An example of the limitations of valuation techniques

The Canadian IFRS Discussion Group recently considered the following fact pattern, versions of which come up fairly often in practice:

• “On December 23, 2014, Entity A recognizes a financial liability at $1,000, which is equivalent to the consideration received;
• Entity A used a valuation technique to measure the fair value of the financial liability at initial recognition and determined that its fair value was $1,200;
• Entity A is prohibited from recognizing the $200 loss on initial recognition (by IAS 39.AG76) because the valuation technique uses unobservable inputs. It would defer off-balance sheet the valuation technique-derived $200 loss;
• On December 31, 2014 (which is Entity A’s year end), it is required to measure the financial liability at the then fair value, with changes in fair value recognized in earnings (assuming the financial liability is not part of a hedging relationship). Entity A uses the same valuation model to measure the financial liability at year end and the result is that the financial liability’s fair value has decreased by $100 (i.e., the valuation technique-derived fair value is now $1,100).”

The group discussed two separate views of how to deal with this change in fair value. One view was that, assuming the valuation technique employed is appropriate, the entity modifies one or more of the input assumptions in the model so that the fair value it initially generates, as a whole, equals the actual transaction price. It then uses that revised valuation process for that instrument on a consistent and appropriate basis throughout its life, recognizing any subsequent changes in the fair value determined by that revised technique in earnings as they arise.

The second view posited that the initial difference between the value generated by the valuation technique and the actual transaction price ($200 in this instance) is an “illiquidity adjustment” (that is, an actual difference from fair value). IAS 39.AG76 says the entity subsequently recognizes such a “deferred difference” as a gain or loss “only to the extent that it arises from a change in a factor (including time) that market participants would take into account when pricing the asset or liability.” Under this view then, the entity should determine a rational method for applying that principle (perhaps by recognizing the difference over the term of the instrument). It recognizes any further changes in the instrument’s fair value, excluding the “illiquidity adjustment”, in earnings.

The group noted “that it is important to understand what is driving the differences between transaction price and fair value and whether all elements of the transaction have been taken into consideration in the valuation model.” This indeed seems to be the key to the issue, as practitioners frequently find themselves dealing with so-called fair value measurements that fly in the face of common sense. To take a related fact pattern, suppose an entity issues a unit consisting of a common share and an attached share purchase warrant (classified as a liability), for total consideration of $1. The entity applies a valuation model at the issue date, which indicates that the warrant has a fair value of 30 cents. If the common share is trading in an active market and therefore has a demonstrable fair value of 90 cents, then it might appear that the entity (due to inept negotiation?) has given away value, and that the excess 20 cents of value transferred to the acquirer has to be dealt with somehow.

But it’s far more likely that this only shows the artificiality of the valuation model. In the absence of compelling evidence to the contrary, it’s likely that the entity carried out the only real-world negotiation available to it, and that the deal it actually made counts for much more than some theoretical indication of the price it could/should have had. By the same token, it’s not usually likely that the price it obtained on the transaction date would have been materially different the following day, or the following week. In this simple example, the entity might perhaps conclude that the fair value for the warrant that best corresponds to the IFRS 13 definition (that is, what would be received or paid to sell or transfer an instrument in an orderly transaction between market participants) is actually one third of what’s indicated by the model (on the transaction date, 10 cents rather than 30 cents) and – in the absence of any evidence that emerges to the contrary – apply that same one-third methodology to measure subsequent gains and losses. This might be a cruder approach than the first view set out above (which talked about modifying input assumptions rather than monkeying with the outcome), but let’s face it: it’s going to be a largely arbitrary result either way.

Anyway, unsurprisingly, the group mostly supported the first view, although some noted that it may go the other way in specific circumstances. No doubt that’s true – sometimes, one side genuinely outsmarts the other, and walks away from a deal with more than they paid for. But most of the time, we’re better sticking to the premise that cash speaks louder than theory…

The opinions expressed are solely those of the author