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Valuation risk
Valuation risk is the risk that an entity suffers a loss when trading an asset or a liability due to a difference between the accounting value and the price effectively obtained in the trade.
In other words, valuation risk is the uncertainty about the difference between the value reported in the balance sheet for an asset or a liability and the price that the entity could obtain if it effectively sold the asset or transferred the liability (the so-called "exit price").
This risk is especially significant for financial assets and related marketable contracts with complex features and limited liquidity, that are valued using internally developed pricing models. Valuation errors can result for instance from missing consideration of risk factors, inaccurate modeling of risk factors, or inaccurate modeling of the sensitivity of instrument prices to risk factors. Errors are more likely when models use inputs that are unobservable or for which little information is available, and when financial instruments are illiquid so that the accuracy of pricing models cannot be verified with regular market trades.
According to the International Financial Reporting Standards, or IFRS, entities must classify their financial instruments in different categories, depending on their business model and their intention to trade such instruments or keep them in their balance sheet. The classification of financial instruments determines the methodology for their valuation. The admitted categories are:
The fair value is therefore a key concept in accounting for financial instruments. The accounting principle IFRS 13 defines the rules for the determination of fair value. Whenever possible, the fair value should be determined based on the prices recorded in actual trades. However, when an instrument is not traded in active markets and prices are not regularly available, entities may use models to determine its fair value. Entities should classify each financial instrument measured at fair value on an ongoing basis (FVTOCI and FVTP&L) within a three-level "fair value hierarchy", depending on the level of "observability" of the inputs used for its valuation. Inputs are defined by IFRS 13 as "The assumptions that market participants would use when pricing the asset or liability, including assumptions about risk".
Inputs can be observable or unobservable, according to the following IFRS 13 definitions:
In practice, inputs include:
Entities must classify the inputs they use according to the following hierarchy defined by IFRS 13:
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Valuation risk
Valuation risk is the risk that an entity suffers a loss when trading an asset or a liability due to a difference between the accounting value and the price effectively obtained in the trade.
In other words, valuation risk is the uncertainty about the difference between the value reported in the balance sheet for an asset or a liability and the price that the entity could obtain if it effectively sold the asset or transferred the liability (the so-called "exit price").
This risk is especially significant for financial assets and related marketable contracts with complex features and limited liquidity, that are valued using internally developed pricing models. Valuation errors can result for instance from missing consideration of risk factors, inaccurate modeling of risk factors, or inaccurate modeling of the sensitivity of instrument prices to risk factors. Errors are more likely when models use inputs that are unobservable or for which little information is available, and when financial instruments are illiquid so that the accuracy of pricing models cannot be verified with regular market trades.
According to the International Financial Reporting Standards, or IFRS, entities must classify their financial instruments in different categories, depending on their business model and their intention to trade such instruments or keep them in their balance sheet. The classification of financial instruments determines the methodology for their valuation. The admitted categories are:
The fair value is therefore a key concept in accounting for financial instruments. The accounting principle IFRS 13 defines the rules for the determination of fair value. Whenever possible, the fair value should be determined based on the prices recorded in actual trades. However, when an instrument is not traded in active markets and prices are not regularly available, entities may use models to determine its fair value. Entities should classify each financial instrument measured at fair value on an ongoing basis (FVTOCI and FVTP&L) within a three-level "fair value hierarchy", depending on the level of "observability" of the inputs used for its valuation. Inputs are defined by IFRS 13 as "The assumptions that market participants would use when pricing the asset or liability, including assumptions about risk".
Inputs can be observable or unobservable, according to the following IFRS 13 definitions:
In practice, inputs include:
Entities must classify the inputs they use according to the following hierarchy defined by IFRS 13: