Views from Hong Kong stakeholders and the Institute on how it is working and ways it could be improved
International Financial Reporting Standard (IFRS) Fair Value Measurement came into force 1 January 2013 and represents a single framework which applies whenever fair value measurements or disclosures are used. Fair value is de ned on the basis of an “exit price” notion and uses a “fair value hierarchy,” which results in a market-based, rather than entity- specific, measurement. The International Accounting Standards Board (IASB) recently conducted a post-implementation review as part of the implementation process, where the Institute contributed its views and the views of stakeholders.
In the view of the Institute, IFRS 13 generally works well. However, the following dif culties were noted:
- Analysing the disclosure of aggregated Level 3 fair value information;
- Applying the highest and best use concept; and
- Determining whether a market is active.
The Institute noted other factors outside of IFRS 13 that affected the usefulness of fair value information and the application of fair values:
- Education on the concept of and need for fair values;
- Shortage of specialized professionals in agriculture business and high quality valuation experts for financial reporting in general; and
- The lack of regulation of the valuation industry for financial reporting and auditor education in auditing valuation estimates.
Usefulness of Level 3 fair value information
Respondents generally considered the information provided about Level 3 fair value measurements, that is those unobservable inputs used to determine the fair value of the asset or liability, to be useful. However, there was agreement that aggregation of the information has affected its usefulness, and that disclosures should be restricted to material assets/liabilities.
There were also divergent views between investors and preparers on the usefulness of Level 3 assets/liabilities reconciliation. With some investors nding the reconciliation provided useful for analysing movements between two financial periods, while preparers questioned the bene ts of providing such reconciliations.
The Institute’s view is that the Level 3 fair value information is useful for providing an understanding of the valuation approach, signi cant unobservable inputs and the “sensitivity to change.” At the same time, there needs to be a good balance of aggregation and disaggregation – as it may be unreasonable to expect excessive disaggregation for businesses that have high volumes of transactions that involve Level 3 fair value measurements.
While the Institute is aware that preparers are providing the required information for all Level 3 assets/ liabilities, the usefulness of the fair value information could be in uenced by the format of presentation. The Institute also thinks that entities are already permitted to not disclose all “required” information under International Accounting Standard (IAS) 1 if it is not material. A possible issue to be addressed is the need for further education/guidance for preparers from the IASB on how to apply the aggregation disclosure requirements appropriately. The Institute does not support adding bright-line materiality threshold to any IFRS.
Suggestions to increase the usefulness of fair value information and suggested disclosure
Investors would nd an average or mean of inputs to be more meaningful and useful than the disclosure of aggregated range of unobservable inputs (e.g. discount rate from 10 percent-30 percent).
Valuation experts and auditors recommended that the IASB provide guidance/examples on what types of investment can be aggregated for disclosure (in addition to those in paragraph 92 of IFRS 13), and examples of key assumptions/inputs which should be disclosed for common types of investments, as there are only limited examples provided in paragraph B36 of IFRS 13. Our stakeholders thought that IFRS 13 should also require:
- Name, company and accreditation details of a company’s valuation expert.
- Reason(s) for specific valuation technique chosen and rationale for the inputs.
- Basis of assumption (e.g. why a specific discount rate is used).
- Reason(s) for change in assumptions between nancial years.
- Significant assumption(s) such as risk factors (e.g. possibility of renewing an operating license), default rate for nancial instruments, volatility of nancial instruments and growth rate for unlisted investments.
- Similar information required under paragraph 93 of IFRS 13 when non-monetary assets are initially recognized at fair value. This would include the information on initial recognition of assets and liabilities as part of acquisition accounting and non-monetary exchange of assets (e.g. disposal of assets/business in exchanges of shares and/or other items).
- Separate line items of unrealized gains/ losses arising from Level 3 valuations, when they are material.
Respondents identified two factors increasing the cost of Level 3 disclosures under IFRS 13. Firstly, additional charges will be imposed by valuers if the quantitative sensitivity analysis on unobservable inputs requires complicated nancial modelling. Secondly, the time and cost in determining key assumptions for disclosure and the justification of inputs as Level 2 or Level 3.
Prioritizing Level 1 inputs or the unit of account
Preparers and auditors we spoke to consider it uncommon to measure at fair value: quoted investment in subsidiaries, joint ventures and associates, and quoted cash-generating units. They also reported that joint ventures and associates are usually measured at cost in company-level nancial statements and equity accounted for in consolidated nancial statements.
However, some auditors considered fair value measurement on those investments to be relevant when assessing purchase price allocation and impairment using the value-in-use model.
Stakeholders considered valuing investments in subsidiaries, joint ventures and associates as a whole better reflects an entity’s investment as it incorporates the prospects of holding the investments. This is because:
- The share price of listed entities with low market capitalization can be high, even though the entities are loss making.
- The share price of a listed entity may be affected by single transactions, such as mergers or acquisitions or disposals with temporary impacts.
- The share price of a listed entity may also re ect the value of the listed shell company, and not its underlying operations.
- Finally, the share price may not re ect the liquidity.
Theoretically, the nature and intention of holding an investment dictates the unit of account, and how the investment is measured. For example, when holding shares for short-term trading it is more appropriate to measure the value of the shares using the price times quantity measure. The Institute maintains its views, as provided in response to IASB ED/2014/4 Measuring Quoted Investments in Subsidiaries, Joint Ventures and Associates at Fair Value that investments should be measured at investment as a whole as held by the entity.
Application of the concept of highest and best use for non-financial assets
Valuations experts and auditors the Institute spoke to said it is challenging to apply the highest and best use concept in jurisdictions that apply land-use-rights, as there may be legal restrictions imposed by governments affecting the land values.
They also thought that the residual value method could produce counter-intuitive result. For example, when a factory is on land valued at HK$5 million, but the highest and best use of the land only is HK$6 million, the result of the analysis would be that the value of the factory is nil and the highest and best use of the land is to knock the factory down.
Some auditors noted there was diversity in how preparers apply the highest and best use assessment, due to the effort required to determine it.
The Institute’s view is that the challenge with the highest and best use concept is whether it should apply to a single or group of assets. There is a merit in providing this information to investors to enable them to assess the management’s stewardship and opportunity costs of holding assets. The IASB should consider the overall costs and bene ts of making these assessments. If retained, the concept and objective should be better explained in the standard.
Applying judgments required for fair value measurements
Most stakeholders found that IFRS 13 had sufficient guidance on whether an input is unobservable. However, they found it challenging to assess whether some markets are active and whether an input is signi cant to the entire measurement.
Valuation experts and auditors consider it subjective to determine whether a market is inactive. Especially regarding thinly-traded or infrequently transacted instruments or the bond market in Hong Kong, where transactions are limited.
One regulator and one preparer reported that it is dif cult to judge whether over-the-counter markets are active and whether the instruments traded should be classi ed as Level 1 or Level 2 investments.
One regulator observed that auditors have used “audit materiality” to determine the signi cance of inputs used in valuations. The materiality threshold may be different in practices, and they would like to see a clari cation in the standard on the de nition of “significant” input.
The Institute’s view is that the concept of an active market is subject to judgment and recommends the IASB provides further education and guidance.
Education on fair value measurement of biological assets and unquoted equity instruments
Responses from valuation experts and auditors considered accounting for biological assets to be a highly specialized area, requiring agriculture experts. It may not be possible for the IASB or IFRS 13 to assist practitioners any further as the challenge faced when valuing biological assets is the availability of suf ciently knowledgeable experts. One valuation expert commented that valuers found it dif cult to assess the quality, quantity, yield and stage of growth of biological assets, requiring agriculture experts to help them verify inputs for valuation.
Some preparers have experienced dif culty in determining the fair value of unquoted equity instruments, due to a lack of available information about privately-held entities.
The Institute’s view is that the IASB must produce guidance to help preparers measure unquoted equity instruments, as the cost exemption is no longer available under IFRS 9.
Effects and convergence of IFRS 13
Valuation experts and auditors do not consider that IFRS disclosure can help assess an entity’s future cash ows as nancial reports are meant to re ect the nancial position at the balance sheet date.
One insurance industry preparer felt that IFRS 13 enhances the comparability of fair value measurements between different reporting periods for an individual entity. However the measurement may not be comparable between different entities, depending on the valuation techniques used.
The Institute’s view is that it is desirable to have converged standards. But at the same time the IASB should prioritize high quality standards, which are understandable, implementable and principle-based rather than compromise the standard for the sake of convergence with United States equivalent standard.
The Institute supports the use of fair values in nancial reporting, as it provides useful information to primary users of nancial reports. However, an accounting standard on its own is not sufficient to ensure that fair value measurements are correctly applied or reported, and so the Institute considers the need for a regulator of the valuation industry.
The IASB should also initiate more education programmes, to help practitioners adjust.
This article is contributed by the Institute’s Standard Setting Department.