Fair value measurement and financial statement presentation

Lesson 1 described two families of measurement: historical cost and current value. Historical cost is easy to verify but can grow stale; current value is more relevant for some assets but depends on estimates. Fair value is the current value that standards use most often, for investments in shares and bonds, for impairment tests, for assets acquired in a business combination, for investment property and biological assets under IFRS, and for many disclosures. This lesson explains how fair value is measured and how its inputs are graded by reliability. It then turns to presentation: how the income statement and statement of comprehensive income are organized, including the new IFRS 18 categories and subtotals and the US disaggregated expense disclosures, and how discontinued operations are shown. Lesson 3 covers the statement of financial position and the statement of cash flows.

What fair value means

IFRS 13, Fair Value Measurement, defines fair value as 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. ASPE has no single fair value standard; where ASPE requires fair value (for example, for certain financial instruments) it gives guidance within the relevant section. US GAAP's ASC 820 uses essentially the same definition as IFRS 13; the two were developed together.

Several words in the definition carry weight. It is an exit price, what the company would receive to sell, not what it would pay to buy (an entry price), although the two are often close. It is market-based, not entity-specific: it reflects the assumptions market participants would use, not management's own plans. It assumes an orderly transaction, not a forced sale or distressed liquidation. It is measured in the principal market for the asset (the market with the greatest volume and level of activity) or, if there is none, the most advantageous market. Transaction costs are not deducted from fair value, although transport costs to get the asset to market are.

For non-financial assets such as land, buildings or equipment, fair value assumes the asset's highest and best use: the use by market participants that would maximize its value, provided it is physically possible, legally permissible and financially feasible. If Northlake owns a vacant lot zoned for commercial development that it uses for parking service vans, its fair value reflects commercial development value if that is legally permitted and feasible, even though Northlake intends to keep parking vans there.

Valuation techniques

Standards recognize three valuation approaches, and an entity uses whichever are appropriate and for which enough data is available, maximizing the use of observable inputs. The market approach uses prices and other information from market transactions involving identical or comparable assets, such as quoted share prices or multiples of comparable companies. The income approach converts future amounts (cash flows or earnings) into a single current amount by discounting, as in a discounted cash flow model or option-pricing model. The cost approach reflects the amount that would be required currently to replace the service capacity of an asset (current replacement cost), adjusted for obsolescence; it is common for specialized equipment.

The fair value hierarchy

Because fair value can rely on more or fewer estimates, the standards classify the inputs used into three levels and require disclosure by level. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date, such as the closing price of a share on the TSX or NYSE. Level 2 inputs are observable inputs other than Level 1 prices: quoted prices for similar assets, prices in inactive markets, and observable inputs such as interest rates, yield curves and credit spreads. Level 3 inputs are unobservable, reflecting the entity's own assumptions about what market participants would use, such as projected cash flows for a private company or a discount rate built from judgement. The whole measurement is classified at the lowest level of any significant input.

The hierarchy is about inputs, not about which assets are safe. A share of a large listed company is Level 1 even if its price is volatile; a private company's shares are Level 3 even if the business is stable. For Level 3 measurements, both IFRS 13 and ASC 820 require a reconciliation of opening and closing balances, quantitative information about significant unobservable inputs and a description of valuation processes; IFRS also requires sensitivity information. Analysts pay close attention to Level 3 balances because they are where management judgement can most influence reported values.

# Classify fair value measurements by the lowest significant input (illustrative)
holdings = [
    # name, fair value, levels of significant inputs used
    ("Listed shares (exchange price)", 820_000, [1]),
    ("Corporate bond (priced from yield curve)", 410_000, [2]),
    ("Interest rate swap (observable curves)", 35_000, [2]),
    ("Shares of a private supplier (DCF)", 260_000, [2, 3]),
    ("Contingent consideration owed (probabilities)", -140_000, [3]),
]
totals = {1: 0, 2: 0, 3: 0}
for name, fv, levels in holdings:
    level = max(levels)          # lowest priority = highest level number
    totals[level] += fv
    print(f"Level {level}  {fv:>10,}  {name}")
print("Totals by level:", {k: f"{v:,}" for k, v in totals.items()})
assets = sum(fv for _, fv, _ in holdings if fv > 0)
print(f"Share of fair-valued assets in Level 3: {260_000 / assets:.1%}")

Level 1     820,000  Listed shares (exchange price)
Level 2     410,000  Corporate bond (priced from yield curve)
Level 2      35,000  Interest rate swap (observable curves)
Level 3     260,000  Shares of a private supplier (DCF)
Level 3    -140,000  Contingent consideration owed (probabilities)
Totals by level: {1: '820,000', 2: '445,000', 3: '120,000'}
Share of fair-valued assets in Level 3: 17.0%

The private supplier's shares use some observable inputs, but the cash flow forecast is a significant unobservable input, so the whole measurement drops to Level 3. The contingent consideration is a liability measured at fair value and is also Level 3. About 17 per cent of Northlake's fair-valued assets rely on its own assumptions, which a reader of the notes would want to examine.

Presenting performance: the statement of profit or loss

Under IAS 1, Presentation of Financial Statements, an entity presents a statement of profit or loss and other comprehensive income, either as one statement or as two (a separate income statement followed by a statement of comprehensive income). IAS 1 requires some line items, such as revenue, finance costs, share of profit of associates and tax expense, and allows expenses to be analysed either by nature (raw materials, employee benefits, depreciation) or by function (cost of sales, distribution, administrative), with additional disclosure of nature-based amounts if function is used. Because IAS 1 left so much choice, companies defined their own subtotals, such as 'operating profit', in incompatible ways.

IFRS 18, Presentation and Disclosure in Financial Statements, issued by the IASB in April 2024 and incorporated into Part I of the Handbook, replaces IAS 1 for annual periods beginning on or after 1 January 2027, with comparatives restated. It requires income and expenses to be classified into five categories: operating, investing, financing, income taxes and discontinued operations. Two new defined subtotals must be presented: operating profit, and profit before financing and income taxes. Expenses in the operating category are presented by nature, by function or a mix, based on what gives the most useful summary, and an entity presenting by function must disclose depreciation, amortization, employee benefits, impairment losses and inventory write-downs by nature in a single note. IFRS 18 also requires disclosure of management-defined performance measures (MPMs), subtotals used in public communications such as 'adjusted operating profit', with a reconciliation to the nearest IFRS subtotal. ASPE is unchanged: private enterprises present an income statement with fewer required lines and no other comprehensive income.

Other comprehensive income

Some gains and losses bypass profit or loss and are reported in other comprehensive income (OCI): revaluation surpluses on property, plant and equipment (lesson 10), remeasurements of defined benefit pension plans (ACCT-212), fair value changes on equity investments the entity elects to measure at fair value through OCI, certain cash flow hedge results and foreign currency translation differences. IAS 1 (and IFRS 18) requires OCI items to be grouped into those that will never be reclassified to profit or loss and those that may be reclassified later. Accumulated OCI appears in equity as a reserve. Total comprehensive income equals profit plus OCI. ASPE has no OCI: all recognized gains and losses go through net income.

Discontinued operations

When an entity disposes of, or classifies as held for sale, a component that represents a separate major line of business or geographical area of operations (or is part of a single plan to do so, or is a subsidiary acquired exclusively to resell), IFRS 5 requires its results to be presented separately as a single amount, net of tax, after profit from continuing operations, with comparatives restated. Assets held for sale are measured at the lower of carrying amount and fair value less costs to sell and are no longer depreciated. ASPE Section 3475 has similar requirements. Separating discontinued operations helps users predict future results from the operations that will continue.