Accounting for derivatives at fair value involves judging the level of the inputs used in each measurement. For a Level 3 measurement, it also involves preparing disclosures such as a reconciliation from opening to closing balances. The basis for that judgment and those disclosures is the definition of fair value and the idea of the levels.

Fair value is an exit price

Fair value is the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. This is called an exit price1.

IFRS 13 Fair Value Measurement (International Accounting Standards Board, IASB) and ASC 820 Fair Value Measurement (US Financial Accounting Standards Board, FASB) use the same definition2.

The price actually paid to acquire an asset is an entry price, and it can differ from the exit price3. A measurement uses the assumptions market participants would use in pricing under current market conditions, including assumptions about risk. For that reason, the entity's intention to hold an asset or to settle a liability is not relevant to the measurement1.

Before IFRS 13, the requirements for how to measure fair value and what to disclose were scattered across several standards. The IASB began this work in 2005, brought the requirements together in one standard, and issued it in May 20114. IFRS 13 applies when another standard requires or permits fair value measurement. It does not change what is measured at fair value5.

In valuation articles, such as those on the daily P&L sign-off, the value calculated for a position as the result of a valuation is not the same thing as accounting fair value. Accounting fair value is the value for which a standard sets the objective and conditions of measurement, so the two differ in definition. Japan's standard is covered in Japan's Fair Value Measurement Standard.

Valuation techniques and the inputs that set the level

Fair value is estimated with valuation techniques. ASC 820, as quoted in the Deloitte commentary, requires one or more techniques consistent with the three approaches below6.

Approach Idea Examples of techniques that ASC 820 lists
Market approach Uses prices and other information from market transactions involving identical or comparable assets or liabilities Matrix pricing, which derives a price from its relationship to similar securities
Income approach Converts future cash flows, or income and expenses, into a single current (discounted) amount, reflecting current market expectations Present value techniques, and option pricing models such as the Black-Scholes-Merton formula and binomial models
Cost approach Uses the amount currently required to replace the service capacity of an asset (current replacement cost) Replacement cost methods for tangible assets

The aim of a technique is to estimate the price at which an orderly transaction would take place at the measurement date under current market conditions. A technique that suits the circumstances and for which enough data is available is chosen. Observable inputs are used as much as possible, and unobservable inputs are kept to a minimum6.

The levels described in the next section give priority to the inputs to a technique, not to the technique itself. For example, a fair value derived with a present value technique can be Level 2 or Level 3, depending on the level of the inputs that are significant to the measurement as a whole7. IFRS 13 likewise divides the inputs to valuation techniques into three levels, giving the highest priority to unadjusted quoted prices and the lowest to unobservable inputs8.

Fair value levels 1 to 3 (the fair value hierarchy)

The levels of fair value are called the fair value hierarchy in the glossary. The hierarchy divides the inputs used to measure fair value into three levels by how observable they are. The definitions of the levels in IFRS 13 and ASC 820 are worded the same way910.

Level Inputs Rule for use
1 Quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date Used without adjustment when available (for the ASC 820 exceptions, see below the table)
2 Inputs other than Level 1 quoted prices that are observable for the asset or liability, directly or indirectly If the asset or liability has a contractual term, the input must be observable for substantially the full term
3 Unobservable inputs The entity's own data may be used. If needed, it is adjusted to reflect market participants' assumptions

ASC 820 limits the cases in which a Level 1 input may be adjusted. Examples are a practical expedient such as matrix pricing, when an entity holds many similar assets or liabilities and individual quoted prices are hard to obtain, and a case in which an event after the market closes means the quoted price does not represent fair value at the measurement date. A measurement that has been adjusted falls into a lower level10.

Level 2 inputs include quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active, observable interest rates and yield curves, implied volatilities, and credit spreads11. An active market is one in which transactions take place with enough frequency and volume to provide pricing information on an ongoing basis12.

The figure below shows the order in which the level is set from how observable the inputs are.

YesNoAre all the significantinputs observable?Level 3YesNoIs it an unadjustedactive-market quote foran identical item?Level 2Level 1(in principle)
Figure 1The order for setting the level from how observable the inputs are
Figure description

The figure uses two questions to lay out the levels. The first is whether all the significant inputs are observable. The second is whether the measurement is itself an unadjusted quoted price in an active market for an identical asset or liability. The questions concern only how observable the inputs are, and the type of valuation technique is not part of them.

What the figure does not show is the condition on Level 2 inputs and the judgments involved. For Level 2, if the asset or liability has a contractual term, the input must be observable for substantially the full term. Which inputs are significant, and whether a market is active, are matters of judgment, and the figure only lays out the results of those judgments. The ASC 820 exception that allows adjusting a Level 1 input is dealt with inside question 2, and an adjustment to a Level 2 input that is significant is dealt with inside question 1.

Which level derivatives fall into

The level of a derivative is set by the inputs used in the measurement, not by the type of product. The commentary by the audit firm Deloitte contains the following examples, in line with the approach of ASC 8201415.

Example Basis of the valuation Level
A future traded in an active futures market Exchange quoted price Can be Level 1
An OTC forward that the counterparty settles at the quoted price of a similar future Quoted price of a similar future Level 2 or Level 3
An OTC interest rate swap Discounting with an observable yield curve, or transaction prices of similar swaps Level 2. Level 3 if any significant input is unobservable
A 3-year option on a listed stock Implied volatility extrapolated from the prices of 1-year and 2-year options That volatility is a Level 2 input if it is corroborated by market data for substantially the full term

A forward is not identical to a future because the counterparty is different and the forward cannot be resold on an exchange. In this example, counterparty risk and liquidity risk are described as greater for the forward than for the future. In the interest rate swap example, the swap is not identical to a similar swap even when similar swaps trade, and so it is not Level 114.

When an adjustment to a Level 2 input is significant and unobservable inputs are used, the measurement as a whole can be Level 316.

Consider a hypothetical example in which a bank classifies three derivatives. A derivative with a negative fair value (a liability) is classified on the same basis.

Trade Fair value Level
Listed equity option (quoted price in an active market) +300 million yen 1
OTC interest rate swap (discounted with an observable rate curve) +1.2 billion yen 2
OTC structured trade (volatility, a significant input, is unobservable) −200 million yen 3

The −200 million yen at Level 3 changes with how the unobservable inputs are set.

The example above lists classifications at one point in time. Consider a hypothetical example in which the level of a single trade, an OTC interest rate swap held by Bank H, changes with how observable the inputs are. No amounts are used.

Scenario Inputs used for discounting Level, applying the conditions in the text
1. The yield curve is observable An observable yield curve for substantially the full contractual term Level 2
2. The yield curve becomes unobservable for part of the term, and the entity fills that part with its own estimate An adjustment based on the entity's own estimate is added to the observable inputs Can be Level 3 (when the adjustment is significant)

The product and the valuation technique are the same in both scenarios. What changes is how observable the inputs are, and that moves the level. In scenario 2, a judgment is needed on whether the adjustment is significant.

Level 3 carries more disclosures

Under IFRS 13, disclosure is required of the valuation techniques and inputs used to measure fair value, information about measurement uncertainty, and the level classification. For Level 3 measurements, the following four items are required in addition17.

  • A reconciliation from the opening to the closing balances
  • Quantitative information about the significant inputs used in the valuation technique
  • The valuation processes the entity uses
  • The sensitivity to changes in significant unobservable inputs (in narrative form for all measurements, and with a quantitative analysis for financial instruments)

Disclosures for Level 3 were expanded because of the subjectivity inherent in Level 3 measurements and strong demand from users of financial statements for additional information18. In the review report published by the IFRS Foundation in December 2018, stakeholders named the Level 3 reconciliation and the quantitative sensitivity analysis for financial instruments as the disclosures that cost the most to prepare. The IASB concluded that it had been aware of these costs when it issued the standard and that the benefits to users are greater19.

Credit risk, and measurement on a net position

Under IFRS 13, the fair value of a derivative is required to reflect own and counterparty credit risk21. The fair value of a liability reflects the effect of non-performance risk, which includes the entity's own credit risk22. The adjustments that reflect counterparty and own credit risk in the valuation of derivatives are CVA and DVA, which are part of XVA. The calculation is covered in Overview of XVA.

Financial institutions manage positions whose market risk or counterparty credit risk offsets as a group. As an exception, a group of financial assets and financial liabilities of this kind is permitted to be measured at the price that would be received to sell a net long position (an asset) for a particular risk, or paid to transfer a net short position (a liability). Using the exception requires the following conditions to be met. It applies to financial instruments that are measured at fair value on a recurring basis23.

  • The entity can demonstrate on an ongoing basis that it manages the group on the basis of its net exposure
  • The offsetting market risks are substantially the same
  • If credit risk is measured on a net basis, there is an arrangement with the counterparty that reduces the exposure in the event of default

An adjustment based on the fact that the quantity held is larger than the normal daily trading volume of the quoted price (a blockage factor) is not permitted. Premiums and discounts that reflect characteristics that market participants would consider in a transaction, however, are included in fair value24.

Where IFRS and ASC 820 differ

The definition (an exit price) and the three levels are the same in the two standards. The IASB and FASB worked together and aligned their measurement and disclosure requirements in 201125. The table below lists differences between IFRS and ASC 820 given in the Deloitte commentary. The IFRS side of the first row is a provision of IFRS 9, not of IFRS 13.

Item IFRS ASC 820
Initial gains and losses A difference from the transaction price can be recognized only when the fair value is supported solely by observable market data26 When the transaction price of an asset or liability measured at fair value from initial recognition differs from fair value, the difference is recognized in profit or loss unless another standard specifies otherwise26
Practical expedient for net asset value (NAV) This expedient is not provided for investments in investment entities26 In certain circumstances, the reported net asset value of an investment in an investment company can be used as fair value without adjustment26

At the time of issue in 2011, IFRS required quantitative sensitivity disclosure for Level 3 for financial instruments measured at fair value and classified in Level 3, and US GAAP did not25.

Notes

  1. IFRS Foundation, "IFRS 13 Fair Value Measurement" web page, overview (the definition, the exit price, market participants' assumptions, and the fact that the intention to hold or settle is not relevant). The definition and the exit price also appear on page 16 of the IASB's "IFRS 13 Fair Value Measurement Project Summary and Feedback Statement" (May 2011). ↩ ↩2

  2. IASB, "IFRS 13 Fair Value Measurement Project Summary and Feedback Statement" (May 2011), pages 2 and 9. It says that IFRS and US GAAP now have the same definition of fair value and the same requirements for measurement and disclosure. ↩

  3. The same document, page 17. It describes the acquisition price as the entry price and the hypothetical price received on a sale as the exit price. ↩

  4. The same document, page 2 (issued in May 2011, work begun in 2005) and page 4 (requirements were scattered across several standards, and are brought together into a single set of requirements). ↩

  5. The same document, page 2. It says that the standard applies when another IFRS requires or permits fair value measurement, and does not change what is measured at fair value. ↩

  6. Deloitte's Roadmap "Fair Value Measurements and Disclosures" (the Roadmap), section 10.3, which quotes ASC 820-10-35-24, 35-24A and 55-3A to 55-3G. Examples of techniques run from 55-3C (matrix pricing) to 55-3G (present value techniques, option pricing models). ↩ ↩2

  7. ASC 820-10-35-38, quoted in the same section. It says that the hierarchy gives priority to the inputs to a valuation technique, not to the technique itself, and that a measurement derived with a present value technique can be Level 2 or Level 3, depending on the level of the inputs significant to the measurement as a whole. ↩

  8. IFRS Foundation, "Post-implementation Review of IFRS 13 Fair Value Measurement" (December 2018), page 4. Among the main points of IFRS 13, it lists dividing the inputs to valuation techniques into three levels, with the highest priority given to unadjusted quoted prices and the lowest to unobservable inputs. ↩

  9. IASB, "IFRS 13 Fair Value Measurement Project Summary and Feedback Statement" (May 2011), page 6 (Fair value hierarchy). Level 1 inputs are used without adjustment when available. The fact that the wording of IFRS and US GAAP is aligned is on page 2. ↩

  10. The Roadmap, section 8.2, which quotes ASC 820-10-35-40, 35-41 and 35-41C, and section 8.3, which quotes ASC 820-10-35-47 and 35-48. ↩ ↩2

  11. ASC 820-10-35-48, quoted in section 8.3 of the same Roadmap. The same paragraph also says that, when there is a contractual term, the input must be observable for substantially the full term. ↩

  12. ASC 820-10 glossary (Active Market), quoted in section 8.2 of the same Roadmap. ↩

  13. IFRS Foundation, "Post-implementation Review of IFRS 13 Fair Value Measurement" (December 2018), page 7 (Implementation challenges and inconsistent application), and page 3, which states the conclusions of the review. ↩

  14. The Roadmap, section 8.2, Example 8-6 (OTC forward) and Example 8-7 (OTC interest rate swap). The fact that a future can be Level 1 is stated in Example 8-6. ↩ ↩2

  15. ASC 820-10-55-21 (the examples of an interest rate swap and a 3-year option on a listed stock), quoted in section 8.3 of the same Roadmap. ↩

  16. ASC 820-10-35-51, quoted in the same section. ↩

  17. "IFRS 13 Fair Value Measurement Project Summary and Feedback Statement" (May 2011), page 6 (disclosure), page 8 (valuation processes and sensitivity) and page 27 (the main Level 3 disclosure items). ↩

  18. The same document, page 26. It gives the subjectivity of Level 3 measurements as the reason for the demand for additional disclosures. ↩

  19. IFRS Foundation, "Post-implementation Review of IFRS 13 Fair Value Measurement" (December 2018), page 7 (Unexpected costs). The costs were cited by stakeholders, and the IASB's conclusion is in the same place. ↩

  20. "IFRS 13 Fair Value Measurement Project Summary and Feedback Statement" (May 2011), page 7. ↩

  21. Takashi Kawakami, "ヘッジ取引におけるデリバティブ信用評価調整の影響についての考察" (A study of the effect of derivative credit valuation adjustments on hedge transactions; in Japanese), Bank of Japan Institute for Monetary and Economic Studies, Monetary and Economic Studies (Japanese edition, Kin'yu Kenkyu), April 2018, section 1 (page 120). It says that IFRS 13 requires the fair value of a derivative to take account of own and counterparty credit risk, so that credit valuation adjustments are reflected. ↩

  22. "IFRS 13 Fair Value Measurement Project Summary and Feedback Statement" (May 2011), page 20. The fair value of a liability reflects the effect of non-performance risk. ↩

  23. The same document, page 22. It gives the conditions for using the exception, and says that it applies to financial instruments measured at fair value on a recurring basis. ↩

  24. The same document, page 23. It covers the prohibition of blockage factors and the treatment of premiums and discounts that reflect characteristics market participants consider. ↩

  25. The same document, page 9 (convergence as of May 2011, and the differences that remain). ↩ ↩2

  26. The Roadmap (checked in October 2026), Appendix B, Table B-1. The IFRS-side treatment of initial gains and losses is IFRS 9 paragraph B5.1.2A, in section B.1 of the same appendix. ↩ ↩2 ↩3 ↩4