Fair value of liabilities and of equity

IFRS 13 Fair Value Measurement contains requirements on how to estimate the fair value of liabilities (and of own equity instruments). Those requirements produce sensible and useful outcomes.

The Standard presents those requirements as achieving an overall objective of estimating the price for a transaction. But that transaction is one that, typically, cannot occur. This post investigates whether specifying that objective causes any problems.

Fair value of a liability

IFRS 13 Fair Value Measurement defines the fair value of a liability as ‘the price that would be paid to transfer the liability’ ‘in an orderly transaction between market participants at the measurement date’.

IFRS 13 stresses that the orderly transaction contemplated in the definition of fair value is a transaction that leaves the liability outstanding, with the market participant transferee being required to fulfil the liability. That transaction is one that would not settle the liability with the counterparty, and that would not extinguish the liability in any other way. (paragraphs 34(a) of IFRS 13 and IE 30 of the Illustrative Examples accompanying IFRS 13)

Transferring a liability

In my view, there are serious difficulties with the idea that the measurement of a liability should reflect a transfer of the liability to another party, leaving the liability outstanding:

  • for many liabilities, the party owing the liability is unable to simply transfer the liability to another party. After all, if companies had the ability to make such transfers unilaterally, that ability would negate the substance of a liability.
  • transferring a liability to another party would extinguish one of the liability’s most fundamental characteristics: the identity of the party owing the liability. Changing the identify of that party seems incompatible with the requirement that the transfer must leave the same liability outstanding.
    Of course, IFRS 13 specifies that the hypothetical transfer is to a party that market participants regard as presenting the same level of credit risk. But keeping the same level of credit risk is not the same thing as keeping the same debtor.   

Practical requirements

Fortunately, IFRS 13 contains some practical requirements on how to estimate the fair value of liabilities:

  • if the issuer’s liability is held by other parties as an asset, the issuer should determine the liability’s fair value from the perspective of a market participant holding the asset. (paragraphs 37-39)
  • on the other hand, if the issuer’s liability is not held by other parties as an asset, the issuer should determine the liability’s fair value from the perspective of a market participant owing the liability. (paragraphs 40-41). That market participant would need to be one facing the same level of non-performance risk as the issuer. (paragraphs 42-44).  

Those practical requirements in paragraphs 37-41 of IFRS 13 are sensible. They are consistent with the overall framework set up in IFRS 13 and with its market-based definition of fair value:

  • Fair value reflects (estimates of) the inputs that market participants would use, not the entity-specific inputs.
  • Fair value is an estimate of the price for a transaction between market participants. It is not an estimate of the price between the entity and another market participant.
  • Estimates of fair value maximise the use of observable inputs.

IFRS 13 addresses some other details of measuring the fair value of liabilities, including own credit risk (and other forms of non-performance risk), credit enhancements (such as guarantees by another party), financial liabilities with a demand feature. Because those details do not affect the point I discuss in this post, I do not cover them here.

Basis for the IASB’s conclusions

The Basis for Conclusions on IFRS 13 discusses why the IASB concluded that the fair value of a liability should reflect the estimated price for transferring the liability to another party, rather than the estimated price that the entity could negotiate for a settlement with the counterparty:

  • paragraph BC82 explains that the IASB rejected using a settlement notion, because that notion ‘may incorporate entity-specific factors’.
  • on the other hand, that same paragraph goes on to conclude—after a rather confusing discussion—that ‘similar thought processes are needed to estimate both the amount to settle a liability and the amount to transfer that liability’.

The liability’s value as an asset

The Basis for Conclusions also appears to explain one reason why the IASB based the fair value of a liability on the fair value of that financial instrument to the counterparty holding it as an asset. Paragraph BC89 states that ‘in an efficient market, the price of a liability held by another party as an asset must equal the price for the corresponding asset’, because any difference would permit arbitrage opportunities.

I do not find that argument convincing. For liabilities that cannot be transferred, there would be no arbitrage opportunities that could be exploited.

But, even though the argument is unconvincing, arriving at the same fair value as the fair value to the holder seems a sensible result.

Fair value of own equity instruments

The requirements in IFRS 13 for liabilities also apply to an entity’s own equity instruments:

  • the instrument’s fair value is the estimated price for a transaction that leaves the instrument outstanding, with the market participant transferee taking all rights and responsibilities associated with the instrument.
  • if the equity instrument is held by other parties as an asset, the issuer should determine the liability’s fair value from the perspective of a market participant holding the asset.

Not a credible notion

The notion that an entity could transfer its own equity instrument entirely to another party while still leaving the instrument outstanding is even less credible than the similar notion for own liabilities. By far the most fundamental term of an equity instrument is that it gives the holder a claim on the residual interest in the issuer’s assets less liabilities. By definition, a claim on the residual interest continues to exist only if the issuer itself is still subject to that claim.  

For discussion of the term ‘residual interest’, please see https://accountingmiscellany.com/equity-is-not-a-residual/

Transferring the liability or selling the company?

I believe there may be a useful way to use the idea that the fair value of a liability should reflect the price for a transaction between market participants, leaving the liability still outstanding. That way is to consider the (estimated) price for shares in the legal entity that owes the liability. The fair value of the liability would be the difference between:

  • the total fair value of the legal entity’s own equity instruments; and
  • the total fair value those equity instruments would have if the liability being measured simply ceased to exist at the measurement date.
    (That difference might need adjustment if removing that liability would cause any consequential effects on the fair value of other liabilities or of assets.)      

The same type of with-and-without calculation might also be usable in determining the fair value of own equity instruments.

Conclusion

Overall, IFRS 13’s requirements for measuring the fair value of liabilities and of own equity instruments give sensible and useful outcomes. Those outcomes measure the burden imposed by a liability (or the value of own equity instruments). That measurement is on a basis reflecting market participants’ views of the cash flows that will result from the liability (or own equity instruments).

However, it is unfortunate that IFRS 13 presents its requirements as achieving an overall objective of estimating the price for a transaction that typically cannot occur. That objective is unrealistic. Perhaps that does not matter too much because the more detailed requirements typically generate sensible and useful outcomes. But there is always a risk that having a mis-specified overall objective could make it more difficult to reach the best answer in unusual cases when the detailed requirements do not help.

Perhaps one way to create a more useful objective would be to focus on a different transaction: the price for shares in the legal entity owing the liability. This objective would consider how much the price for those shares would increase if the liability (or the own equity instrument) did not exist.

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