Individuals who have been involved with preparing their organisation’s financial instruments note over the last few years will no doubt be aware of the concept of a hierarchy of fair values. This is outlined in IFRS 13 (the accounting standard on fair values) and goes a bit like this:
Level 1: use the quoted market price for the financial instrument
Level 2: if a quoted market price is not available, but you do have other observable inputs use these to calculate the fair value
Level 3: If you don’t have either a quoted market price or observable inputs then you have to use unobservable inputs to calculate a fair value
Typical instruments where the fair value would be a level 1 include t-bills, gilts, most publicly traded bonds and most strategic pooled fund shares. These are bought and sold frequently in active markets and have a quoted market price. The level 2 instrument that authorities will be most familiar with are their PWLB loans. These are not frequently brought and sold in an active market and so don’t have a market price you can use. However an observable input is the price that local authorities that have issued bonds in active markets pay for their debt. This can be used as a proxy to work out a suitable fair value.
Most financial instruments will be either level 1 or level 2 in the hierarchy. Level 3 is usually the one that everyone wants to avoid, not just because it is last in the pecking order but because it tends to have more disclosures that you will have to write about in your accounts. What does fall under level 3 will be shares owned that aren’t publicly traded: these don’t have an available market price and rarely have observable inputs that can be used.
It is not uncommon for local authorities to own shares that aren’t publicly traded: most commonly these will be 100% ownership or part ownership of subsidiary companies or joint ventures. Housing companies and airports are the more common types of companies owned, but there are also some more exotic examples out there. Calculating a fair value for a level 3 instrument is hard because you don’t usually have a set method to go on or, by definition, some easily downloadable data you can use. Valuing a company is in fact regarded as an art more than a science and there are lots of potential approaches, the skill often being on picking the most appropriate approach for the type of company you are looking at.
Probably the most common method to use to value a company is a discounted cash flow model. A company can be regarded as the value of all the future dividends, from cash flows, that it expects to generate. Unlike a loan where these things are contractual, you don’t know what these cash flows will be and you will have to estimate them. You will also need to discount them for the time value of money, and you would normally reduce or discount them further to account for the uncertainty in your estimate. Whilst this will involve a degree of guesswork your decisions will need to be justifiable to your auditors: picking numbers out of the air will not do! There are also required disclosures in the accounts about the impact of assumptions you make and how sensitive the fair value is to them.
Other suitable valuation methods may include comparing your shares to shares that are publicly traded and have a price: if you can justify that they are suitably similar or the difference between them can be quantified you can use one value as the basis for the other. If there have been historical sales of shares that you own this historical price can be used as a basis for the current value, but the current valuation will need to incorporate changes to the company since. For very asset heavy companies a valuation based on the companies key asset or assets may be suitable.
Fortunately Arlingclose are here to assist with these complicated level 3 fair value calculations. We have many years of experience in valuing a large number of different types of companies. Our experience means we can choose a suitable methodology, work out what estimates are most appropriate to use and provide information on these to assist you with the required level 3 disclosures.
For more information on please contact Laura Fallon at lfallon@arlingclose.com or on 07702 788303.
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