ED Fair value measurements - P2

There have been many problems in fair valuing an asset or liability because there are a number of ways to determine the fair value such as using exit price, net realisable value and so on. Efforts are focused on determining consistent fair value measurement method which an ED is proposed which is examinable in P2 2011 (actually IFRS 13 has been developed).

Fair value
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly (ie. not forced) transaction between market participants at the measurement date. All fair value measurements will follow this definition. The following elements have to be determined:
1. Particular asset/liability that is the subject of the measurement.
2. For a non-financial asset, the valuation premise that is appropriate for the measurement (consistently with its highest and best use.
3. Principal or most advantageous market for the asset or liability.
4. Appropriate valuation techniques - consider availability of data with which to develop inputs and fair value hierarchy.

Market participants in most advantageous market
Market participants should not be related party, are knowledgeable, and willing to enter into the transaction. Most advantageous market is the market that maximises the amount that would be received on sale of the asset (or minimises the amount that would be paid to transfer the liability), taking into account transaction and transport costs. However transaction costs do not form part of the fair value measurement because they are not a characteristic of asset/liability.

Fair value hierarchy
The hierarchy categorises the inputs used in valuation techniques into three levels. It gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.
Level 1 inputs are unadjusted quoted prices in active markets that the entity can assess at measurement date.
Level 2 inputs are inputs other than quoted market prices included in level 1 that are observable.
Level 3 inputs are unobservable inputs for the asset or liability, eg. interest rate swap.

Valuation techniques
There are three approaches for determining fair value using a valuation technique:
1. Market approach - uses prices and other relevant information generated by market transactions involving identical or comparable assets/liabilities. Eg. for level 1 inputs.
2. Income approach - converts future amounts (eg. cash flows or income and expenses) to a single discounted present value amount. Eg. for level 3 inputs.
3. Cost approach - use current replacement cost. Eg. for level 2 inputs.
An appropriate valuation technique will be consistently applied, will maximise the use of relevant observable inputs (minimise unobservable inputs) and will be calibrated periodically to actual transactions.

For more information you can refer to IFRS 13, this article did covered some of it. :)