“Level 3” measures under IFRS 13 – observe the unobservable

A European example of challenges in applying the IFRS 13 disclosure requirements

Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 19th edition:

  • “The issuer is a Real Estate Investment Trust and owns approximately 1,500 multi-unit residential rental apartment properties in and near urban centres. In its 2014 annual financial statements, the issuer disclosed that the ‘capitalization rate’ and ‘stabilized net rental income’ were the key unobservable inputs/assumptions. ‘Stabilized net rental income’ represents the net rental income from a stabilized portfolio, defined as all properties owned continuously during an accounting period.
  • Regarding the capitalization rate, the issuer disclosed all information required by paragraph 93 of IFRS 13. However, with regard to the stabilized net rental income, the issuer’s fair value notes did not disclose the information required by paragraphs 93(d) and (h)(i) of IFRS 13:
  •    a description of the valuation technique and the inputs used in the fair value measurement of the investment property;
  •    quantitative information about the significant unobservable inputs used in the fair value measurement of investment property; and
  •    a narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs if a change in those inputs to a different amount might result in a significantly higher or lower fair value measurement.
  • Contradicting its disclosures regarding the key unobservable inputs/assumptions, the issuer argued that the disclosures required by paragraphs 93 of IFRS 13 were not provided for the stabilized net rental income, because it was not a significant unobservable input. In the issuer’s view, whereas the capitalization rate is determined by the use of market data and the application of professional judgement, the stabilized net rental income was built up unit-by-unit based on most recent rents knowledge and therefore there would be no single ‘input’ applied to determine the stabilized net rental income. The issuer argued that a variation in the net rental income for an individual unit (even a significant variation) would not have a significant impact on the fair value measurement of the property portfolio. Therefore, the issuer considered that the stabilized net rental income was not a significant unobservable input.”

The enforcer (as ESMA likes to term it) disagreed with this conclusion, taking the view that ‘stabilized net rental income’ was indeed a significant unobservable input. Basically, the enforcer noted that the calculation is influenced by how the issuer chooses to define it, and that it involves a degree of aggregation; this calculation could plainly be subject to variation that could affect the ultimate measurement.

There’s certainly one clear message here – it’s never a good idea to make contradictory assertions in your own disclosure. That aside, the issuer’s argument does appear to have been rather strained. Put in very basic terms, the concept of unobservable inputs entails that a third party has no way to know how a particular asset’s fair value was measured, beyond what the issuer itself discloses about it. Stabilized net rental income might seem to the issuer like a straightforward and uncontroversial way of measuring fair value in this situation, but a user of the statements would only have the issuer’s word for that, and for “level 3” inputs, that’s basically never enough. If nothing else, the issuer evidently forgot one big thing – the extent of the neurosis that underlies IFRS 13 when it comes to “level 3” measurements.

The basis for conclusions to the standard records that some respondents to the original exposure draft thought it would be misleading to describe a measurement using significant unobservable inputs even as being a fair value measurement, given for example that these inputs may include entity-specific factors that market participants wouldn’t consider (if only, I suppose, because they wouldn’t know about them, although the standard requires adjusting the data used in the calculation if information indicates other market participants would use different data). These respondents suggested a different label, but the IASB rejected the idea, relying on extensive disclosure requirements instead. Still, the point has some validity. Whereas (say) the balance sheet carrying amount of a quoted equity does provide a meaningful sense of the proceeds the issuer might have received from selling the asset at that date, the value attached to a “level 3” asset is often, in effect, really more a way of engaging with and thinking about it. But then a user of the statements can’t even do that much, unless the issuer gives them some information to actually engage with.

If you’re a skeptic, you might question whether all the disclosed data really has any specific value. In some cases it might as well be replaced by a single bolded sentence saying simply: “Don’t trust this number.” And, perhaps, a lot of the time, no one fully does. Still, IFRS 13 requires providing disclosure as if they might

The opinions expressed are solely those of the author

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