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IFRS 7 – FAIR VALUE HIERARCHY

As a part of the disclosure requirements for fair value measurements, an entity should classify the financial instruments measured at fair value using a ‘fair value hierarchy’ that reflects the significance of the inputs used in making the measurements. IFRS 7 consist of fair value hierarchy in its required disclosures to increase the comparability and consistency.

A new standard “Fair Value Measurements” by IASB is expected to come by April 2011 on the lines of Statement No. 157 or ASC 820 of the US GAAP as a part of joint project of FASB and IASB.

As per existing IFRS 7, the fair value hierarchy has three different levels:

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. A quoted price in an active market provides the most reliable evidence of fair value and should be used to measure fair value whenever available, except as follows:

  • In some situations, a quoted price in an active market might not represent fair value at the measurement date. That might be the case if, for example, significant events (announcements) occur after the close of a market but before the measurement date. If the quoted price is adjusted for new information, the adjustment renders the fair value measurement a lower level measurement.

Level 1 input instrument is listed equities, listed debt, listed investment fund.

Level 2 inputs are observable for the asset or liability, either directly or indirectly. If the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability. Level 2 inputs include the following:

  • Quoted prices for identical or similar assets or liabilities in markets that are not active.
  • Quoted prices for similar assets or liabilities in active markets.
  • Inputs other than quoted prices that are observable for the asset or liability (e.g. yield curves).
  • Inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs).

Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs should reflect the reporting entity’s own assumptions which assumptions the market participants would use in pricing the asset or liability (including assumptions about risk). The reporting entity’s own data used to develop unobservable inputs should be adjusted if information is reasonably available without undue cost and effort that indicates that market participants would use different assumptions.

As explained above, the level is determined by the inputs used to determine fair value. There are some misperceptions about how to determine where in the hierarchy a fair value measurement falls. For example, one misperception is that the valuation model utilized affects the level determination. Instead, one must analyze the inputs used in the model to determine their significance and the hierarchy level.

The inputs with the most significance will determine the level of the fair value measurement.

Another misperception is that the higher the risk, the lower in the hierarchy the fair value measurement falls. For example, if the counterparty credit risk is high and that input is significant, it has been assumed that the fair value measurement is Level 3. However, the correct answer is based on how observable the counterparty credit risk is. If an entity’s credit-risk rating is published and/or available from many sources, that would be considered observable and a Level 2 input, therefore making the fair value measurement a Level 2. However, if the risk rating is determined using data gathered by a client and not from observable sources, the input would be Level 3.

Example:

An instrument for which there is currently no active market. A consensus pricing mechanism is used to determine its fair value.

The consensus pricing mechanism gets its inputs from market participants. These participants may determine the fair value by using models with unobservable inputs. The quotes that the participants provide to the consensus pricing mechanism are not binding bids and are not necessarily supported by prices from observable current market transactions.

Response:

Usually level 3 unless evidence can be provided that the quotes are supported by observable transactions or inputs, in which case, level 2.
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