration
- Functional/technological obsolescence
- Economic obsolescence
These three approaches are consistent with generally accepted valuation methodologies used outside financial reporting.
The determination of the appropriate technique(s) to be applied requires significant judgment, sufficient knowledge of the asset (or liability) and an adequate level of expertise regarding valuation techniques. Within a given approach, there may be a number of possible valuation methods.
For instance, there are a number of different methods used to value intangible assets under the income approach, namely the multi-period excess earnings method and the relief from royalty method, depending on the nature of the asset.
Selection, application and evaluation of the valuation techniques can be complex. As such, the reporting entity may need assistance from valuation professionals.
Regardless of the valuation technique(s) used, the objective of a fair value measurement remains the same, that is, an exit price under current market conditions from the perspectives of market participants.
Premiums and discounts
In certain instances, selection of inputs could result in a premium or discount being incorporated into the fair value measurement. The standard distinguishes between premiums or discounts that reflect size as a characteristic (especially blockage factor), control premium/discount for minority interest and discount for lack of marketability.
The standard explicitly prohibits the consideration of blockage discounts in fair value measurement. Blockage discount is an adjustment to the quoted price of an asset because the market’s normal trading volume is not sufficient to absorb the quantity held by a reporting entity.
When measuring the fair value of interest in private business, control premium/discount for minority interest and discount for lack of marketability can be taken into consideration.
Fair value of a liability
SFRS 113 applies to liabilities, both financial (e.g. debt obligation) and non-financial (e.g. decommissioning liability), whenever a standard requires those instruments to be measured at fair value. For example, in accordance with FRS 103 Business Combination, management needs to determine the fair value of liabilities assumed when contemplating a purchase price allocation.
The fair value measurement of a liability contemplates the transfer of the liability to a market participant at the measurement date. The liability is assumed to continue (i.e. it is not settled or extinguished), and the market participant to whom the liability is transferred would be required to fulfil the obligation.
The fair value of a liability also reflects the effect of non-performance risk.
Non-performance risk is the risk that an obligation will not be fulfilled and includes the reporting entity’s own credit risk and other risks such as settlement risk.
For example, there is no observable price available for a decommissioning liability. Hence, the reporting entity might consider the future cash outflows that a market participant would expect to incur in fulfilling the obligation, discounted at a rate, which reflects the risk-free rate and risk premium to reflect its credit risk, i.e. a present value technique.
SFRS 113 provides a framework to estimating fair value. It is intended to reduce inconsistencies and increase comparability in fair value measurements used in financial reporting. However, it does not provide specific rules or detailed ‘how to’ guidance. Hence, judgment is involved in estimating fair value.
The effect of applying this standard is likely to vary from entity to entity.
In most cases, it will lead to a refinement of previous practice. However, in some cases, the change may be more significant. For example, if a reporting entity did not consider the highest and best use when revaluing its plant and equipment, adopting this standard could result in a higher fair value than it would have previously determined.
Ong Woon Pheng is a partner at CAS Consultants Pte Ltd heading the financial advisory services department.