Chapter Two

Fair Value Measurement and Impairment

Chapter Objective: Upon completion of this chapter the student will be able to:

 Define what it means by fair value

 Know how to use fair value as a measurement
 Describe the different valuation methods used in determination of fair value
 Describe the fair value hierarchy
 Define the concept of impairment
 Describe the measurement and reversal of impairment
 Describe the required disclosures needed for impairment and fair value
2.1: Fair value measurement
Definition

Fair value is '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'. This price is
basically determined in a transaction that takes place between market participants in an
active market.

DEFINITIONS OF TERMS RELATED TO THE FAIR VALUE CONCEPT

 Active market: A market in which transactions for the asset or liability occur with
sufficient frequency and volume to provide pricing information on an ongoing basis.
 Cost approach: A valuation technique that reflects the amount that would be required
currently to replace the service capacity of an asset (sometimes referred to as current
replacement cost).
 Entry price: The price paid to acquire an asset or received to assume a liability in an
exchange transaction.
 Exit price: The price that would be received to sell an asset or paid to transfer a
liability.
 Expected cash flow: The probability-weighted average (i.e., mean of the distribution) of
possible future cash flows.
 Fair value: 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.
 Highest and best use: The use of a nonfinancial asset by market participants that
would maximize the value of the asset or the group of assets and liabilities (e.g., a
business) within which the asset would be used.
 Income approach: Valuation techniques that convert future amounts (e.g., cash flows
or income and expenses) to a single current (i.e., discounted) amount. The fair value
 measurement is determined on the basis of the value indicated by current market
expectations about those future amounts.
 Inputs: The assumptions that market participants would use when pricing the asset or
liability, including assumptions about risk, such as the risk inherent in a particular
valuation technique used to measure fair value (such as a pricing model) and the risk
inherent in the inputs to the valuation technique. Inputs may be observable or
unobservable.
 Level 1 input: Quoted prices (unadjusted) in active markets for identical assets or
liabilities that the entity can access at the measurement date.
 Level 2 inputs: Inputs other than quoted prices included within Level 1 that are
observable for the asset or liability, either directly (i.e., as prices) or indirectly (i.e.,
derived from prices).
 Level 3 inputs. Unobservable inputs for the asset or liability.
 Market approach: A valuation approach that uses prices and other relevant information
generated by market transactions involving identical or comparable (i.e., similar) assets,
liabilities or a group of assets and liabilities (i.e., a business).
 Market-corroborated inputs: Inputs that are derived principally from or corroborated
by observable market data by correlation or other means.
 Market participants: Buyers and sellers in the principal (or most advantageous) market
for an asset or liability that have all of the following characteristics:
1) Independent of each other, i.e., they are not related parties as defined in IAS 24,
although the price in a related party transaction may be used as an input to a fair value
measurement if the entity has evidence that the transaction was entered into a market
term.
2) Knowledgeable and have 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.
3) Able to enter into a transaction for the asset or liability.
4) Willing to enter into a transaction for the asset or liability (i.e., they are not under duress
that would force or compel them to enter into the transaction).
 Most advantageous market: The market that maximizes the amount that would be
received from the sale of the asset or that minimizes the amount that would be paid to
transfer the liability, after consideration of transaction and transport costs. (Although
transaction costs are considered in making a determination of the market that is most
advantageous, such costs are not to be factored into the fair value valuation determined
by reference to that market).
  Nonperformance risk: The risk that the entity will not fulfill an obligation. This
includes, but is not limited to, the entity’s own credit risk.
 Observable inputs: Inputs that are developed on the basis of available market data,
such as publicly available information about actual events or transactions, and that
reflect the assumptions that market participants would use when pricing the asset or
liability.
 Orderly transaction: 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 (e.g., a forced liquidation or distress sale).
 Principal market: The market with the greatest volume and level of activity for the
asset or the liability.
 Risk premium: Compensation sought by risk-averse market participants for bearing the
uncertainty inherent in the cash flows of an asset or a liability, sometime referred to as a
“risk adjustment.”
 Transaction costs. The costs to sell an asset or transfer a liability in the principal (or
most advantageous) market for the asset or liability that are directly attributable to the
disposal of the asset or the transfer of the liability and result directly from and are
essential to the transaction, and would not have been incurred had the transaction not
occurred (similar to the “costs to sell” in terms of IFRS 5, Noncurrent Assets Held
forSale and Discontinued Operations).
 Transport costs: The costs that would be incurred to transport an asset from its current
location to its principal or most advantageous market.
 Unit of account: The level at which an asset or liability is aggregated or disaggregated
in an IFRS for recognition purposes.
 Unobservable inputs: Inputs for which market data are not available and that are
developed using the best information available about the assumptions that market
participants would use when pricing the asset or liability.

Measurement of Fair Value

Fair value is a market based measurement, not an entity specific measurement. It focuses on
assets and liabilities and on exit (selling) prices. It also takes into account market conditions at
the measurement date. In other words, it looks at the amount for which the holder of an asset
could sell it and the amount which the holder of a liability would have to pay to transfer it. It
can also be used to value an entity's own equity instruments.
Because it is a market-based measurement, fair value is measured using the assumptions that
market participants would use when pricing the asset, taking into account any relevant
characteristics of the asset such as the condition of the asset, its location along with any
restriction on the asset.

It is assumed that the transaction to sell the asset or transfer the liability takes place either:

(a) In the principal market for the asset or liability; or

(b) In the absence of a principal market, in the most advantageous market for the asset or
liability.

The principal market is the market which is the most liquid (has the greatest volume and level
of activity) for that asset or liability. In most cases the principal market and the most
advantageous market will be the same.

IFRS 13 which is a standard that is set for the measurement of fair value, acknowledges that
when market activity declines an entity must use a valuation technique to measure fair value. In
this case the emphasis must be on whether a transactionprice is based on an orderly
transaction, rather than a forced sale.

Fair value is not adjusted for transaction costs. Under IFRS 13, these are not a feature ofthe
asset or liability, but may be taken into account when determining the mostadvantageous
market.

Fair value measurements are based on an asset or a liability's unit of account, which isspecified
by each IFRS where a fair value measurement is required. For most assets andliabilities, the unit
of account is the individual asset or liability, but in some instances may bea group of assets or
liabilities.

 Self-Check Questions
1. Explain the difference between fair value and market value?
2. Identify a market in Ethiopia where you can be able to get fair value price for you asset
or liability.

2.1: Valuation methods

Valuation techniques used to measure fair value shall maximize the use of relevant observable
inputs and minimize the use of unobservable inputs.

Examples of markets in which inputs might be observable for some assets and liabilities (eg
financial instruments) include exchange markets, dealer markets, brokered markets and
principal-to-principal markets.
An entity shall select inputs that are consistent with the characteristics of the asset or liability
that market participants would take into account in a transaction for the asset or liability.

There are three valuation techniques used in measurement of fair value

1. Market approach
2. Income approach
3. Cost approach

Market approach

A valuation technique that uses prices and other relevant information generated by market
transactions involving identical or comparable (i.e. similar) assets, liabilities, or a group of
assets and liabilities. (e.g. a business)

 The following valuation techniques are described under the market approach:

a) Transaction price paid for an identical or a similar instrument in an investee;

b) Comparable company valuation multiples.

Income approach

A valuation technique that converts future amounts (e.g. cash flows or income and expenses) to
a single current (i.e. discounted/Present value) amount.

 The following valuation techniques are described under income approach:

a) Discounted cash flow method:Under this method, the investor would discount
expected cash flows to a present value at a rate of return that represents the time value of
money and the relative risks of the investment.

b) Dividend discount model:This model assumes that the price of an equity instrument
equals the present value of all its expected future dividends in perpetuity when the
investee consistently pays dividends.

c) Constant-growth dividend discount model:This model determines the FV of the

equity instrument by referring to a forecast of growing dividend streams. This model is
sensitive to the assumptions about the growth rate.

d) Capitalization model:This model applies a rate to an amount that represents a measure

of economic income to arrive at an estimate of present value. The model is useful as a
cross-check when other approaches have been used.

Cost approach / Adjusted net asset method

A valuation technique that reflects the amount that would be required currently to replace the
service capacity of an asset (often referred to as current replacement cost).

This cost approach definition assumes that FV is the cost to acquire or construct a substitute
asset of comparable utility, adjusted for obsolescence (including physical deterioration,
functional (technological) obsolescence and economic (external) obsolescence)

Fair value hierarchy

To increase consistency and comparability in fair value measurements and related disclosures,
IFRS establishes a fair value hierarchy that categorizes into three levels the inputs to valuation
techniques used to measure fair value. The fair value hierarchy gives the highest priority to
quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest
priority to unobservable inputs (Level 3 inputs).

IFRS 13 establishes a three level fair value hierarchy for inputs to measure fair values indicated
in the below diagram:

 Level 1: unadjusted quoted prices in active markets for identical assets or liabilities

A quoted price in an active market provides the most reliable evidence of fair value and
should be used without adjustment to measure fair value subject to some exceptions.

Active market is “a market in which transactions for the asset or liability take place with sufficient
frequency and volume to provide pricing information on an ongoing basis.”
  Level 2:inputs other than quoted prices included in Level 1 that are observable,
either directly or indirectly

Level 2 inputs are to be considered when quoted prices for the identical asset or liability are not
available.
If the asset or liability being measured has a contractual term, a Level 2 input must be
observable for substantially the entire term. These inputs include:
 Quoted prices for similar assets or liabilities in active markets.
 Quoted prices for identical or similar assets or liabilities in markets that are not active.
 Inputs other than quoted prices that are observable for the asset or liability (e.g., interest
rates and yield curves observable at commonly quoted intervals; implied volatilities;
prepayment speeds; loss severities; credit risks; and default rates).
 Inputs that are derived principally from or corroborated by observable market data that,
through correlation or other means, are determined to be relevant to the asset or liability
being measured (market-corroborated inputs).
 Level 3: unobservable inputs developed using best information available (e.g.
entity’s own data)

 Unobservable inputs should be used to measure fair value to the extent that
relevant observable inputs are not available.
 Unobservable inputs should reflect the assumptions that market participants
would use when pricing the asset or liability, including assumptions about risk.

Valuation techniques used to measure fair value should maximize the use of relevant observable
inputs and minimize the use of unobservable inputs

Observable inputs – developed using market data such as publicly available information about
actual events or transactions

Unobservable inputs – market data not available and developed using best information available
about assumptions that market participants would use
Example of fair value determination

Your factory is built on Plot 900 in a recentlydeveloped industrial development zone on the
outskirts of Addis Ababa where the land that is divided into one hundred two acre plots that
before their further development were essentially homogenous. Factories, like yours, are the
highest and best use for the land rights.

On 31 December 2000 two of the plots adjoining your plot were sold (ie sale of the land rights
and the buildings, if any, constructed thereon):

 Plot 901 sold for $30 million: land rights with a similar factory of the same age,
same condition and same floor area as yours.
 Plot 899 sold for $10 million because it is undeveloped (yet to be built on).

On 31 December 2000 what is the fair value of your land rights (ie excluding the factory
building)?

 Choose 1 of:

1) $0; 2) $10 million; 3) $20 million; 4) $30 million; 5) $70 million; 6) $80 million; 7) $100;
million; or 8) another amount
On 31 December 2000 what is the fair value of your factory building (ie excluding the land
rights)?

Answer: #2. 10 Million

 Choose 1 of:

1) $0; 2) $10 million; 3) $20 million; 4) $30 million; 5) $70 million; 6) $80 million; 7) $100;
million; or 8) another amount

Answer: #3. 20 Million

Disclosure

Disclose information that helps users assess both of the following:

 for assets and liabilities measured at fair value on a recurring or non-recurring basis
after initial recognition:

– the valuation techniques

– the inputs used

– for recurring fair value measurements using significant unobservable

inputs (Level 3), the effect of the measurements on:

 profit or loss

 other comprehensive income

Furthermore, for none recurring fair value measurements disclosure is needed about

1. the fair value measurement at the end of the period and the Level in the hierarchy

2. the policy for determining when transfers between levels of the hierarchy are deemed to
have occurred

3. A description of the valuation techniques, the inputs used in Levels 2 and/or Level 3,
any changes to the valuation techniques and reasons for that change.

N.B: Fair values that are required or permitted only on initial recognition are exempted
from IFRS the above disclosures

 Self-Check Questions

1. Explain in brief the difference between the three levels of fair value hierarchy?
2. Give example of each level’s in Ethiopia country case.
3.1: Impairment
After the successful completion of this session, students are expected to know

 The definition of impairment

 Definition of key terms in Impairment
 When to measure impairment
 How to measure impairment
 When to reverse impairment
 What to disclose about impairment

Reading Text
An entity applies an IFRS standard to ensure that its assets are carried at no more than their
recoverable amount. An asset is carried at more than its recoverable amount if its carrying
amount exceeds the amount to be recovered through use or sale of the asset. If this is the case,
the asset is described as impaired and the Standard requires the entity to recognize an
impairment loss.

Definition of key terms in Impairment

Carrying amount: is the amount at which an asset is recognized after deducting any
accumulated depreciation (amortization) and accumulated impairment losses thereon.

A cash-generating unit: is the smallest identifiable group of assets that generates cash inflows
that are largely independent of the cash inflows from other assets or groups of assets.

Corporate assets: are assets other than goodwill that contribute to the future cash flows of
boththe cash-generating unit under review and other cash-generating units.

Costs of disposal:are incremental costs directly attributable to the disposal of an asset or

cashgeneratingunit, excluding finance costs and income tax expense.

Depreciable amount: is the cost of an asset, or other amount substituted for cost in the
financialstatements, less its residual value.

Depreciation (Amortization): is the systematic allocation of the depreciable amount of an

assetover its useful life.

Fair value:is the price that would be received to sell an asset or paid to transfer a liability in
anorderly transaction between market participants at the measurement date.

An impairment loss: is the amount by which the carrying amount of an asset or a

cashgeneratingunit exceeds its recoverable amount.
The recoverable amount: of an asset or a cash-generating unit is the higher of its fair value
lesscosts of disposal and its value in use.

Value in use:is the present value of the future cash flows expected to be derived from an
assetor cash-generating unit.

Measurement of impairment

An entity shall assess at the end of each reporting period whether there is any indication that an
asset may be impaired. If any such indication exists, the entity shall estimate the recoverable
amount of the asset. Additionally, even if there is no indication of any impairment, these assets
should be tested for impairment at the end of each reporting period:

 An intangible asset that has an indefinite useful life

 An intangible asset that is not yet available for use
 Goodwill that has been acquired in a business combination
The IFRS’s Standard that is used in the concept of impairment calculation is IAS 36, and its
states that the following items might indicate that an item might be impaired:
• External sources of information:-
• The decline in asset values
• significant change in technological, market, economic or legal environment in
which the entity operates (eg devaluation)
• the increase in market interest rate or market rate of return on investment
• Internal sources of information
• obsolescence or physical damage
• decline in performance
• significant plan change made by the management
Impairment test

In testing for impairment, one must compare the carrying value of the item with its recoverable
amount. The recoverable amount of an item it the higher of fair value less cost to sell and its
value in use. If either the fair value less costs to sell or value-in-use is higher than the carrying
amount, there is no impairment. If both the fair value less costs to sell and value-in-use are
lower than the carrying amount, a loss on impairment occurs.
N.B: If it is not possible to estimate the recoverable amount of the individual asset, an entity
shall determine the recoverable amount of the cash-generating unit to which the asset belongs

1.1.1 Reversal of impairment

An entity shall assess at the end of each reporting period whether there is any indication that an
impairment loss recognized in prior periods for an asset other than goodwill may no longer exist
or may have decreased.

These indicators are

External sources of information:-

 The increase in asset values

 Favorable change in technological, market, economic or legal environment in which the

entity operates

 the decrease in market interest rate or market rate of return on investment

Internal sources of information:-

 Increase in performance

 Favorable plan change made by the management

 decline in performance

An impairment loss recognized in prior periods for an asset other than goodwill shall be
reversed if, and only if, there has been a change in the estimates used to determine the asset’s
recoverable amount since the Last impairment loss was recognized.

Furthermore, reversal of an impairment loss shall not exceed the carrying amount of the asset
that was in the prior period and the reversal of an impairment loss for an asset other than
goodwill shall be recognized immediately in profit or loss, unless the asset is carried at revalued
amount in accordance with another standard. eg IAS 16

N.B: A reversal of an impairment loss for a cash-generating unit shall be allocated to the assets
of the unit, except for goodwill, pro rata with the carrying amounts of those assets.

Example of impairment loss and reversal

On January 1 2012 ABC co bought a machine for 100,000 birr. The machine has an estimated
useful life of 10 years with no residual value. ABC uses the straight line method to depreciate
its machine.
» On December 31, 2014 the recoverable amount the machine = $30,000
» 31 December 2016 the recoverable amount of the machine = $80,000
Required: calculate if there is any amount to be recorded as impairment loss and show the
necessary journal entries.

Solution:
On Dec 31,2014: the carrying value of the asset is 80,000 and the recoverable amount of this
asset is 30,000. Hence the recoverable amount is less than the carrying amount, the asset is
impaired by 50,000 birr and is recorded as

Impairment loss………..50,000

Accumulated impairment ………….50,000

On Dec 31, 2016 the carrying amount of the asset is 22,500. This is because of the previous
impairment, the annual depreciation has changed to 3,750 rather than 10,000. Thus, the carrying
amount will be 22,500 i.e 30,000- 7,500.

Therefore an impairment reversal will be made by the amount of 37,500.

Accumulated impairment………..37,500

Recovery of impairment loss………….37,000

N.B: The 12,500 of impairment loss is already recovered by the decrease in annual depreciation
for two years by 6,250 birr

Disclosure

An entity shall disclose the following for each class of assets:

 the amount of impairment losses recognized in profit or loss

 the amount of reversals of impairment losses recognized in profit or loss

 Explanation of the events and circumstances that contributed to the

impairment loss or reversal

 The amount of Impairment loss on a revalue asset recognized in OCI

 The amount of reversal of Impairment loss on a revalue asset recognized

in OCI