Tutorial Week 12 Moodle Questions and Solutions

Chapter 5 Fair value measurement

REVIEW QUESTIONS
1. Name three current accounting standards that permit or require the use of
fair values.
AASB 3 Business combinations para 32
AASB 9 Financial instruments para 4.1
AASB 116 Property, plant and equipment, para 31
AASB 138 Intangibles para 33, 75
AASB 140 Investment property para 30
AASB 141 Agriculture para 13

3. What are the key elements of the definition of fair value?

The key characteristics are:
i. a current exit price:
The price is based on expectations about the future cash flows to be generated by an
asset or used to pay or transfer a liability.
The cash flows for an asset can be generated from use of the asset or sale of the
asset.
The price may be different from an entry price.
The effect of this characteristic, for an asset, is that the price is a selling price not a
buying price.
ii. an orderly transaction:
An orderly transaction is defined in Appendix A as:
A transaction that assumes exposure to the market for a period before the measurement date to
allow for marketing activities that are usual and customary for transactions involving such assets
or liabilities; it is not a forced transaction (eg a forced liquidation or distress sale).

The transaction is a hypothetical one.

The transaction occurs in current markets, in particular in markets where orderly
transactions occur. Market transactions in cases of liquidation sales or fire sales are
not relevant markets.
This characteristic affects the choice of markets to be observed.

Tutorial Week 12 Moodle Questions and Solutions

iii. between market participants:

A definition of market participants is given in Appendix A:
Buyers and sellers in the principal (or most advantageous market) for the asset or liability that have
all the following characteristics:
a) They are independent of each other, ie they are not related parties as defined in AASB
124 Related Party Disclosures .
b) They are knowledgeable, having a reasonable understanding about the asset or liability
and the transaction using all available information, including information that might be
obtained through due diligence efforts that are usual and customary;
c) They are able to enter into a transaction for the asset or liability;
d) They are willing to enter into a transaction for the asset or liability, ie they are motivated
but not forced or otherwise compelled to do so.

The phrase knowledgeable, willing parties in an arms length transaction has the
same meaning.
The assumptions made in the valuation process are those made by the market
participants, not those made by the reporting entity.
There is no need to identify specific market participants the emphasis is on the
characteristics of the participants.
The fair value measure is not entity-specific.
The market participants are assumed to have the other assets to combine with the
asset being valued where an in-use valuation premise is applied.
iv. at the measurement date:
Fair value is measured at a specific point of time taking into consideration the
conditions and restrictions in relation to an asset and a liability at that date

8. What are the key steps in determining a fair value measure?

An entity has to determine:
1. the particular asset or liability that is the subject of the measurement
(consistent with its unit of account).
2. for a non-financial asset, the valuation premise that is appropriate for the
measurement (consistently with its highest and best use).
3. the principal (or most advantageous market) for the asset or liability.
4. the valuation technique(s) appropriate for the measurement, considering the
availability of data with which to develop inputs that represent the
assumptions that market participants would use in pricing the asset or liability
and the level of the fair value hierarchy within which the inputs are
categorised.

Tutorial Week 12 Moodle Questions and Solutions

12. What valuation techniques are available to measure fair value?

-

the market approach: prices generated by market transaction

the cost approach: prices based on amounts required to replace the service
capacity of an asset.
the income approach: prices generated by considering future cash flows or
future income and expenses

14. Explain the different levels of fair value inputs.

Level 1 inputs are quoted prices in active markets for identical assets or liabilities.
The inputs are observable.
The markets must be active.
The assets/liabilities must be identical.
Level 2 inputs are inputs other than quoted market prices included within Level 1 that
are observable for the asset or liability, either directly as prices or indirectly as
derived from prices.
The inputs are observable.
The inputs are based on market prices or other market data such as interest rate
curves.
Level 3 inputs are inputs for the asset or liability that are not based on observable
market data.
The inputs are unobservable.
The information may include entity-specific data.

Tutorial Week 12 Moodle Questions and Solutions

PRACTICE QUESTIONS
Question 5.4
Benston raises 2 issues:
1. Although fair value is defined as an exit price, use of entry prices in level 2 inputs
and determination of values using level 3 inputs will mean that fair values are not
always really exit prices.
Where the valuation relies on an in-use valuation premise, the fair value may be
determined by calculating the cost of constructing an item of plant and equipment.
Also if an income valuation approach is used, there may be no market measures at
all as the NPV calculation could be based on unobservable market data.
This also raises questions in terms of the fair value being entity-specific versus
that of market participants. Where unobservable data such as income stream is
used, the numbers used in that calculation will generally be based on those coming
from an entitys own data. This is firstly because a reporting entity has no access
to other entitys internal data, and secondly because the asset being valued may
not currently be being used by other entities.
2. In some cases, the exit price will be zero. Does this affect relevance of
information?
A classic case of this is the land on which there is currently a factory but, because
of rising residential prices, the highest and best use of the land is for residential
purposes.
For unique assets, those that are special tools for the entity, are there
circumstances where there are no other market participants. Or must the valuer
assume that other market participants have the relevant other assets to use with the
asset being valued? This seems to stretch the hypothetical transaction very thinly,

Tutorial Week 12 Moodle Questions and Solutions

Question 5.8
The measurement of fair values under AASB 13 is based on a hypothetical transaction
between the reporting entity and market participants. Being hypothetical this allows
management to decide the constraints and the determinants of that transaction.
The assumptions used as inputs into the valuation process are those made by the
market participants, not those made by the entity itself. Hence the fair value under
AASB 13 is not supposed to be an entity-specific measure.
However, even though this is the intent of the standard-setters, the question is whether
in practice fair value measures will not be based on entity-specific information:
- a reporting entity is not required to identify specific market participants, so
any assumptions made will not relate to the circumstances facing any entity
currently operating in practice.
- In an endeavour to make the inputs more reliable, an entity may rely on
information generated within itself rather than less reliable, hypothetical
information concerning some non-existent market participant.
- If the market participant buyer steps into the shoes of the entity that holds
those specialised assets, then potentially the market participant is assumed to
be the same as the reporting entity and entity-specific factors are used in the
valuation.
- Where an income valuation approach is used, and a net present value method
applied, it is hard to see that entities will not insert the entity-specific
information into the present value calculations.
- Similarly where level 3 unobservable inputs are used, non-market data is not
readily available for in-use assets carried by other entities.
- Simple cost-benefit considerations will encourage an entity to use in-house
data rather than model what a market participant might hypothetically do.
Under these circumstances, management bias could potentially enter into the
determination of the fair value.