IFRS - Fair Value hierarchiesFollow @PwC_UK
In March 2009, the IASB issued an amendment to IFRS 7: Financial Instruments: Disclosures, which will be effective for financial periods after 1 January 2009. One of the amendments relates to additional disclosures on classification of fair value measurement. Similar to the US accounting standard SFAS 157, the amendment introduces a three tier hierarchy disclosure for fair value measurement based on the significance of inputs. The three levels are:
- Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities, i.e. those that are readily available in the market and are normally obtainable from multiple sources.
- Level 2: 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 for assets or liabilities that are not based on observable market data (unobservable inputs).
The significance of the input determines the classification of the financial instrument in the fair value hierarchy and each instrument would need to be evaluated in detail on a separate basis. The levels are to be ascertained on the basis of the lowest level input that is significant to the fair value measurement in its entirety. For example, if a fair value measurement uses observable inputs that require significant adjustment based on unobservable inputs, that measurement is a Level 3 measurement.
While one would imagine that financial institutions will be more concerned about this additional disclosure, given the types of complex instruments they transact, corporates too have to carefully consider what levels their financial instruments would fall under, particularly when they hold over-the-counter (OTC) or bespoke type instruments such as interest rate swaps.
The following are some key considerations to help corporates in their classification:
Are all listed instruments classified as Level 1?
- Normally instruments that have direct listing on an exchange are classified as Level 1. However, questions such as how active the market is and how tradable the instrument is should be considered. An active market is one in which transactions take place regularly and at arm’s length basis. For example, if the trading activity for a security is low and the prices not updated on a regular basis, the security is likely to be classified as Level 2 or Level 3. Stale prices are also indicative of Level 3.
Are all FX forward and swap contracts Level 2?
- No. The underlying rates tradability and contract maturity should be considered. In the case of a swap with maturity of 30 years with observable market of 15 years, due to the long maturity factor, the swap may be classified as Level 3.
- Corporates should also consider other inputs such as credit risk and liquidity premium which may significantly impact the fair value measurement of the instruments in their entirety. If these inputs are based on an unobservable or inactive benchmark, the instrument may be classified as Level 3.
Are “Broker Quotes” indicative of Level 2?
- Quotes from brokers (intermediary market participants) are generally indicative of Level 2, if those quotes are executable and do not contain any waiver notices indicating that they are not necessarily tradable.
- Corporates should source quotes from more than one broker to ascertain their executability. If possible, corporates should evaluate the quotes based on the quality of supplier, how current the quotes are, the number of contributors, and the bid-ask spreads (higher spreads are indicative of an inactive market).
Is interpolation of pricing inputs indicative of Level 2?
- Interpolation between two inputs whether based on linear method or more sophisticated method is generally more reliable. This is because information is based on two surrounding known data points rather than one, hence indicative of Level 2. However, if a significant adjustment is required when interpolating, this would be indicative of Level 3.
How about extrapolation, is it indicative of Level 3?
- Not necessarily. The significance of the level of extrapolation required and the data from which the input is being extrapolated are key factors in determining the likely fair value hierarchy.
For example, for a market quote up to five years, extrapolating for the six year quote may not impact significantly the fair value measurement of a six year instrument. In this case the instrument is likely to be classified as Level 2. However, if the five year quote is extrapolated to 10 years for fair value measurement of a 10 year instrument, the long maturity will significantly impact the fair value of the instrument and it would likely be classified as Level 3.
Whilst Level 1 and 2 disclosures are relatively easy, the challenges will be on Level 3 disclosure which can be onerous. However, as indicated above, assessing the significance of a particular input to the fair value measurement requires judgement and careful consideration on factors specific to the asset or liability. Corporates should have enough justification and evidence to satisfy their auditors when deciding on their classification.
If you are in doubt or have questions regarding the fair value hierarchy classification, please do not hesitate to get in contact with me using the comment facility.