On a worldwide level, the Ukrainian conflict has had a huge impact on people, economic activity, and financial markets. The conflict and the ensuing sanctions have caused supply chain disruptions and a sharp increase in commodity prices, particularly for energy, metals, and agricultural products. As a result, businesses that trade with counterparties in Russia, Belarus, or Ukraine as well as those with activities (or assets) there have all suffered serious consequences. Other businesses, including those in the automotive, food manufacturing, agricultural, and transportation industries, may have indirect effects as a result of rising commodity prices, supply constraints, and a weaker economic climate.
Fair value is a measurement that is dependent on market assumptions; it is calculated utilizing these assumptions. Due to the increased uncertainty and enhanced dangers, determining fair value in these conditions has become more difficult.
The war is a current-period event that should be taken into account when determining the fair value of assets (and liabilities), such as debt and equity securities and investment property, or when testing cash-generating units for impairment using fair value less costs of disposal, for reporting periods ending after February 24, 2022 (when Russia invaded Ukraine). This will grow more difficult due to greater risks and uncertainties because fair value is a market-based measurement (i.e., it is calculated using assumptions that market participants would apply).
An asset’s (or liability’s) fair value should reflect market circumstances as of the measurement date. This has become increasingly difficult, especially for investments and assets that have been directly impacted by the war or the enforced sanctions.
Fair value is an exit price, or the sum paid to transfer a liability to another market participant or the sum received in exchange for the sale of an asset. It is calculated based on predictions made by market participants when valuing the asset (or liability). Therefore, the purpose of a firm to hold an asset or its own value expectations are irrelevant when determining fair value. [IFRS 13.2-3]
The most trustworthy proof of fair value under IFRS 13 Fair Value Measurement is a stated price in an active market, and IFRS 13 requires that it be utilized, even in extremely volatile markets. [IFRS 13 .77]
A listed price may only be disregarded if the transaction supporting it is chaotic, such as a forced liquidation or distressed sale. (“IFRS 13.B44(a)”)
The volume or degree of activity in the market for an item may be significantly lower than it would normally be because to the conflict and associated events. This decline on its own does not imply that a transaction, a reported price, or the orderliness of a market transaction in question do not represent fair value. A corporation may need to conduct additional research on the transactions or stated pricing if it determines that the amount or level of activity has dramatically dropped. A business won’t ignore market pricing, though, unless they come from transactions that it deems to be out of the ordinary. If a business decides that a transaction or quoted price does not accurately reflect fair value, it must modify the price if it is the foundation for figuring out fair value. Additionally, it may be acceptable to adjust the valuation technique used or to combine different valuation techniques to determine an item’s fair value if a company determines that there has been a material decline in activity. [IFRS 13.B37, 38, and 40, Insights 2.4.480] .30]
It is necessary to apply valuation methodologies that maximize the use of pertinent observable inputs and minimize the use of unobservable inputs in order to establish the fair value of securities for which a quoted price is no longer accessible due to the suspension of trading. If information on secondary market transaction prices for identical or comparable securities is available, it can only be used to the extent that the transactions are organized. [IFRS 13 .3]
Companies may need to adjust their valuation methodologies and rely more on assumptions and judgment when they try to identify fair value due to increased estimating uncertainty and a lack of readily available market data.
The classification of the fair value measurement within the fair value hierarchy may change if a different valuation approach is utilized or if additional valuation techniques are applied.
Capturing market dynamics and dangers on the measuring date
The following are examples of inputs that may need to be modified when using valuation procedures under the income approach to estimate future cash flows:
– commodity prices and foreign exchange rates;
– growth rates and inflation rates;
– sales: sanctions, capital controls and reputational damage may hinder a company’s ability or willingness to trade with counterparties in Russia;
– profit margins; and
– expected capital expenditure to enhance or improve the business (or an asset) and the associated benefits
The discount rate, which should take into account the time value of money and the hazards unique to the asset or business, is another important factor in the income method. The following risks could have been significantly impacted by recent events.
Country Risk: Taking into account the additional risk involved with generating and incurring financial flows in a specific country, country risk is a premium (e.g. Russia, Ukraine).
Forecasting Risk: Due to the difficulties in predicting the scope of the impact of the war and imposed sanctions, fair value assessments should include the greater uncertainty in formulating economic and financial forecasts in the short future.
Illiquidity Risk: An extra charge that accounts for how difficult it is to sell an investment.
Quantifying risk premiums and other adjustments for these risks may require a lot of discretion. Furthermore, inflationary expectations, which have been rising as a result of the war’s effects on commodity prices, are taken into account by nominal (risk-free) discount rates. [IFRS 13 .B14]
It is not appropriate for the discount rate to account for factors that have been taken into account while estimating cash flows, and vice versa. Otherwise, some assumptions’ effects will be doubly counted. [IFRS 13 .B14]
Which Approach Should You Use?
The expected cash flow approach (ECF), which use multiple, probability-weighted cash flow predictions, and the classic approach, which uses a single cash flow projection, can both be used to project cash flows. Insights 2.4, IFRS 13.B12 .160]
In order to identify and predict several potential outcomes, it may be helpful to employ the ECF approach (rather than the conventional approach). For instance, modeling various scenarios to estimate the worth of operations halted in Russia, such as asset seizures.
Loans and Debt Instruments
Some of the most important elements to take into account when determining the fair value of a debt instrument include the instrument’s currency, credit risk, illiquidity risk, interest rate risk, and inflation risk. These elements ought to take into account how exposed the issuer is to the conflict and its consequences. Perspectives 2.4.997 .50]
Companies that have been negatively impacted by the war have had their credit ratings lowered to “junk” status by credit rating agencies. The increased credit and currency risk, as well as the rise in illiquidity for those debt securities for which trading has been halted, must all be reflected in the fair value of debt instruments. Furthermore, if capital controls or other restrictions are in place (such as paying principal and interest into a limited-access account that limits an investor’s ability to withdraw funds), then these must be reflected in the fair value if market participants are going to factor them into the price of the debt instrument.
There may be both direct and indirect exposures to the conflict in some securities. For instance, asset-backed securities (ABSs) secured by aircraft leases may have direct exposure via leases to Russian airlines and may also have indirect exposure via the impact of increasing oil prices, a significant cost component, on the creditworthiness of other airlines.
Leverage of an issuer may have a greater impact on a security’s value; for instance, corporations with higher leverage are typically less able to withstand shocks to the economy. Because of the crisis, there is a higher chance of a reduction in operating performance, which could result in a breach of a financial covenant, which implies they may be at a higher risk of financial distress.
In a broader sense, fixed-interest loans and debt securities that are not inflation-indexed are subject to interest rate and inflation risk.
In actual fact, corporations frequently decide on an explicit credit valuation adjustment (CVA) to absorb counterparty credit risk and an explicit debit valuation adjustment (DVA), when necessary, to incorporate own non-performance risk. For over-the-counter (OTC) derivatives that are not centrally cleared, including these modifications is frequently important. The likelihood of default, credit exposure at the time of default, and loss in the event of default all influence these modifications. As a result, they might need to be changed to account for how the dispute has affected these variables. [Insights 2.4.460.40-60
The number of Level 3 measurements may rise as a result of a probable increase in the number of major unobservable inputs. Consequently, more disclosures may be required under IFRS 13.]
What Information Must You Divulge?
Regulators are likely to concentrate on disclosures relating to fair value measurement. Preparers are expected to explain how the war in Ukraine has affected significant judgments and estimation uncertainty – e.g. the assumptions underlying fair value measurement.
Companies may need to provide sensitivity disclosures – along with disclosure of the key assumptions and judgments made by management – to enable users to understand how fair value has been determined given the impact of economic uncertainty on forecasting cash flows and other unobservable inputs used in valuation techniques (e.g., certain risk-adjusted discount rates). Both IFRS 13 and IAS 1 Presentation of Financial Statements require these disclosures. When items are moved into Level 3 of the fair value system, IFRS 13 also specifies certain disclosure obligations. [IAS 1.125, 129, 13.93(e)(iv), 93(h), IFRS 13.93(e)]
Many of the IFRS 13 disclosures on fair value measurements of financial instruments, such as the sensitivity disclosures and significant transfers between the levels in the fair value hierarchy, are required to be provided by corporations under IAS 34 Interim Financial Reporting. IAS 34 further mandates that businesses describe transactions and events that are crucial to comprehending how a company’s financial condition and performance have changed since the prior annual reporting date. Fair value disclosures are therefore necessary if they are crucial to comprehending the present intermediate period. When fair values vary dramatically, this can be the case. [IAS 34.15, 16A(j)].
You have to think about whether:
- Depending on information available and market circumstances at the measurement date, the valuation represents market players’ assumptions;
- The employed method minimizes the use of unobservable inputs while maximizing the use of pertinent observable inputs;
- Updated cash flow predictions and the valuation with the relevant risk premiums;
- Unobservable inputs have increased in importance, necessitating a Level 3 categorization and more disclosures;
- It is necessary to improve disclosures of the main hypotheses, sensitivities, and sources of estimation uncertainty.