Question

On the basis of IFRS 13, explain the fair value hierarchy. Also undertake a review of literature to critically appreciate the assumptions of fair value hierarchy.

Answer 1

International Financial Reporting Standards (IFRS) is a set of accounting standards developed by an independent, not-for-profit organization called the International Accounting Standards Board (IASB). IFRS set common rules so that financial statements can be consistent, transparent and comparable around the world. They specify how companies must maintain and report their accounts, defining types of transactions and other events with financial impact.

IFRS 13 was originally issued in May 2011 and applies to annual periods beginning on or after 1 January 2013. IFRS 13 which is for Fair Value Measurement applies to IFRSs that require or permit fair value measurements or disclosures and provides a single IFRS framework for measuring fair value. It requires disclosures about fair value measurement. It defines fair value on the basis of an 'exit price' notion and uses a 'fair value hierarchy', which results in a market-based measurement rather than entity-specific measurement.

IFRS 13 increases consistency and comparability in fair value measurements and related disclosures through a 'fair value hierarchy'. The hierarchy categorises the inputs used in valuation techniques into three levels. The hierarchy gives the highest priority to (unadjusted) quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. These three levels are Level 1 inputs, Level 2 inputs and Level 3 inputs that can be explained as:

Level 1 inputs

As per IFRS13, Level 1 inputs are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. A quoted market price in an active market provides the most reliable evidence of fair value and is used without adjustment to measure fair value whenever available, with limited exceptions.

Level 2 inputs

As per IFRS13, Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. If the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability. Level 2 inputs would include, for example, quoted prices for similar assets or liabilities.

Level 3 inputs

As per IFRS13, Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs should be used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date.

An entity develops unobservable inputs using the best information available in the circumstances, which might include the entity's own data, taking into account all information about market participant assumptions that is reasonably available.

Critical appraisal of the assumptions of fair value hierarchy:

In fair value hierarchy, fair value measurement of a liability, or the entity’s own equity, assumes that it is transferred to a market participant at the measurement date. In many cases there is no observable market to provide pricing information. In this case, the fair value is based on the perspective of a market participant who holds the identical instrument as an asset. If there is no corresponding asset, then a corresponding valuation technique may be used. This would be the case with a decommissioning activity. Transaction price is not always the best indicator of fair value at recognition because entry and exit prices are conceptually different.

There is also an assumptions that a market participant, acting in their economic best interest, would use IFRS13, when pricing the asset or a liability. The key concept here is that the standard requires your entity to put itself in the place of a market participant and exclude any entity-specific factors that might impact the price that your entity is willing to accept in the sale of an asset or be paid in the transfer of a liability.