Measurement bases in accounting are fundamental pillars of preparing financial statements in accordance with International Financial Reporting Standards (IFRS), as they directly affect the reliability and relevance of financial information for economic decision-making.
The principles and concepts for measuring fair value are set out under IFRS 13, which provides an integrated framework for measuring fair value and related disclosures.
Considering the requirements and applications of this Standard, the appropriate framework becomes clearer for applying the requirements of IAS 36 and IFRS 9, particularly in relation to the concepts of fair value and value in use.
Although both concepts relate to measuring the economic value of assets, they are based on different methodologies and assumptions, which require a precise understanding of the differences between them and the appropriate context for applying each.
Concept of Fair Value under IFRS 13
IFRS 13 defines 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. This definition emphasizes that fair value is a market-based measurement, rather than an entity-specific measurement; that is, it reflects the assumptions of market participants and not solely management’s estimates.
Fair value measurement is based on an input hierarchy comprising three main levels:
- Level 1: Quoted prices in active markets for identical assets or liabilities.
- Level 2: Inputs that are directly or indirectly observable, other than quoted prices included within Level 1.
- Level 3: Unobservable inputs based on valuation models and professional estimates.
The concept of fair value is widely used in the application of IFRS 9, particularly when measuring financial instruments classified as fair value through profit or loss or fair value through other comprehensive income. Its impact also extends to IAS 36 when determining fair value less cost of disposal as part of the impairment test.
Read more about: IFRS 13 Guidance For Fair Value Measurement
IAS 36 and Impairment Testing
IAS 36 requires an entity to assess whether an asset, or a cash-generating unit, has been impaired by comparing its carrying amount with its recoverable amount. Recoverable amount is defined as the higher of:
- Fair value less cost of disposal; and
- Value in use.
Accordingly, impairment testing under IAS 36 requires consideration of two different measurements: one market-based, represented by fair value less cost of disposal, and the other entity-specific, represented by value in use.
Value in use refers to the present value of the future cash flows expected from the continued use of an asset, along with the cash flows anticipated from its disposal at the end of its useful life.
It is considered an entity-specific measurement because it is based on management’s own estimates of future cash flows, the selected discount rate, and assumptions regarding how the asset will be used within the entity’s operations. As a result, value in use reflects the entity’s particular circumstances, strategies, and internal expectations, and may differ from the assumptions that market participants would make.
By contrast, fair value less cost of disposal reflects the amount that could be obtained from the sale of an asset or cash-generating unit in an orderly transaction, after deducting incremental costs directly attributable to the disposal.
The fair value component is determined by reference to IFRS 13, which provides the market-based measurement framework, while IAS 36 requires the deduction of costs of disposal in order to arrive at the comparable amount for impairment testing purposes.
In practice, the use of these two measurements may result in different outcomes. Value in use may be higher where the entity expects to generate economic benefits from the continuing use of the asset that exceed market expectations.
In other cases, fair value less costs of disposal may be higher, particularly where selling the asset or cash-generating unit is more beneficial than retaining it. An impairment loss is recognized only when the carrying amount exceeds the recoverable amount, which is the higher of these two measurements.
Read more about: Is Impairment Testing an Annual Mandatory Requirement?
IFRS 9 and Financial Instruments
IFRS 9 plays an important role in applying the concept of fair value, as it sets out the requirements for the classification and measurement of financial instruments.
Under this standard, financial assets are measured either at amortized cost, fair value through other comprehensive income, or fair value through profit or loss, based on the entity’s business model for managing those assets and the contractual cash flow characteristics of the financial asset.
Financial liabilities are also subject to specific measurement requirements under the same standard, including measurement at fair value in certain cases. When IFRS 9 requires or permits a financial instrument to be measured at fair value, reference is made to IFRS 13 to determine how that value should be measured.
It is important to emphasize that IFRS 13 does not determine which instruments or items must be measured at fair value. Rather, it provides a framework for how fair value should be measured whenever another standard, such as IFRS 9, requires the use of this measurement basis.
Under this framework, the fair value measurement of financial instruments must reflect the assumptions that market participants would use when pricing the instrument under current market conditions, including assumptions relating to risk. In practice, fair value may be measured using quoted market prices where active markets exist, or through appropriate valuation techniques where observable market prices are not available.
The fair value hierarchy is particularly important in measuring financial instruments, as it gives priority to observable inputs over unobservable inputs. Level 1 inputs comprise quoted prices in active markets, Level 2 inputs include other observable inputs, while Level 3 inputs rely on valuation models and significant professional estimates.
Although IFRS 9 does not use the concept of value in use, it includes specific requirements for the impairment of financial assets through the expected credit loss model.
This model applies to financial assets measured at amortized cost and certain financial assets measured at fair value through other comprehensive income. These requirements rely on forward-looking information and assessments of credit risk. However, they differ from the concept of value in use under IAS 36, and also differ from fair value measurement under IFRS 13, as their objective is to measure expected credit losses rather than a market-based exit price.
Practical and Application Challenges
Business entities face multiple challenges when applying the concepts of fair value and value in use, particularly in environments where active markets or sufficient market data are not available. In such cases, the use of complex valuation models becomes necessary, increasing the importance of professional judgment and the quality of the assumptions applied.
Reliance on management estimates in determining value in use may also lead to significant differences between entities, even when similar assets are being assessed, which may affect the comparability of financial statements. By contrast, fair value may be affected by market volatility, the availability of observable inputs, and the degree of reliance on valuation models.
Therefore, the proper application of these concepts requires a high level of professional judgment, together with adequate disclosure of the methodologies, assumptions, and data sources used in the measurement process. Transparent disclosure contributes to enhancing the confidence of users of financial statements and enables them to understand the nature of the estimates and their sensitivity to changes in key assumptions.
Conclusion
Fair value and value in use each represent essential tools within the accounting measurement framework under International Financial Reporting Standards; however, each has a different objective and perspective.
Fair value reflects the market perspective and the exit price in an orderly transaction between market participants, whereas value in use reflects the entity’s perspective and the present value of the cash flows expected from the continuing use of the asset.
A precise understanding of the differences between these two concepts is critically important for accountants, auditors, and decision-makers, particularly considering the complexity of economic environments and the increasing reliance on estimates and professional judgments.
Through the proper application of the relevant standards and clear disclosure of the assumptions and methodologies used, business entities can achieve an appropriate balance between the relevance and reliability of financial information, thereby enhancing the quality of financial statements and supporting the decisions of their users.