IFRS 13 Fair Value Measurement - Assignment Example

IFRS 13 Fair Value Measurement Student’s name: Institution of Learning Instructor’s Name Course Name IFRS 13 Fair Value Measurement Introduction In accounting and economics, the procedure and standards for preparing and reporting financial statements have often varied from one jurisdiction to another. There are countries that rely on the directions given by the International Accounting Standards Board (IASB) in preparing the financial statements; they thus use the International Financial Reporting Standards (IFRS) in preparing and making financial reports. On the other hand, the U.S. generally accepted accounting principles (U.S. GAAP) are used by those organizations that subscribe to the Financial Accounting Standards Board (FASB). The guidelines for preparing financial reports as required by these two boards varies and even where they refer to the same requirement, the words used tend to differ. There has been a need to come up with a harmonized financial reporting standard in order to enhance transactions across jurisdictions that employ different financial reporting styles. In 2006, a memorandum of understanding was reached between the IASB and the US national standards-setter, FASB that set up the roadmap for convergence between IFRSs and the US GAAP. Included in this Memorandum of understanding was the Fair Value Measurement Project. In the realization of fair value project, on 12th May 2011, the IASB issued IFRS 13 Fair Value Measurement. In this essay, I discuss the definition of fair value, how fair value is measured and most importantly, the issue of convergence between IFRSs and US GAAP as addressed in this new report. The term fair value has over time been used in accounting and economics to allude to the rationale and the unbiased estimate of the potential market price of a good, service or asset, taking into account such objective factors as: acquisition or production costs, distribution costs, replacement costs or the costs of close substitute goods, the actual utility at a given level of development of social capability and the supply Vs demand. Other than the objective factors, the definition also incorporates subjective factors which include among other: risk characteristics, cost of and return on capital and individually perceived factors. There is a very close relationship between the fair value of a product or a service and its market value or price; however, a variation between the two terms still exists. To draw a clear distinction between the two terms, two schools of thought were developed, especially where tradable assets are involved. In the first school of thought, “the efficient market hypothesis”, it is argued that in a well organized and transparent market, the market price is generally equal or approaches the fair value of a product since investors react quickly in their attempt to incorporate new information about relative scarcity, utility or potential returns on their investments. The second school of thought, the “behavioral finance” asserts that the market price diverges from fair value because of various common cognitive biases among buyers or sellers. It has however been established that even the proponents of this behavioral finance view agree that such factors are nothing but anomalies are unpredictable (IASB, 2006). In IFRS 13 Fair Value Measurement, 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. The standard thus defines fair value using the exit price. This definition is similar to that provided by the US GAAP standard. It was reached after evaluating the respondent’s views in regard to the definition of fair value as had been provided in the exposure draft. The experts further considered all the definitions that were used in the earlier IFRSs (Cahill & Reindell, 2011). Explain the purpose of the Memorandum of Understanding between the IASB and the US national standard-setter, the Financial Accounting Standards Board (FASB). Joint meetings between IASB and FASB, which were first held in September 2002, saw board members identify a number of issues that had to be addressed in order to develop quality and compatible accounting standards that could be used for both domestic and cross-border financial reporting. It was the realization of how much time was spent in trying to reconcile financial reports that were prepared using a different standard from the one in which the potential user of the report was accustomed to. This called for the dire need for having an accounting standard that would transcend jurisdictions while maintaining usefulness and the ease at which the report could be used (Deloitte, 2011). In 2006, the Memorandum of Understanding between IASB and FASB was established. The two boards agreed to work together to ensure that their existing financial reporting standards become fully compatible as soon as it could be practicable. This agreement would witness the convergence of the International Financial Reporting Standards (IFRSs) and the US generally accepted accounting principles (US GAAP). The convergence of these crucial reporting standards would ensure bring to an end the need for reconciling financial reports that were prepared using the IFRSs standards in order for them to be useful in transactions where US GAAP standard was used and likewise. Secondly, the Memorandum of Understanding established the process by which the two boards would coordinate their future activities to ensure that once achieved, the compatibility would be maintained. Owing to the fact the two boards were coming up with an agreement on how they could effectively ensure that their two different accounting standards eventually come to a convergence point, it was necessary that they leave nothing hanging about the future of this convergence. For the success of any process, coordination of the various components that constitute the entire process is very important. The two boards therefore had to come to an understanding on how they would ensure that the established reporting standard continues to be useful in the future. Changes are usually inevitable and it was therefore important that the boards coordinate well so as to adapt to any changes that would arise with time (IASB, 2011). The Memorandum of Understanding was important as it made the work of financial reporters for non-US companies using IFRS and registered in the United States not to be forced reconcile their reports. This was a crucial recognition by both FASB and IASB, it was an issue that had been targeted by financial reporters for a long time and they indeed gave it the much required support. How did IFRSs and US generally accepted accounting principles (GAAP) define fair value prior to the issue of IFRS 13 and what were the disclosure and measurement requirements of IFRSs and US generally accepted accounting principles (GAAP) with regard to fair value prior to the issue of IFRS 13? It has not been easy to come up with a unanimous definition of Fair Value prior to the introduction of IFRS 13. Each accounting standard has attempted to establish its own definition. The major problem has always been lack of an agreement among the different stakeholders in financial reporting on the key issues around a good’s or service’s fair value. In 2005, IFRS defined fair value as “the price of a commodity that would be received for an asset or paid to a transfer a liability in a current transaction between market place participants in the reference market for the asset or liability”. (IASB, 2006). Those criticizing this definition argued that the inclusion of the word reference market in the definition caused confusion. It was suggested that the word be clarified in the context of principal market and where a principal market does not exist, the most advantageous market in which the reporting entity would sell or otherwise dispose of the asset or transfer the liability. It was also suggested the words ‘current market’ also be reworded’. These words were observed to be defining words and hence not necessary in the definition. The new choice of words necessitated the need for words that would make definition clearly indicate that the objective of the measurement was to establish the fair value as if the transaction was to take place on the measurement date. The US GAAP (FAS 157) defines fair value as the amount at which the asset could be bought or sold in a current transaction between willing parties or transferred to an equivalent party, other than in a liquidation sale. This definition as a matter of fact refers to the exit price of the asset. It is a comprehensive definition and the different stakeholders involved in preparation of financial reports, reporting, and even using the prepared reports, that is the investors do conform to this definition (Deloitte, 2011). IASB in its attempt to come up with a suitable definition that would eventually be adopted by IFRS had to consider the US GAAP’s definition. It eventually ended up with the exit price definition since majority of the correspondents urged the board members to consider this kind of definition. Identify and explain four reasons as to why the IASB developed IFRS 13, particularly with regard to the global financial crisis. Particular reference should be made to the goals of the fair value measurement project. To begin with IASB recognized the need for the reduction of complexity and hence improving consistency in the application of fair value measurements principles by having a single set of requirement for all fair value measurements. In determining the fair value of an entity, IFRS 13, clearly outlines the four elements that should be determined in order for such a value to be effective. The first element is the asset or liability whose fair value is to be measured. The measure in this case is expected to be in line with its unit of account. Secondly, the principal, that is, the most advantageous market in which an orderly transaction for the asset or liability is expected to be carried out should be duly identified before any discussion on the fair value of the asset or liability is initiated. Thirdly, for a non-financial asset, the highest and best use of the asset and whether the asset is used jointly with others or it stands out on its own accord. The appropriate valuation technique for the asset or liability should be established, focusing on the inputs that a market participant would use when pricing the entity. The last element that should be considered is the assumptions that market participants would use when pricing the entity. These four elements ensure that complexity is reduced when measuring fair value of an entity. This was especially important during the global financial crisis as special interests had to be considered especially the fair value of assets and liabilities when the market for such assets or liabilities became less active. Avoiding complexities would ensure that no matter the situation, a fair value for the assets or liabilities would always be established (IASB, 2011). The second objective of IFRS 13 in the fair value measurement is to communicate the measurement objective more clearly by clarifying the definition of fair value. The standard clearly outlines three basic situations that bring out the objective of measurement of fair value of an entity namely: the principal (most advantageous market, highest and best use and lastly the liabilities and own equity. By communicating the three objectives, it becomes easy to classify a particular entity whose fair value is to be determined. For instance, the fair value of a non-financial asset is measured on the basis of the highest and best use of the asset by a market participant. This way, the entity is able to attract its best value in the market as opposed what it would if it were to be valued using any other objective. For liabilities and equity instrument, their fair value is usually determined on the assumption that the instrument would be transferred on the measurement date, but would remain outstanding. The third objective of IFRS 13 is to improve transparency by enhancing disclosures about fair value measurement. It employs valuation techniques that are easy to follow hence avoiding complexities. It has been understood that other accounting standards employ very complex techniques when it comes to valuation of entities and hence making it difficult to establish the fair value of assets and liabilities. IFRS requires the disclosure of the fair value measurement procedures employed in arriving at the reported value. It also requires that as a matter of fact, the valuation techniques used during the valuation process also be made available. This makes transparency in the measurement of the fair value to be questionable (IASB, 2011). Lastly, IFRS 13 increases the convergence of IFRS and GAAP. This is an important objective of this standard and whose role in financial reporting cannot be overlooked. It improves the convergence between these two accounting standards by borrowing incorporating the earlier agreements in the previous IFSRs and adding new ones. This way, it makes it easier to use financial reports prepared in either standard. Identify and explain the main differences between IFRS 13 and the exposure draft proposal that precluded the issuing of IFRS 13. The exposure draft was prepared by the IABS and it provided the foundation through which a number of accounting issues that are addressed by the IFRS 13 were deliberated. There are numerous differences between the exposure draft and the final document that was eventually prepared. The main differences are as explained below. In the exposure draft, the fair value was measured based on the most advantageous market for the asset or liability. In IFRS 13, the fair value is measured using the price in the principal market for the market for the asset or the liability. As mentioned earlier, IFRS 13 addresses the fair value according to the nature of the entity involved. For instance, it separately meets the demands of financial assets from those of non-financial assets. The same is true for liabilities and own equity, they are not treated in the same category with the assets when their fair value is being measured (Deloitte, 2011). An addition was made in the IFRS 13 on the issue of high level guidance for measuring the fair value of liabilities. In this case, in IFRS 13, a detailed guidance for measuring the fair value of liabilities is given , including the description of the compensation that market participants would demand to in order to take an obligation. This standard provides a hierarchy of methods for arriving at the fair value, it states that when a quoted price for the transfer of liability or equity is not available, the fair value of the instrument from the perspective of a market participant holding the item as an asset is used in preference to a value determined using a valuation technique. The exposure draft simply required that the financial assets be measured on an individual instrument basis (using the in-exchange valuation premise. In IFRS 13, the guidance was made more explicit. In this standard, the financial assets and financial liabilities with offsetting positions in market risks or counterparty credit risk can be measured on the basis of the entity’s net risk exposure (IASB, 2011). No guidance was provided in exposure draft on how the different classes of assets or liabilities for the disclosure purposes. Following deliberations by different stakeholders involved in financial reporting, this issue was added in the IFRS 13. In the standard, the various classes of assets and liabilities are identified according to the nature, characteristics and risks of assets or liabilities and the level of fair value hierarchy within which the fair value measurement is categorized. On the issue of disclosure of information, the exposure draft said totally nothing about the requirement to provide information about an entity’s valuation process. In the IFRS 13, an addition was made in this area, requiring that an entity’s valuation process be explained for fair value measurement, categorized within level 3. This clause on disclosure borrows directly from the Fair Value Expert Advisory Panel’s report that was released in October 2008. Lastly, in the exposure draft, it is observed that the qualitative sensitivity for all assets and liabilities falling in the level 3 of the fair value hierarchy were given this classification without entering the corresponding narrative discussion. In IFRS 13, it was made a requirement that the narrative discussion be provided. How, and to what extent, did the IASB seek to ensure comparability between IFRS 13 and US GAAP? The 2006 updated MoU between IASB and FASB had already set the basic foundation for bringing forth the convergence between IFRSs and the US GAAD. It was therefore in the best interest of all the stakeholders in the financial markets that when establishing the IFRS 13, the recommendations of the stakeholders be taken into consideration. The recommendations here served to ensure that the new standard becomes more comparable with the US GAAP. It should first of all be understood that the discussion paper that was developed in 2006 by IASB in November 2006 with the intention getting the views of different respondents (mainly auditors, financial reporters, investors and other stakeholders using financial reports) made use of the US GAAP requirements provided in SFAS 157 as the basis for forming preliminary views. It was from these preliminary views that the experts working under the direction of IASB eventually came up with the IFRS 13. The process was however more complex than it might sound on the paper here (IASB, 2011). The preliminary views that were collected had to be seriously scrutinized before their adoption. It should be noted here that not all of the preliminary views conquered with requirements in SFAS 157. As a result, the IASB worked together with FASB beginning from October 2009. As proof of the joint effort, the FASB even agreed to amend Topic 820 in order to enhance harmony between IFRS 13 and the US GAAP. This enabled the two standards to be more comparable. As it stands now, the two standards have same definition of fair value, and the measurement, and disclosure requirements have been aligned. It is therefore evident that IASB played a crucial role in ensuring that comparability between the IFRS 13 and the US GAAP financial reporting standards is enhanced. Much has been attained so far as far the journey to ensuring that the two standards get to a convergence point. It was not an easy activity to undertake, it required a lot of dedication and willingness from the members of IASB, bearing in mind the process called for participation of another independent body, the FASB. Explain how, and to what extent, we can expect there to be differences between IFRS 13 and US GAAP. Particular reference should be made to theoretical reasons as to why international differences are expected to exist, and perhaps should still exist. Despite the fact that IFRS 13 endeavored to match with the US GAAP, a number of differences still exist between the two accounting standards. For instance, there are different disclosure requirements about fair value measurements. A good example is observed in the IFRS 13’s requirement for the quantitative sensitivity analysis for financial instruments that are measured at fair value and categorized within level 3 of the fair value hierarchy (this disclosure was previously found in IFRS 7). On the other hand, the US GAAP does not require the disclosure of a quantitative sensitivity analysis. Another key difference between the two standards that still remain is observed in the different requirements about whether, and in what circumstances, an entity with an investment in an investment company may use the reported net asset value as a measure of fair value. The mentioned differences that still exist are important on the international front. They provide financial reporters to attend to the specific needs of their financial markets. Since these requirements may vary from one jurisdiction to another, it is important that such differences be upheld. Conclusion Converging the IFRSs and the US GAAP has been a major challenge that IASB and FASB jointly worked to achieve. The journey has been long and calling upon each board to make recommendations on what it felt had to be changed in order for conformity. Crucial joint meetings were held beginning from 2002 throughout 2011. The Memorandum of Understanding between IASB and FASB was critical in ensuring that the two boards keep in touch with each other and hence watch their progress in seeing to it that they do not lose track. They held meetings and carried out evaluation of their progress. The fair value measurement was one of the issues that the MoU between IASB and FASB addressed. The critical issues here included among others: the definition of fair value, the procedure of measuring the fair value, the techniques of measuring fair values, and classification of assets and liabilities. Another important aspect of financial reports that had to be addressed was reaching an agreement over the items constituting the fair value that could be disclosed. In 2006, IASB sought to come up with a financial reporting standard that would easily compare with the US GAAP. The task was however not to be achieved without the support of FASB. The two boards joined hands and as a result of the joint effort, IFRS 13 was eventually born ON 12th May 2011. This new financial standard compares a lot with the US GAAP and thus financial reporters will be able to use the two accounting standards without necessarily having to reconcile financial statements prepared using either standard. Bibliography IASB (2011). IFRS 13 Fair Value Measurement: project summary and feedback statement. Accessed on http://www.fairvaluemeasurementfeedbackstatement_may2011.pdf Deloitte (2011). IASB Issues New Standard ON Fair Value Measurement and Disclosure. IFRS in Focus. Accessed on http://www.iasplus.com/iasplus/1105ifrs13.pdf (n a) (2006). A Roadmap for Convergence between IFRSs and US GAAP—2006-2008 Memorandum of Understanding between the FASB and the IASB 27 February 2006 Accessed on http://www.iasb.org/NR/rdonlyres/874B63FB-56DB-4B78-B7AF- 49BBA18C98D9/0/MoU.pdf Cahill Gordon &Reindel LP (2011). FASB and IASB Common Fair Value Accounting Guidance.Accessed on http://www.cahill.com/news/memoranda/100276/_res/id=sa_File1/CGR%20Memo0- %20FASB%20and%20IASB%20Common%20Fair%20Value%20Accounting%20Gui dance.pdf IASB (2006). Fair Value Measurements (Agenda Paper 8A): Principles and Definition. Accessed on http://www.iasb.org/NR/rdonlyres/B9A519D6-AAF5-4ACF-ABFF- F9958BFE519C/0/ObNotes_FVM_0605ob08a.pdf Read More