1. Introduction
  2. The Accounting Standard for Fair Value Measurement (hereinafter referred to as “Fair Value Measurement Standard”), released in 2019, has become standard treatment applied for fiscal years beginning on or after April 1, 2021. Since this standard is based on IFRS 13, there may be some expressions and terms that may initially seem difficult to comprehend. In this article, let’s look at how the Fair Value Measurement Standard is different from previously existing standards, and understand the basic terms and concepts that make it up.

  3. Background
  4. price_value

    For a long time, Japan has used the acquisition cost basis as its accounting principle. The acquisition cost, which is determined by the amount paid, was considered more important than the so-called fair value because it is more objective.

    However, the acquisition cost is only the value at a specific point in time in the past and does not indicate the current value, making it not appropriate for measuring the current strength of a company. Nowadays, the international trend is to use current fair value for accounting treatment and disclosure. In Japan, accounting using this method has been gradually introduced, but there were no specific regulations on how to calculate the fair value.

    Even if the fair value is provided, differences in calculation methods can result in different solutions. Therefore, in order to ensure that accounting methods in Japan are compatible with those used internationally, the Fair Value Measurement Standard was introduced in Japan in accordance with IFRS13, which defines the calculation method of fair value.

    In other words, the main goal of the Fair Value Measurement Standard is not to determine what to treat at fair value, but about how to calculate the fair value.

  5. Defining “Fair Value”
  6. fair_value

    With the introduction of Fair Value Measurement Standard, the term “fair value” has been redefined.

    Under the Accounting Standard for Financial Instruments, fair value is defined as “the price value of an instrument, which is based on market prices, quotes, indices or other prices formed in a market. If there is no market price, the price computed using a reasonable calculation method share be considered the fair value”.

    On the other hand, in terms of the market value calculation standard, it is defined as “the price to be received for the sale of assets, or paid for the transfer of liabilities in a transaction, assuming that orderly transactions will be conducted among market participants on the calculation date.

    Comparing the two, they are similar in that they are based on market transaction prices. However, the Fair Value Measurement Standard is based on cash inflow or outflow of the concerned asset or liability once it is released.

    The term “fair value” is also used in IFRS and U.S. GAAP. IFRS 13, or the Fair Value Measurement, is the basis of the Fair Value Measurement Standard.

    Among Japanese texts, the terms “時価” and “公正価値” both generally translate to “fair value”. However, the former is already commonly used in related laws and regulations in Japan, and the two terms present no significant difference when considering the criteria for calculating fair value.

  7. Scope
  8. Next, let’s look at what circumstances the Fair Value Measurement Standard would apply.

    Two major areas are covered. The first would be financial instruments defined in the “Accounting Standard for Financial Instruments”. The second would be the inventory assets held for trading purposes defined in the “Accounting Standard for Measurement of Inventories”.

    The first is financial instruments as defined in the Accounting Standard for Financial Instruments, and the second is inventories held for trading purposes as defined in the Accounting Standard for Measurement of Inventories.

    Among these, treatment for financial instruments need extra attention as it is “extremely difficult to determine the fair value”.

    The Fair Value Measurement Standard takes the position that fair value can be determined by making certain assumptions, whereas the previous Japanese standard assumed that it would be extremely difficult to determine fair value. In the next section, we will explain how the Fair Value Measurement Standard allows for the calculation of fair value, even if there is no general market price, based on assumptions using the best available information.

    Because of that, financial instruments that were considered to be “extremely difficult to determine fair value” will also need to be recorded on the balance sheet at fair value. Specifically, financial instruments that fall under the provisions of Paragraphs 19 and 88 of the “Accounting Standard for Financial Instruments” fall under this category.

    However, shares that initially did not have a market price are to be recorded at their acquisition cost in order to have as little impact as possible on current practice.

    Balance sheet amounts of securities whose fair value is deemed to be extremely difficulty to determine are calculated using the following methods:
    (1) The value of bonds and other debentures reflected in the balance sheet shall be the same as the amount of receivables
    in the balance sheet.
    (2) For securities other than bonds and debentures, the acquisition cost shall be used as the balance sheet amout.

    Item 19

    When it is deemed extremely difficult to determine the market value of a financial instrument that is the subject of a derivative transaction due to the fact that it does not have a market price, the acquisition price may be used as the balance sheet value.

    Item 89

  9. Valuation Techniques
  10. The Fair Value Measurement Standard lists the market approach and income approach as representative techniques for calculating fair value, which have not been specifically defined in previous accounting standards. The Fair Value Measurement Standard, however, does not limit itself to the market approach, but also allows the selection of other techniques such as the cost approach. As these are typical valuation techniques used in corporate valuation, this may be familiar to you.

    It isn’t a necessity to use a single valuation technique, and in some cases multiple techniques are required to be used to determine fair value using the method that best represents fair value. In principle, valuation techniques should be applied continuously each period. For example, when multiple techniques are used, a change in the weighting of the techniques would be considered an “accounting estimate”.

    We will not go into the details of each valuation technique, but a brief description of each approach is as follows:

    【Market Approach】
    A valuation technique that uses market prices for identical or similar assets and liabilities as a reference and is highly objective.

    【Income Approach】
    A valuation technique based on the future earning power and can reflect the inherent value of the subject asset in the valuation.

    【Cost Approach】
    A valuation technique based on the amount of money that would be required to re-procure the asset and is referred to as the net asset approach. In the case of equity valuation, this technique focuses on net assets.

  11. Disclosure by Level
  12. In the past, the book value and fair value of assets and liabilities were mainly noted in the notes to financial instruments. Moving forward, however, the market value will be required to be classified into three levels and then disclosed in the notes.

    The 3 classification levels are based on what inputs are used to calculate the fair value. Inputs here refer to the assumptions used in the calculation. The three levels are based on whether the inputs are observable or not, and the level of fair value is determined by the level of inputs used.

    The input levels are as follows:

    Input Levels Definition
    Level 1 Quoted prices for identical assets or liabilities in active markets that are available to the entity at the date of the fair value measurement and have not been adjusted.
    Level 2 Inputs other than Level 1 inputs that are directly or indirectly observable for the asset or liability.
    Level 3 Unobservable inputs for assets or liabilities

    The definition of Level 1 encompasses the following requirements:

    1. The quoted price must be quoted in an active market, that is, a market that is traded in sufficient volume and frequency to provide price information on a continuous basis;
    2. Only identical assets and liabilities are allowed. Quoted prices for similar assets and liabilities are considered to be Level 2;
    3. Only purely quoted prices can be used as Level 1 inputs, and adjusted prices are not classified as Level 1 in principle.

    Examples include stock prices on active stock exchanges and quoted prices in active relative markets.

    Level 2 inputs are those that are observable in the market but not considered under the requirements under Level 1. If it is observable in the market, it does not have to be an active market. Prices of similar assets and liabilities can also be used, as they can be indirect inputs.

    Examples include swap rates that are observable over the entire period, and prices per square meter for buildings that are calculated from observable market data for similar buildings in circulation.

    Level 3 covers inputs that are not observable in the market. For example, financial figures specific to a company, such as cash flows, are considered Level 3 inputs. Interest rate swaps, which are not supported by observable market data, also fall into this category.

    However, because Level 3 inputs are less objective, they are permitted to be used only when Level 1 and 2 inputs are not available. When Level 3 inputs are used, additional information such as valuation techniques and reconciliations from the beginning to the end of the period must be disclosed in order to ensure verifiability for those viewing the financial statements.

  13. Conclusion
  14. There are some financial instruments for which the process of calculating fair value is complicated, and many companies may need to improve their internal operations following the adoption of the Fair Value Measurement Standard.

    In particular, if a company holds a large amount of assets that use unobservable inputs, the impact of valuation gains and losses can be significant, making it important to clarify the division of duties, such as separating the departments that prepare the calculation and verify fair value.

    In addition, even for companies where this may have virtually no impact other than what is disclosed in their financial statement notes, the practical burden of disclosure will be significant in the first year the standard is adopted. It requires time and effort to refer to the standards and guidelines, and we hope this column will be helpful.