This Comment Letter was sent by BDO Global Coordination B.V. on behalf of BDO International, to the International Accounting Standards Board on 6 October 2009:
Dear Sir
IASB Exposure Draft ED/2009/05: Fair Value Measurement
We are pleased to comment on the above exposure draft (the ED) on behalf of BDO International. Our detailed comments are set out in the attached appendix.
We welcome the IASB’s proposal to develop a standard on fair value measurement which sets out a clear measurement objective and a robust framework. We agree that this will be helpful in reducing complexity in existing guidance and in enhancing consistency of approach.
We note that the IASB’s proposals are largely consistent with the equivalent US Standard, FAS 157 Fair Value Measurements. However, certain of the requirements of the IASB’s proposals differ from US GAAP and, while we agree that certain these represent an improvement in guidance, we also consider that it is desirable for IFRS and US GAAP to be fully converged. We therefore encourage the IASB to work with the FASB in order to eliminate differences that might exist between the IFRS Standard when it is issued in final form and US GAAP. These differences extend to cover other aspects of fair value measurement where the proposals in the Exposure Draft differ from US GAAP because of existing differences between IFRS and US GAAP, such as the measurement of financial liabilities with demand features.
We hope that our comments and suggestions are helpful. Should you wish to discuss any of them further, please contact either Tracey-Lee Massey at +32 2 778 0130 or Andrew Buchanan, our Global Head of IFRS, at +44 (0)20 7893 3300.
Yours faithfully
BDO Global Coordination B.V.
Appendix
Definition of fair value and related guidance
Question 1
The exposure draft proposes defining fair value 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’ (an exit price) (see paragraph 1 of the draft IFRS and paragraphs BC15–BC18 of the Basis for Conclusions). This definition is relevant only when fair value is used in IFRSs.
Is this definition appropriate? Why or why not? If not, what would be a better definition and why?
Yes, we agree with the proposed definition of fair value as exit price as it provides a conceptually clear measurement objective. Distinctions between current exit and current entry price which currently exist in IFRS result in unnecessary complexity.
The exit price notion describes a robust framework for fair value measurement and improves comparability between different entities. In addition, an exit price based measurement achieves convergence with US GAAP. However, we note that certain IFRSs contain references to entry prices (for example IAS 16), and it would be helpful to introduce a uniform definition of fair value. This might be achieved by amending those standards where there is reference to entry prices in a similar way to the three contexts set out in question 2.
We also agree with the explicit inclusion of transport costs in the definition (Appendix A (Defined terms)), which is an improvement on US GAAP (which is silent as to whether transport costs are included in the determination of the most advantageous market).
Scope
Question 2
In three contexts, IFRSs use the term ‘fair value’ in a way that does not reflect the Board’s intended measurement objective in those contexts:
(a) In two of those contexts, the exposure draft proposes to replace the term ‘fair value’ (the measurement of share-based payment transactions in IFRS 2 Share-based Payment and reacquired rights in IFRS 3 Business Combinations) (see paragraph BC29 of the Basis for Conclusions).
(b) The third context is the requirement in paragraph 49 of IAS 39 Financial Instruments: Recognition and Measurement that the fair value of a financial liability with a demand feature is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid (see paragraph 2 of the draft IFRS and paragraph BC29 of the Basis for Conclusions). The exposure draft proposes not to replace that use of the term ‘fair value’, but instead proposes to exclude that requirement from the scope of the IFRS.
Is the proposed approach to these three issues appropriate? Why or why not? Should the Board consider similar approaches in any other contexts? If so, in which context and why?
We agree that the proposed approach of replacing the term ‘fair value’ is an appropriate means of addressing the three contexts in which IFRS uses the term fair value where these do not reflect the Board’s intended measurement objective.
We agree that the measurement of share-based payment transactions under IFRS 2 and reacquired rights under IFRS 3 Business Combinations need to be considered separately. However, the proposed definition of ‘market based value’ in IFRS 2 is similar to the current definition of the fair value as set out in the ED. We suggest that the proposed definitions are amended to clarify how they differ.
For financial liabilities with a demand feature, we agree that the existing guidance in IAS 39 should be retained. While a technically pure approach might involve the application of the guidance proposed in the exposure draft, in practice we have found the existing guidance to be well understood and accepted. We also note that the approach currently set out in IAS 39 avoids the question of how to deal with a ‘day 1’ gain which might arise on initial recognition, and also means that the measurement of a borrower will be consistent with the measurement of the related asset by a lender or investor.
The transaction
Question 3
The exposure draft proposes that a fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place in the most advantageous market to which the entity has access (see paragraphs 8–12 of the draft IFRS and paragraphs BC37–BC41 of the Basis for Conclusions).
Is this approach appropriate? Why or why not?
We agree with the proposed approach.
However, with respect to the guidance in paragraphs B5 to B15 we question whether it is wholly appropriate to introduce divergence with FSP FAS 157-4. Paragraph B5(a) of the exposure draft states that one of the factors that may indicate an market that is not active is where there has been a significant decrease in the volume and level of activity for the asset or liability in question when compared with normal market activity for the asset or liability (or similar assets or liabilities). We note that a comparison to normal market activity in determining whether a market is not active is not included elsewhere in the exposure draft. The FSP, in the other hand, is based on an approach where the current volume and level of activity for the asset or liability should be compared with the volume and level of normal market activity for the asset or liability. Thus, the FSP’s guidance on inactive markets does not apply if the reporting entity’s market is normally inactive. This does not necessarily appear to be the case with respect to the guidance on inactive markets in the exposure draft.
Question 4
The exposure draft proposes that an entity should determine fair value using the assumptions that market participants would use in pricing the asset or liability (see paragraphs 13 and 14 of the draft IFRS and paragraphs BC42–BC45 of the Basis for Conclusions).
Is the description of market participants adequately described in the context of the definition? Why or why not?
Yes, the description of market participants is adequately described in the context of the definition of fair value.
Application to assets: highest and best use and valuation premise
Question 5
The exposure draft proposes that:
(a) the fair value of an asset should consider a market participant’s ability to generate economic benefit by using the asset or by selling it to another market participant who will use the asset in its highest and best use (see paragraphs 17–19 of the draft IFRS and paragraph BC60 of the Basis for Conclusions).
(b) the highest and best use of an asset establishes the valuation premise, which may be either ‘in use’ or ‘in exchange’ (see paragraphs 22 and 23 of the draft IFRS and paragraphs BC56 and BC57 of the Basis for Conclusions).
(c) the notions of highest and best use and valuation premise are not used for financial assets and are not relevant for liabilities (see paragraph 24 of the draft IFRS and paragraphs BC51 and BC52 of the Basis for Conclusions).
Are these proposals appropriate? Why or why not?
Yes, the proposals are appropriate. We agree that highest and best use should be determined from a market participant perspective even if the reporting entity’s intended use is different, and that the entity need not conduct an exhaustive search for other potential uses if there is no evidence to suggest that the current use of an asset is not its highest and best use.
While an in-exchange valuation premise presumes the utilisation of an individual asset (on a stand-alone basis), an in-use premise presumes the utilisation in a portfolio with other assets. Under this latter approach, while a sale of the asset is presumed, this is not from a stand-alone perspective but rather from a portfolio perspective. We agree that this is often appropriate, as the value of an asset to an enterprise is equal to the decrease in enterprise value arising from the removal of that asset from the group.
We also agree with the guidance in paragraph B2(e) that in certain circumstances it is appropriate to measure the fair value of an individual asset through an allocation of the value that is determined for a group of assets.
For financial instruments and for liabilities we agree that it would be inappropriate to apply the highest and best use guidance. However, it is not clear from the proposals whether it is intended to prohibit or permit the use of mid market prices for financial instruments. The requirement for an ‘in-exchange’ valuation could be taken as precluding the use of mid market prices, while paragraph 55 of the exposure draft suggests that a mid market price could be used. In practice, entities that hold portfolios of financial assets and financial liabilities with offsetting risks do use mid market prices (in accordance with the existing guidance in IAS 39.AG72), and we would support the continued use of that guidance.
Question 6
When an entity uses an asset together with other assets in a way that differs from the highest and best use of the asset, the exposure draft proposes that the entity should separate the fair value of the asset group into two components: (a) the value of the assets assuming their current use and (b) the amount by which that value differs from the fair value of the assets (ie their incremental value). The entity should recognise the incremental value together with the asset to which it relates (see paragraphs 20 and 21 of the draft IFRS and paragraphs BC54 and BC55 of the Basis for Conclusions).
Is the proposed guidance sufficient and appropriate? If not, why?
The proposed approach may be appropriate and operational where there is an incremental valuation uplift to record. However, in some cases (as illustrated by Example 1 in the illustrative examples), the effect may be to reduce the carrying value of an asset. We are not convinced that this is necessarily an appropriate approach and consider that further guidance would be helpful.
We note that in Example 1 (Asset group), the fair value attributed to asset C is CU30 (and not CU100) because the highest overall proceeds of sale would be achieved by selling to a strategic buyer who would not use asset C for the whole or its remaining useful economic life. If the entity which owns the assets intends to use asset C for the whole of its remaining useful economic life, it is not clear why it is appropriate to record depreciation of only CU 30 and not CU100, when the latter amount may be more representative of the value of resources consumed by the entity which owns asset C (rather than a hypothetical purchaser).
We also consider that the application of the proposed guidance on splitting into two or more components might be complex in practice, as there are frequently more than two assets in interaction as described in the example. In addition, paragraph 21 of the exposure draft refers to an attribution of incremental value to the asset to which it relates. While this may be relatively straightforward in the context of land and buildings, where the highest and best use of the land may often involve demolishing the existing building, it is common for existing buildings (or at least their structural shell) to be retained and refurbished or converted for a different use. In these circumstances it is not clear how the incremental value should be allocated. We suggest that the IASB considers a relative fair value approach.
Application to liabilities: general principles
Question 7
The exposure draft proposes that:
(a) a fair value measurement assumes that the liability is transferred to a market participant at the measurement date (see paragraph 25 of the draft IFRS and paragraphs BC67 and BC68 of the Basis for Conclusions).
(b) if there is an active market for transactions between parties who hold a financial instrument as an asset, the observed price in that market represents the fair value of the issuer’s liability. An entity adjusts the observed price for the asset for features that are present in the asset but not present in the liability or vice versa (see paragraph 27 of the draft IFRS and paragraph BC72 of the Basis for Conclusions).
(c) if there is no corresponding asset for a liability (eg for a decommissioning liability assumed in a business combination), an entity estimates the price that market participants would demand to assume the liability using present value techniques or other valuation techniques. One of the main inputs to those techniques is an estimate of the cash flows that the entity would incur in fulfilling the obligation, adjusted for any differences between those cash flows and the cash flows that other market participants would incur (see paragraph 28 of the draft IFRS).
Are these proposals appropriate? Why or why not? Are you aware of any circumstances in which the fair value of a liability held by one party is not represented by the fair value of the financial instrument held as an asset by another party?
No, we do not consider that the proposals on measuring the fair value of liabilities are appropriate.
We disagree in particular with the assertion in paragraph 27 of the exposure draft that the fair value of a liability equals the fair value of a corresponding asset. We note that even for assets and liabilities that are traded in the same market there can be differences in measurement due to (for example) liquidity spreads and risk premiums.
The current guidance under IFRS also distinguishes two measurement principles for liabilities, being ‘transfer’ (which typically applies to financial liabilities) and ‘expected settlement’ (which typically applies to non-financial liabilities).
If a transfer notion is required for a fair value measurement of any liability, this might cause ‘day 2’ valuation issues regarding the subsequent measurement of non-financial liabilities in accordance with IAS 37 (we refer to our response to question 8). We are not convinced that exit price is the appropriate measurement objective for liabilities recognised at settlement value.
We note that the Board is currently discussing consideration of credit risk in the measurement of liabilities. We suggest that the output from this discussion is incorporated into any final standard based on the exposure draft.
Application to liabilities: non-performance risk and restrictions
Question 8
The exposure draft proposes that:
(a) the fair value of a liability reflects non-performance risk, ie the risk that an entity will not fulfil the obligation (see paragraphs 29 and 30 of the draft IFRS and paragraphs BC73 and BC74 of the Basis for Conclusions).
(b) the fair value of a liability is not affected by a restriction on an entity’s ability to transfer the liability (see paragraph 31 of the draft IFRS and paragraph BC75 of the Basis for Conclusions).
Are these proposals appropriate? Why or why not?
a) We do not agree with the proposal. We also note that liabilities are rarely transferred on a stand alone basis, and therefore there is typically no market for the liability, nor observable prices which can be used to calibrate inputs to a valuation model.
We also note that a requirement to consider non-performance risk for fair value measurements could result in inconsistencies in subsequent measurement for non-financial liabilities assumed in a business combination. There is an explicit scope-out for fair value measurement of pensions, but not for provisions under IAS 37 (IFRS 3.26). Therefore we believe that a ‘day 2’ measurement inconsistency could arise from the subsequent measurement of provisions at settlement value without non-performance risk.
For purposes of a business combination, provisions would be measured with a (higher) discount rate (risk free plus spread). However, with respect to the subsequent measurement objective the interest rate would be the risk-free discount rate as required by to IAS 37. In our view, this diversity in treatment represents a conceptual flaw.
Example:
Assume a business combinations takes place at the end of 2009 (December 30). The acquire accounts for a provision for a pending lawsuit. The expected future settlement which is expected to occur at the end of 2014 would cause an outflow of resources amounting to 1,000 CU. The appropriate risk-free rate is 5 percent. The non-performance risk is deemed to be 2 percent.
The fair value of the non-financial liability would amount to 712.99 CU (present value factor: 0.713) in accordance with the guidance in the ED for fair value measurements. However, the acquirer presents its financial statements as of December 31, 2009 and accounts for the non-financial liability in accordance with IAS 37. Under IAS 37 the provision should be stated at management’s best estimate. The appropriate discount rate is the risk-free rate. The present value of the non financial liability amounts to 783.53 CU (present value factor: 0.784) as of December 31, 2009. Should the acquirer recognise a “day-2”-loss amounting to 70.54 CU only with respect to the change in the measurement objectives?
To avoid ‘day-2’ measurement inconsistencies the Board might either consider a scope out from a fair value measurement for non-financial liabilities similar to pension liabilities or redefine the measurement objective for non-financial liabilities.
b) We consider the proposal to be appropriate, as the fair value measurement requirements stipulate a hypothetical transaction. However, we are concerned that the proposal could be taken to imply that an unrestricted liability would have the same total fair value as a liability which has a restriction on transfer. We suggest that the Board clarifies this aspect in any final standard based on the exposure draft.
Fair value at initial recognition
Question 9
The exposure draft lists four cases in which the fair value of an asset or liability at initial recognition might differ from the transaction price. An entity would recognise any resulting gain or loss unless the relevant IFRS for the asset or liability requires otherwise. For example, as already required by IAS 39, on initial recognition of a financial instrument, an entity would recognise the difference between the transaction price and the fair value as a gain or loss only if that fair value is evidenced by observable market prices or, when using a valuation technique, solely by observable market data (see paragraphs 36 and 37 of the draft IFRS, paragraphs D27 and D32 of Appendix D and paragraphs BC76–BC79 of the Basis for Conclusions).
Is this proposal appropriate? In which situation(s) would it not be appropriate and why?
We agree that a transaction price will typically be the best evidence of fair value, and also agree that the four examples given in paragraph 36 of the exposure draft set out circumstances where the transaction price may not be representative of fair value.
While we agree with the proposed approach to dealing with day 1 gains and losses, we do not agree with the interaction of this with the revised IAS 39.AG76.
As drafted, where market data is not available for level 1 or level 2 measurement, the revised IAS 39.AG76 would appear to be capable of precluding the recognition of a day 1 gain or loss even if the transaction price is demonstrably not fair value (for example, in a related party transaction where an entity might force a non market price on another within the same group, or between groups under common control). We assume that this is not the Board’s intention.
The revisions to IAS 39.AG76 would also appear to create a further measurement basis for financial instruments, where a difference between a transaction price and a level 3 valuation would be amortised over the term of a financial instrument.
We suggest that consideration is given to retaining the existing wording of IAS 39.AG76.
Valuation techniques
Question 10
The exposure draft proposes guidance on valuation techniques, including specific guidance on markets that are no longer active (see paragraphs 38–55 of the draft IFRS, paragraphs B5–B18 of Appendix B, paragraphs BC80–BC97 of the Basis for Conclusions and paragraphs IE10–IE21 and IE28–IE38 of the draft illustrative examples).
Is this proposed guidance appropriate and sufficient? Why or why not?
We agree the proposed guidance on valuation techniques. It is appropriate that a fair value hierarchy should consist of the three levels set out in the guidance.
For the measurement of financial instruments, we consider that the fair value of financial instruments should not be determined within a bid-ask spread, but rather for assets the bid price and liabilities the ask price should be used. An exception to this approach should be where financial assets and liabilities with offsetting risks are held, where we consider that it would be appropriate to use mid market prices to the extent that the asset and liability positions are matched (as currently set out in IAS 39.AG72).
We believe that it would be helpful for more guidance to be included to assist in evaluating risk. It would be appropriate to include the following:
For debt instruments, default risk,
For equity instruments, investor risk,
For assets, general market (systematic) risk
Disclosures
Question 11
The exposure draft proposes disclosure requirements to enable users of financial statements to assess the methods and inputs used to develop fair value measurements and, for fair value measurements using significant unobservable inputs (Level 3), the effect of the measurements on profit or loss or other comprehensive income for the period (see paragraphs 56–61 of the draft IFRS and paragraphs BC98–BC106 of the Basis for Conclusions).
Are these proposals appropriate? Why or why not?
We have a number of concerns regarding the proposed disclosure requirements and question whether it is appropriate for the proposed disclosure requirements to differ substantially from those required by US GAAP.
There appears to be a disconnect between paragraph 56 and paragraph IE40 (Example 12). Paragraph 56 states that certain disclosures are required for ‘assets and liabilities measured at fair value’ while example 12 refers to ‘assets and liabilities measured at fair value during the period’. It is not clear whether the disclosures required under paragraph 56 are intended to apply only to assets and liabilities measured at fair value as of the end of the period, or also to assets and liabilities measured at fair value at some point during the period (including assets and liabilities that are no longer on the balance sheet as of the end of the period).
We believe the disclosure requirements of FAS 157, which are split into disclosures for recurring and non-recurring fair value measurements, are superior to those proposed in the exposure draft. We are unsure why the IASB has proposed different requirements (other than where there are differences between IFRS and US GAAP), and in this respect we are also unsure why paragraph BC110 – the section of the exposure draft that discusses significant differences between the exposure draft and FAS 157 – does not discuss this.
While we have suggested that it would be appropriate for to include the disclosure requirements of FAS 157, there are certain additional disclosures that are proposed in the exposure draft that we believe should be retained. In particular, we agree with the proposed disclosure requirements of paragraph 57 (d), which goes beyond US GAAP since paragraph 20 of FAS 157 does not require the disclosure provisions of FAS 154, Accounting Changes and Error Corrections, for a change in accounting estimate for revisions resulting from a change in valuation technique or its application. We also support the disclosure of a sensitivity analysis proposed Paragraph 57(g), which is also encouraged by the SEC for public companies. In addition, we note that the FASB has recently issued additional proposed guidance for fair value measurement disclosures, and the Board might consider whether it would be appropriate to incorporate certain of these into a final IFRS.
The last sentence of the first paragraph 57 indicates that certain disclosures should be made for each class of assets and liabilities. However, it does not indicate whether those disclosures should be made even if such assets and liabilities have a zero balance at the end of the reporting period. Example 13 does not clarify the point because it does not include examples of classes of assets or liabilities for which either the beginning-of-period or end-of-period balance is zero. It would be helpful for the guidance to clarify the point and for this to be incorporated into Example 13.
We also note that, while IFRS 7 provides guidance for allocating financial assets and financial liabilities into classes, IFRS does not contain related guidance for non financial assets and liabilities. We suggest that this is included in the final standard.
Convergence with US GAAP
Question 12
The exposure draft differs from Statement of Financial Accounting Standards No. 157 Fair Value Measurements (SFAS 157) in some respects (see paragraph BC110 of the Basis for Conclusions). The Board believes that these differences result in improvements over SFAS 157.
Do you agree that the approach that the exposure draft proposes for those issues is more appropriate than the approach in SFAS 157? Why or why not? Are there other differences that have not been identified and could result in significant differences in practice?
We have noted a number of areas in our responses to the questions set out above, in particular the disclosure requirements, where we consider that the requirements of FAS 157 should be incorporated into the final standard. In principle, we are in favour of the elimination of GAAP differences, provided that the quality of the resultant accounting and disclosure is not compromised.
We acknowledge that in some areas the proposals set out in the exposure draft which differ from US GAAP are attributable to existing differences in IFRS in comparison with US GAAP (such as the measurement of a liability with a demand feature) and that these differences may need to remain for the moment.
Other comments
Question 13
Do you have any other comments on the proposals in the exposure draft?
With respect to the meaning of ‘legally permissible’ as included in paragraph 17 of the exposure draft, it would be helpful for a final standard to clarify whether the term means legally permissible strictly as of the measurement date or whether the term also considers market participant views of potentially legal permissibility at some future date (for example, with respect to zoning regulations). The FASB’s Valuation Resources Group (VRG) considered this (VRG Issue No. 2008-4) and leaned toward the broader view, but the issue was not taken up by the FASB.
Copies of our comment letter and the exposure draft in .pdf format are attached below:
ED-2009-5-Fair Value Measurement.pdf
ED-2009-5-Fair Value Measurement Basis of Conclusions.pdf
ED-2009-5-Fair Value Measurement Illustrative Examples.pdf
BDO Comment Letter 2009 16.pdf