Scope Of Fair Value Measurement (HKFRS 13)

Adopting fair value measurement is reshaping how companies report their financial health, moving towards more transparent and market-reflective practices. Fair value measurement stands at the forefront of financial reporting and aims to provide a realistic snapshot of an entity’s assets and liabilities. 

HKFRS 13, the standard set forth by Hong Kong’s financial regulatory bodies, governs the measurement of fair value in Hong Kong. It relies on the price received for selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. 

In this article, we will learn everything about what is fair value measurement and the various methods used to measure fair value under HKFRS 13.

HKFRS 13 Fair value measurement

HKFRS 13 plays a pivotal role in ensuring that financial statements offer a true and fair view of an entity’s financial position, thereby aiding stakeholders in making informed decisions. Let’s begin by learning what is fair value measurement.

What is fair value measurement? 

Fair value measurement is a financial reporting method that estimates the price of an asset on sale or a liability settled between informed, willing parties in a transaction. It’s about figuring out what is worth in the market right now, not just what it costs when bought or what it might sell for in a different scenario​​​​. This method is crucial because it gives a more realistic picture of a company’s financial health, moving away from historical costs to how much things are worth now.

How does fair value measurement work? 

When a company needs to figure out the fair value of something, they look at the current market prices for similar items. They can use the going price if there’s an active market. If not, they might need to get more creative, using estimates or calculations based on similar, more commonly traded items. 

This process uses a “fair value hierarchy” that prioritizes the types of information used in these estimates, from most to least reliable. This structured approach helps derive a value as close to the market price as possible, considering the specific characteristics of what’s being measured, like its condition or location​​.

The role of fair value in financial reporting transparency 

Fair value is important in enhancing financial reporting transparency, serving as a critical measure that reflects the true market value of an entity’s assets and liabilities. Let’s look at the role of fair value.

Unlike historical cost accounting, which records assets and liabilities based on their original purchase price, fair value accounting updates these valuations to reflect current market conditions. Financial reporting transparency is vital for building trust between companies and their investors. By incorporating fair value measurements into financial reports, companies offer stakeholders a clear view of the economic reality of their financial position and performance. 

Moreover, fair value accounting can lead to greater volatility in financial statements, as the values of assets and liabilities can fluctuate with market conditions. Adopting fair value measurement is important under various accounting standards, including the International Financial Reporting Standards (IFRS) and, specifically, IFRS 13 Fair Value Measurement. 

Understand HKFRS 13 

HKFRS 13, the Fair Value Measurement standard, was issued to establish a framework for measuring fair value and disclosures about fair value measurements across financial statements. This initiative aimed to harmonize the definition of fair value and the information required from entities about fair value measurements.

Reasons of issuing HKFRS 13

The primary reason for issuing HKFRS 13 was to bring clarity and consistency to the fair value measurement process. By consolidating the fair value measurement principles into a single standard, HKFRS 13 aimed to:

• Provide a single, clear definition of fair value, ensuring that the fair value measurement and disclosure requirements are similar across the board.
• Enhance transparency in financial reporting by requiring detailed disclosures about fair value measurements.
• Help users of financial statements understand how fair value measurements were determined and the impact of fair value measurements on financial statements.

Case study for HKFRS 13

HK Prime Properties, a Hong Kong REIC with prime office buildings, anticipates a fair value decline due to a 5% rental rate drop. They use various valuation methods (like for “The Center” in Central, Hong Kong) following HKFRS 13, considering market data and specific asset characteristics.  Here is an example:

Market Comparison Approach (Level 1):

• Recent transaction data: Two comparable office buildings in the same location were sold in the past quarter.
  • Building A: Similar size and amenities, sold for HKD 20,000 per square meter 
  • Building B: Slightly smaller size, sold for HKD 18,500 per sqm.
• Adjustment: 5% premium for the Center’s superior cooling system.
• Estimated fair value per sqm: (Average of comparable transactions) * (1 + premium) = [(HKD 20,000 + HKD 18,500) / 2] * 1.05 = HKD 19,625.
• Total building area: 50,000 sqm.
• Fair value using the market comparison approach: HKD 19,625/sqm * 50,000 sqm = HKD 981,250,000.

Income Capitalization Approach (Level 2):

• Estimated future net operating income (NOI): HKD 120 million per year
• Capitalization rate: 8% (based on current market cap rates for similar properties).
• Fair value using income capitalization approach: HKD 120 million (NOI) / 8% (capitalization rate) = HKD 1.5 billion.

Cost Approach (Level 3):

• Original construction cost: HKD 1.2 billion.
• Accumulated depreciation: HKD 200 million.
• Replacement cost: HKD 1.4 billion (based on current construction costs and adjustments for building upgrades).
• Depreciated replacement cost: HKD 1.4 billion – HKD 200 million = HKD 1.2 billion.

Fair Value Conclusion:

HK Prime Properties considers all three approaches and their hierarchy levels according to HKFRS 13:

• Level 1 is prioritized due to its high reliability and objectivity. 
• Level 2 is used as a supporting measure due to its reliance on estimates and market assumptions.
• Level 3 is considered a last resort due to its inherent subjectivity but provides a lower bound for the valuation.

Considering all methods and hierarchy levels (HKFRS 13), the fair value is likely between HKD 981.25 million and HKD 1.2 billion. A reasonable estimate is HKD 1.05 billion.

Takeaways:

• Regular, Multi-Method Valuations: Commitment to frequent valuations using diverse methods ensures accuracy and reliability.
• Internal Expertise & Data Analytics: Establishing a valuation committee and leveraging data fosters internal expertise for informed decision-making.
• Continuous Refinement: Ongoing refinement, including a formal process for challenging valuations, demonstrates a commitment to continuous improvement in the competitive Hong Kong real estate market.

Features of HKFRS 13 

HKFRS 13 introduced several key features that set it apart from the previous fair value measurement guidelines:

• Fair Value Hierarchy: The HKFRS sets up a fair value hierarchy that divides the valuation method inputs into three levels. This makes the measurements and disclosures related to fair value more consistent and easy to compare. Level 1 inputs, or quoted prices for equivalent assets or liabilities in active markets, receive the highest priority under this hierarchy, whereas Level 3 inputs, or unobservable inputs, receive the lowest priority.
• Market Participant View: The standard requires fair value to be determined based on the perspective of market participants rather than a specific entity, promoting a market-based measurement.
• Highest and Best Use Concept: For non-financial assets, fair value measurement considers the asset’s highest and best use, which might not necessarily be its current use.
• Disclosure Requirements: HKFRS 13 expanded the disclosure requirements for fair value measurements, especially for measurements that use significant unobservable inputs (Level 3), to increase transparency about the valuation techniques and inputs used in determining fair value.

HKFRS 13: Framework and Scope

HKFRS 13 aims to clarify how fair value measurements happen across various financial reporting standards. It enhances the comparability and reliability of financial information by ensuring that fair value measurements under Hong Kong Financial Reporting Standards (HKFRS) are consistent.

The scope of HKFRS 13 is broad and applies to financial and non-financial assets and liabilities for which other HKFRSs require or permit fair value measurements or disclosures about fair value measurements. 

• It includes, for example, investments in securities, real estate properties held for investment purposes, and certain types of liabilities. 
• However, it excludes certain items such as share-based payment transactions, leasing transactions, and measurements that have similarities to fair value but are not fair value, such as the net realizable value used in HKFRS for inventories or value in use in impairment testing.

The standard introduces a fair value hierarchy that prioritizes the inputs used in valuation techniques into three levels. Entities must use the highest and best-use concept for non-financial assets, considering what market participants would use the asset for. The standard also emphasizes using appropriate valuation techniques when sufficient data is available, including the market, cost, and income approaches.

Valuation Techniques and Inputs under HKFRS 13

Under HKFRS 13, “Fair Value Measurement” entities use various valuation techniques like the Meket-based, Asset-based, and income-based approaches to determine the fair value of assets and liabilities. HKFRS 13 categorizes the inputs used in these valuation techniques into three levels:

• Level 1 Inputs: The most reliable, these are unadjusted quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date.
• Level 2 Inputs: These include 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: The least observable inputs, these are unobservable inputs for the asset or liability, reflecting the entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability.

Where Can You Apply These Techniques in Real Life?

The application of these valuation techniques depends on the availability and reliability of data for the asset or liability measured:

• For Real Estate: The market approach could be used, utilizing recent transaction prices for similar properties in the same location. However, considering the potential rental income, the income approach might be more appropriate if no recent transactions have occurred.
• For Financial Instruments: Level 1 inputs would be used directly if actively traded. Level 2 inputs like comparable market transactions or model-based valuation techniques using observable market data might apply to less liquid instruments.
• For Intangible Assets or Unique Items: In cases where there are no market-based inputs available, the cost approach or the income approach using Level 3 inputs, such as forecasted cash flows or earnings, would be necessary. Entities must rely on their data and assumptions, carefully documented and justified.

What are the methods used to measure fair value under HKFRS 13?

There are three main methods used to measure fair value under HKFRS 13: the market approach, the cost approach, and the income approach. Each method offers a unique perspective on value, tailored to the specific characteristics of the asset or liability.

Market Approach

The market approach estimates fair value based on what similar assets or liabilities are currently sold for in the market. This method relies heavily on the availability of market data, making it most applicable when there are active markets for comparable items. 

It’s straightforward and transparent because it reflects current market conditions. For instance, if a company wants to value its publicly traded stocks, it would look at the current trading price of those stocks in the stock market.

Cost Approach

The cost approach determines fair value based on the cost to replace an asset with another of comparable utility. This method is particularly useful for assets that do not have active market prices but still contribute to a business’s production process or operation, such as machinery or equipment. 

It considers the replacement cost as if a similar asset were to be acquired or constructed today, adjusting for any depreciation or obsolescence.

Income Approach

The income approach converts future amounts (cash flows or earnings) that an asset would generate into a single present value. This method requires assumptions about future earnings and a discount rate to calculate the present value of those earnings. 

It’s applicable for valuing businesses, real estate properties capable of generating rental income, or any asset where you can estimate future cash flows. The approach reflects the present worth of future economic benefits, making it particularly relevant for investments or assets that do not have comparable market prices but would provide future economic benefits.

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With Eqvista’s support, companies can confidently address fair value measurement requirements, enhancing transparency and strategic decision-making. For personalized assistance and to explore the full range of valuation services, contact Eqvista through our website.