IFRS 13 establishes a fair value hierarchy to increase consistency and comparability in fair value measurements. This hierarchy sorts the inputs used in valuation techniques into three distinct levels:
If multiple levels of inputs are used in determining fair value, the classification is determined by the lowest level input that is significant to the entire measurement (IFRS 13.72-75).
Level 1 inputs
Level 1 inputs utilise unadjusted quoted prices in active markets for identical assets or liabilities on the measurement date. A prime example includes prices of financial assets and liabilities traded on stock exchanges considered to be active markets. An ‘active market’ is defined as one with frequent and voluminous transactions, offering continuous pricing data (IFRS 13 Appendix A).
While prices from active markets offer the most reliable indication of fair value, there are scenarios where adjustments to Level 1 inputs may be necessary. For instance, when an entity has a multitude of similar assets or liabilities, and individual quoted prices are difficult to access due to their abundance, alternative pricing approaches like matrix pricing may be considered. However, employing such methods shifts the valuation to a lower hierarchy level.
Similarly, if a significant event impacts the quoted market price after market closure or if specific characteristics of an asset or liability necessitate adjustments, the valuation is reclassified to a lower level in the hierarchy (IFRS 13.77-79).
Level 2 inputs
Level 2 inputs encompass observable data, other than the quoted prices found in Level 1, either directly or indirectly. For assets or liabilities with a specified term, a Level 2 input should be observable for the majority of the term’s duration. Examples include quoted prices for similar assets or liabilities in active and inactive markets, and other observable data points such as standard interest rates, yield curves, implied volatilities, or credit spreads.
Adjustments to Level 2 inputs depend on factors unique to the asset or liability in question. These include the asset’s condition or location, the relevance of the inputs to comparable items, and the market activity where the inputs are observed. If a significant adjustment to a Level 2 input relies on unobservable data, it might push the valuation into Level 3 of the hierarchy (IFRS 13.82-84).
Entities commonly employ over-the-counter (OTC) derivatives as hedging instruments, irrespective of hedge accounting application. By their very nature, OTC derivatives can’t be slotted into Level 1 since they’re tailored to an entity’s requirements without quoted prices for identical instruments.
Other examples of Level 2 inputs include:
- For finished goods (inventory) acquired in a business combination, a retail or wholesale price, adjusted for condition and location differences, so that the valuation reflects a selling transaction to another retailer.
- For buildings in use, a Level 2 input could be the price per square metre based on comparable buildings in similar locations.
- For a cash-generating unit, a Level 2 input might involve a valuation multiple, like earnings or revenue multiples, derived from comparable businesses and considering operational, market, financial and non-financial factors (IFRS 13.B35).
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Level 3 inputs
Level 3 inputs consist of unobservable inputs and come into play when relevant observable data is unavailable. These inputs come into play primarily when there’s minimal or no market activity for a particular asset or liability on the date of measurement. Despite this, the goal of fair value measurement remains consistent: determining an exit price on the measurement date from the perspective of a market participant holding the asset or bearing the liability. Thus, unobservable inputs should reflect the assumptions market participants would consider, including risk-related assumptions.
Risk assumptions encompass risks intrinsic to specific valuation techniques (like a particular pricing model) and those inherent in the technique’s inputs. If a measurement omits a risk adjustment that market participants would factor in, then it wouldn’t reflect a genuine fair value measurement. For instance, when there’s pronounced measurement uncertainty, a risk adjustment might be vital, especially if the asset or liability experiences a notable decline in market activity or if the transaction price seems misaligned with its real fair value (IFRS 13.B37–B47).
Entities should develop unobservable inputs based on the best accessible information. While an entity might start with its own data, it should be adjusted if evidence suggests other market participants might employ differing data or if specific aspects exclusive to the entity aren’t accessible to others (e.g., a unique synergy). Entities aren’t expected to conduct exhaustive data searches but should incorporate any reasonably available information about market participant assumptions (IFRS 13.86-89).
For example, in the context of a decommissioning liability acquired in a business combination, a Level 3 input could be a current forecast based on the entity’s data regarding anticipated future cash outflows to meet the obligation. This could include market participant perspectives on fulfilment costs and the compensation required for undertaking the obligation. If no evidence suggests market participants would adopt different assumptions, this Level 3 input, paired with other data (like a current risk-free interest rate), would be used in a present value technique. An alternative consideration is the entity’s credit profile, which might influence the fair value of the liability either in the discount rate or in the future cash outflow estimates.
Conversely, for a cash-generating unit, a Level 3 input might revolve around financial forecasts, such as cash flows projections, made using the entity’s own data (IFRS 13.B36).
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