FRC Review of Fair Value Measurement

In June 2023, the Financial Reporting Council (FRC) released a thematic review focusing on IFRS 13, Fair Value Measurement. Although this review primarily concerns companies reporting under IFRS, its findings are relevant for entities applying FRS 102, particularly as economic and environmental challenges increase the degree of estimation uncertainty.

The following were highlighted as key findings:

• Fair value measurements should use market participants’ assumptions and not the company’s own assumptions.

• Companies should consider the need for specialist third party advice.

• High quality disclosures are key.

The report goes on to state that most of the issues the FRC finds are in relation to disclosures rather than measurement of fair value.

Measurement

A significant issue identified by the FRC is that some companies are incorrectly using their own assumptions when determining fair value, rather than considering the assumptions that market participants would make under current market conditions. This can distort fair value measurements, leading to inaccurate financial reporting.

Additionally, the FRC highlights the importance of adjusting transaction prices when necessary, particularly in related party transactions where the price may not reflect fair value. In such cases, companies are encouraged to seek third-party specialist advice, especially for material items or where internal expertise is lacking.

Disclosures

The FRC notes that most issues arise from inadequate disclosures. Under IFRS 13 and FRS 102, entities are required to provide disclosures that help users understand the valuation techniques and inputs used in fair value calculations. These disclosures are critical, especially when entities rely on unobservable inputs, categorised as Level 3 in the fair value hierarchy (see below).

The FRC stresses the importance of quantitative disclosures. Preparers often disclose the nature of inputs but omit quantitative details. Sensitivity analyses for Level 3 measurements, which are essential for understanding the potential variability of fair value, are frequently incomplete or omitted. Furthermore, recurring Level 3 measurements, such as contingent consideration, must include a reconciliation of opening and closing balances, a requirement that is often neglected.

Categorisation

The fair value hierarchy classifies inputs used in measurement into three levels:

• Level 1: Quoted prices in active markets for identical assets or liabilities.

• Level 2: Inputs other than quoted prices that are observable, either directly or indirectly.

• Level 3: Unobservable inputs, often requiring significant estimation and judgment.

The FRC frequently challenges the categorisation, particularly when companies misclassify Level 2 or 3 inputs. For example, instruments with no apparent quoted prices may be incorrectly categorised as Level 1. Similarly, some companies categorise inputs as Level 2 even though their peer groups classify similar measurements as Level 3.

Key Areas for Improvement in Disclosures

To address the recurring issues, the FRC provides several recommendations for improving the quality of disclosures:

• Detailed Disclosure of Valuation Techniques: Preparers must disclose the valuation techniques used for both Level 2 and 3 measurements, including any changes in these techniques. This is often overlooked.

• Quantitative Sensitivity Analysis: For recurring Level 3 measurements, preparers should provide quantitative sensitivity analyses to help users assess the range of reasonably possible alternative assumptions.

• Avoidance of Boilerplate Information: Disclosures should avoid generic, boilerplate language and focus on providing meaningful, entity-specific information.

• Climate-Related Disclosures: Companies should explain how climate-related risks have been incorporated into fair value measurements, particularly where these risks have a material impact on the valuation of assets and liabilities.

• Consistency Across Financial Statements: Fair value disclosures should be consistent with other information in the financial statements, helping users better understand how fair value measurements relate to the company’s overall financial performance and risk profile.

• Transfers Between Levels: Companies must disclose any transfers between the fair value hierarchy levels, particularly between Level 1 and 2, which are often overlooked.