as well as buyers, would consider in pricing the asset or liability, an entity’s conclusion
that it would not sell its own asset (or transfer its own liability) at prices currently
observed in the market does not mean these transactions should be presumed to be
distressed. IFRS 13 makes clear that fair value is a market-based measurement, not an
entity-specific measurement, and notes that the entity’s intention to hold an asset or
liability is not relevant in estimating its fair value. The objective of a fair value
measurement is to estimate the exit price in an orderly transaction between willing
market participants at the measurement date under current market conditions. This
price should include a risk premium that reflects the amount market participants would
require as compensation for bearing any uncertainty inherent in the cash flows, and this
uncertainty (as well as the compensation demanded to assume it) may be affected by
current marketplace conditions. The objective of a fair value measurement does not
change when markets are inactive or in a period of dislocation.
8.3
Estimating fair value when there has been a significant decrease
in the volume and level of activity
Estimating the price at which market participants would be willing to enter into a
transaction if there has been a significant decrease in the volume or level of activity for
the asset or liability will depend on the specific facts and circumstances and will require
judgement. However, the core concepts of the fair value framework continue to apply.
For example, an entity’s intentions regarding the asset or liability, e.g. to sell an asset or
settle a liability, are not relevant when measuring fair value because that would result in
an entity-specific measurement. [IFRS 13.B42].
If there has been a significant decrease in the volume or level of activity for the asset or
liability, it may be appropriate to reconsider the valuation technique being used or to
980 Chapter
14
use multiple valuation techniques, for example, the use of both a market approach and
a present value technique (see 8.3.2 below for further discussion). [IFRS 13.B40].
If quoted prices provided by third parties are used, an entity must evaluate whether
those quoted prices have been developed using current information that reflects orderly
transactions or a valuation technique that reflects market participant assumptions,
including assumptions about risk. This evaluation must take into consideration the
nature of a quote (e.g. whether the quote is an indicative price or a binding offer). In
weighting a quoted price as an input to a fair value measurement, more weight is given
to quotes that reflect the result of actual transactions or those that represent binding
offers. Less weight is given to quotes that are not binding, reflect indicative pricing or
do not reflect the result of transactions.
In some instances, an entity may determine that a transaction or quoted price requires
an adjustment, such as when the price is stale or when the price for a similar asset
requires significant adjustment to make it comparable to the asset being measured.
[IFRS 13.B38]. The impact of these adjustments may be significant to the fair value measure
and, if so, would affect its categorisation in the fair value hierarchy (see 16.2 below for
further discussion on categorisation within the fair value hierarchy).
8.3.1
Assessing the relevance of observable data
While observable prices from inactive markets may not be representative of fair value
in all cases, this data should not be ignored. Instead, paragraphs B38 and B44 of IFRS 13
clarify that additional analysis is required to assess the relevance of the observable data.
[IFRS 13.B38, B44]. The relevance of a quoted price from an inactive market is dependent
on whether the transaction is determined to be orderly. If the observed price is based
on a transaction that is determined to be forced or disorderly, little, if any, weight should
be placed on it compared with other indications of value.
If the quoted price is based on a transaction that is determined to be orderly, this data
point should be considered in the estimation of fair value. However, the relevance of
quoted prices associated with orderly transactions can vary based on factors specific to
the asset or liability being measured and the facts and circumstances surrounding the
price. Some of the factors to be considered include:
• the condition and(or) location of the asset or liability;
• the similarity of the transactions to the asset or liability being measured (e.g.
the extent to which the inputs relate to items that are comparable to the asset
or liability);
• the size of the transactions;
• the volume or level of activity in the markets within which the transactions
are observed;
• the proximity of the transactions to the measurement date; and
• whether the market participants involved in the transaction had access to
information about the asset or liability that is usual and customary.
If the adjustments made to the observable price are significant and based on
unobservable data, the resulting measurement would represent a Level 3 measurement.
Fair value measurement 981
Figure 14.3:
Orderly transactions: measuring fair value and estimating market
risk premiums
Does
analysis indicate
that the observed
transaction is not
orderly?
Cannot
Yes
No
conclude
Take the transaction
Place little weight, if any,
Take the transaction
price into account – its
on the transaction price,
price into consideration,
weighting compared to
compared with other
placing less weight on it,
others would depend on
indications of fair value
compared to prices from
the facts and
orderly transactions
circumstances
8.3.2
Selection and use of valuation techniques when there has been a
significant decrease in volume or level of activity
As discussed above, when activity has significantly decreased for an asset or liability, an
assessment of the relevance of observable market data will be required and adjustments to
observable market data may be warranted. A significant decrease in volume or activity can
also influence which valuation technique(s) are used and how those techniques are applied.
The following example from IFRS 13 highlights some key valuation considerations for
assets that trade in markets that have experienced a significant decrease in volume and
level of activity. [IFRS 13.IE49-58].
Example 14.9: Estimating a market rate of return when there is a significant
decrease in volume or level of activity
Entity A invests in a junior AAA-rated tranche of a residential mortgage-backed security on 1 January 20X8
(the issue date of the security). The junior tranche is the third most senior of a total of seven tranches. The
underlying collateral for the residential mortgage-backed security
is unguaranteed non-conforming residential
mortgage loans that were issued in the second half of 20X6.
At 31 March 20X9 (the measurement date) the junior tranche is now A-rated. This tranche of the residential
mortgage-backed security was previously traded through a brokered market. However, trading volume in that
market was infrequent, with only a few transactions taking place per month from 1 January 20X8 to 30 June
20X8 and little, if any, trading activity during the nine months before 31 March 20X9.
Entity A takes into account the factors in paragraph B37 of the IFRS to determine whether there has been a
significant decrease in the volume or level of activity for the junior tranche of the residential mortgage-backed
security in which it has invested. After evaluating the significance and relevance of the factors, Entity A
concludes that the volume and level of activity of the junior tranche of the residential mortgage-backed
security have significantly decreased. Entity A supported its judgement primarily on the basis that there was
little, if any, trading activity for an extended period before the measurement date.
Because there is little, if any, trading activity to support a valuation technique using a market approach, Entity A
decides to use an income approach using the discount rate adjustment technique described in paragraphs B18-B22 of
the IFRS to measure the fair value of the residential mortgage-backed security at the measurement date. Entity A uses
the contractual cash flows from the residential mortgage-backed security (see also paragraphs 67 and 68 of the IFRS).
982 Chapter
14
Entity A then estimates a discount rate (i.e. a market rate of return) to discount those contractual cash flows.
The market rate of return is estimated using both of the following:
(a) the risk-free rate of interest.
(b) estimated adjustments for differences between the available market data and the junior tranche of the
residential mortgage-backed security in which Entity A has invested. Those adjustments reflect available
market data about expected non-performance and other risks (e.g. default risk, collateral value risk and
liquidity risk) that market participants would take into account when pricing the asset in an orderly
transaction at the measurement date under current market conditions.
Entity A took into account the following information when estimating the adjustments in paragraph IE53(b):
(a) the credit spread for the junior tranche of the residential mortgage-backed security at the issue date as
implied by the original transaction price.
(b) the change in the credit spread implied by any observed transactions from the issue date to the measurement
date for comparable residential mortgage-backed securities or on the basis of relevant indices.
(c) the characteristics of the junior tranche of the residential mortgage-backed security compared with
comparable residential mortgage-backed securities or indices, including all the following:
(i) the quality of the underlying assets, i.e. information about the performance of the underlying
mortgage loans such as delinquency and foreclosure rates, loss experience and prepayment rates;
(ii) the seniority or subordination of the residential mortgage-backed security tranche held; and
(iii) other relevant factors.
(d) relevant reports issued by analysts and rating agencies.
(e) quoted prices from third parties such as brokers or pricing services.
Entity A estimates that one indication of the market rate of return that market participants would use when
pricing the junior tranche of the residential mortgage-backed security is 12 per cent (1,200 basis points). This
market rate of return was estimated as follows:
(a) Begin with 300 basis points for the relevant risk-free rate of interest at 31 March 20X9.
(b) Add 250 basis points for the credit spread over the risk-free rate when the junior tranche was issued in
January 20X8.
(c) Add 700 basis points for the estimated change in the credit spread over the risk-free rate of the junior
tranche between 1 January 20X8 and 31 March 20X9. This estimate was developed on the basis of the
change in the most comparable index available for that time period.
(d) Subtract 50 basis points (net) to adjust for differences between the index used to estimate the change in
credit spreads and the junior tranche. The referenced index consists of subprime mortgage loans, whereas
Entity A’s residential mortgage-backed security consists of similar mortgage loans with a more
favourable credit profile (making it more attractive to market participants). However, the index does not
reflect an appropriate liquidity risk premium for the junior tranche under current market conditions.
Thus, the 50 basis point adjustment is the net of two adjustments:
(i) the first adjustment is a 350 basis point subtraction, which was estimated by comparing the implied
yield from the most recent transactions for the residential mortgage-backed security in June 20X8
with the implied yield in the index price on those same dates. There was no information available
that indicated that the relationship between Entity A’s security and the index has changed.
(ii) the second adjustment is a 300 basis point addition, which is Entity A’s best estimate of the
additional liquidity risk inherent in its security (a cash position) when compared with the index (a
synthetic position). This estimate was derived after taking into account liquidity risk premiums
implied in recent cash transactions for a range of similar securities.
As an additional indication of the market rate of return, Entity A takes into account two recent indicative
quotes (i.e. non-binding quotes) provided by reputable brokers for the junior tranche of the residential
mortgage-backed security that imply yields of 15-17 per cent. Entity A is unable to evaluate the valuation
technique(s) or inputs used to develop the quotes. However, Entity A is able to confirm that the quotes do not
reflect the results of transactions.
Fair value measurement 983
Because Entity A has multiple indications of the market rate of return that market participants would take
into account when measuring fair value, it evaluates and weights the respective indications of the rate of
return, considering the reasonableness of the range indicated by the results.
Entity A concludes that 13 per cent is the point within the range of indications that is most representative of
fair value under current market conditions. Entity A places more weight on the 12 per cent indication (i.e. its
own estimate of the market rate of return) for the following reasons:
(a) Entity A concluded that its own estimate appropriately incorporated the risks (e.g. default risk, collateral
value risk and liquidity risk) that market participants would use when pricing the asset in an orderly
transaction under current market conditions.
(b) The broker quotes were non-binding and did not reflect the results of transactions, and Entity A was
unable to evaluate the valuation technique(s) or inputs used to develop the quotes.
In Example 14.9 above, Entity A uses an income approach (i.e. discount rate adjustment
technique, see 21 below for further discussion regarding present value techniques) to
estimate the fair value of its residential mortgage-backed security (RMBS), because
limited trading activity precluded a market approach as at the measurement date.
&nbs
p; Example 14.9 illustrates that the entity’s use of an income approach does not change the
objective of the fair value measurement, which is a current exit price. Valuation models
should take into account all the factors that market participants would consider when
pricing an asset or liability. The discount rate used by Entity A, for example, tries to
incorporate all of the risks (e.g. liquidity risk, non-performance risk) market participants
would consider in pricing the RMBS under current market conditions. Liquidity, credit
or any other risk factors market participants would consider in pricing the asset or
liability may require adjustments to model values if such factors are not sufficiently
captured in the model.
Entity A prioritises observable inputs (to the extent available) over unobservable
inputs in its application of the income approach. Entity A assesses market-based
data from various sources to estimate the discount rate. For example, the entity
estimates the change in the credit spread of the RMBS since its issuance based on
spread changes observed from the most comparable index, for which trades
continue to occur. Using the best available market information, the entity adjusts
this input to account for differences between the observed index and the RMBS.
These adjustments include the entity’s assessment of the additional liquidity risk
inherent in the RMBS compared to the index.
Paragraph 89 of IFRS 13 indicates that an entity may use its own internal assumptions
when relevant observable market data does not exist. [IFRS 13.89]. However, if reasonably
available data indicates that market participant assumptions would differ, the entity
should adjust its assumptions to incorporate that information. Relevant market data is
not limited to transactions for the identical asset or liability being measured.
In the above example, Entity A is unable to use a market approach because of limited
trading activity for the RMBS. Therefore, Entity A considers implied liquidity risk
premiums from recent transactions for a range of similar securities to estimate the
incremental premium market participants would demand for its RMBS in the current
market (as compared to the benchmark spread). In addition, Entity A considers two
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 193