How to Audit Fair Value Measurements Under IFRS 13

What IFRS 13 requires and where auditors go wrong

IFRS 13 is a measurement standard, not a recognition standard. It does not tell you when to measure at fair value. IAS 16, IAS 40, IFRS 9, IFRS 16, and other standards make that determination. IFRS 13 tells you how to measure it once the decision to use fair value has been made.

The standard’s core principle sits in IFRS 13.2: fair value is a market-based measurement, not an entity-specific measurement. This single sentence drives more audit findings than any other paragraph in the standard. When a client values an investment property based on its own rental income projections rather than what a market participant would assume, the measurement is entity-specific. When a client values an unquoted equity instrument based on its own cost of capital rather than a market participant’s required return, the measurement is entity-specific. IFRS 13 requires the market participant perspective even when no active market exists.

IFRS 13.B2 defines a market participant: buyers and sellers in the principal market (or most advantageous market) who are independent, knowledgeable, able to enter into a transaction, and willing (not forced). Your audit work on a fair value measurement starts here. Before assessing the valuation model, before checking the discount rate, you need to confirm that the inputs reflect what a market participant would use. If the client’s valuation expert built the model around entity-specific cash flows, the hierarchy classification and every number downstream are potentially wrong.

The second area where auditors consistently underperform is hierarchy classification. IFRS 13.72 through 13.90 establish the hierarchy, but the classification itself is often treated as an afterthought. The client records an investment at fair value, the auditor confirms the number to a valuation report, and the hierarchy level gets filled in at the disclosure stage without independent assessment. Hierarchy classification affects disclosure requirements (IFRS 13.93 through 13.99), and getting it wrong means the disclosures are incomplete even if the fair value figure is correct.

The fair value hierarchy: classification is not a formality

IFRS 13.72 establishes the hierarchy. Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Level 2 inputs are observable inputs other than Level 1 prices. Level 3 inputs are unobservable.

The hierarchy classifies the entire fair value measurement based on the lowest level of input that is significant to the measurement (IFRS 13.73). A valuation that uses a Level 1 quoted price adjusted by a Level 3 unobservable input is a Level 3 measurement, not Level 1. This is the paragraph most often missed in practice: the classification follows the lowest significant input, not the highest or most prominent one.

Level 1 is narrow. IFRS 13.76 requires an active market for an identical asset or liability and access to that market at the measurement date. A quoted equity price on Euronext Amsterdam for a listed share the entity holds is Level 1. A quoted price on a market the entity cannot access is not Level 1 (IFRS 13.78). If the entity holds restricted shares that cannot be sold on the exchange for a specified period, the quoted price may need adjustment, and that adjustment moves the measurement out of Level 1.

Level 2 is where most non-Big 4 audit clients’ fair value measurements land. IFRS 13.81 through 13.85 define Level 2 inputs: quoted prices for similar (not identical) assets or liabilities in active markets, quoted prices for identical or similar items in non-active markets, observable inputs other than quoted prices (interest rates, yield curves, credit spreads), and market-corroborated inputs. The key audit judgment is whether the adjustment from a Level 2 observable input to the specific asset or liability being measured requires a significant unobservable input. If it does, the measurement is Level 3 regardless of how observable the starting input was.

For example: a client values a term loan’s fair value for disclosure purposes using a discounted cash flow model with an observable swap rate plus a credit spread. If the credit spread comes from an observable market (credit default swap spreads for similarly rated entities), the measurement is Level 2. If the credit spread is management’s estimate based on its own borrowing history and no observable market data supports it, that spread is a Level 3 input, and if it’s significant to the measurement, the entire fair value is Level 3.

Level 2 inputs: the grey area most files underwork

Level 2 measurements look straightforward on the surface but contain the most common classification errors. The problem is that IFRS 13.81 permits adjustments to Level 2 inputs for factors specific to the item being measured, but IFRS 13.84 states that a significant adjustment using unobservable inputs shifts the measurement to Level 3.

The word “significant” is not defined quantitatively in IFRS 13. IFRS 13.84 leaves this to judgment. In practice, the audit question becomes: could the unobservable adjustment change the fair value conclusion by an amount that matters? If a Level 2 observable yield curve produces a fair value of €3.8M for a debt instrument, and management applies an unobservable liquidity adjustment that changes the result by €50K on a €3.8M instrument, that adjustment is unlikely to be significant. If the liquidity adjustment changes the result by €400K, you have a different conversation.

When auditing Level 2 measurements, your working paper should address four questions. First, what is the observable input and what is its source? If the client says “market interest rate” without specifying which rate, from which market, on which date, the input is not verifiable. Second, what adjustments were made to the observable input? Every adjustment needs identification and quantification. Third, are those adjustments based on observable or unobservable data? This determines whether the measurement stays at Level 2 or migrates to Level 3. Fourth, is the adjusted fair value consistent with other available evidence (recent transactions, broker quotes, comparable sales)?

A common Level 2 measurement for non-Big 4 clients is the fair value of a fixed-rate term loan disclosed under IFRS 7.25. The typical approach is a discounted cash flow using the remaining contractual cash flows discounted at a current market rate for equivalent debt. If the discount rate comes from an observable source (ECB reference rates plus an observable credit spread for the entity’s rating), the measurement is Level 2. If the entity has no external credit rating and the discount rate uses an internally estimated credit spread, you need to assess whether that internal estimate is significant to the measurement.

Level 3 inputs: where the audit risk concentrates

Level 3 fair value measurements carry the highest audit risk because the inputs are unobservable, meaning they reflect the entity’s own assumptions about what market participants would use (IFRS 13.87). The standard requires these assumptions to be developed using the best information available in the circumstances, which may include the entity’s own data (IFRS 13.89).

The audit challenge with Level 3 is that you cannot independently verify the inputs against a market source by definition. Instead, ISA 540.18 through 540.22 require you to evaluate whether management’s assumptions are reasonable, the data underlying those assumptions is reliable, the model is appropriate for the item being measured, and the entity has applied the model consistently. For fair value under IFRS 13, this translates to specific audit procedures.

First, understand the valuation model. IFRS 13.62 permits the market approach, the income approach, the cost approach, and combinations of these. For Level 3 measurements, the income approach (typically a discounted cash flow) is most common for investment properties and unquoted equity instruments. The market approach is common for real estate where comparable transactions exist. You need to evaluate whether the chosen technique is appropriate for the specific asset or liability per IFRS 13.61.

Second, test the key assumptions. For a DCF-based Level 3 measurement, the key assumptions are usually the cash flow projections, the discount rate, the terminal value or exit assumption, and the growth rate. Each requires audit evidence. Cash flow projections should reconcile to the entity’s budgets and forecasts, which you may already have audited for going concern under ISA 570. The discount rate should reflect a market participant’s required return, not the entity’s WACC (unless the entity’s WACC approximates the market participant rate, which needs to be demonstrated, not assumed).

Third, perform a sensitivity analysis. IFRS 13.93(h)(ii) requires the entity to disclose a sensitivity analysis for Level 3 measurements showing how the fair value would change if one or more unobservable inputs were altered to reflect reasonably possible alternative assumptions. Your audit should independently stress-test the key inputs. If changing the discount rate by 50 basis points moves the fair value by 12%, that input is both significant and sensitive, and the disclosure needs to reflect that.

Fourth, evaluate internal consistency. Does the Level 3 fair value make sense given other information you have about the entity? If an investment property is valued at €14.2M on a 5.2% capitalisation rate but comparable properties in the same area transacted at 6.5% capitalisation rates (per publicly available Kadaster data in the Netherlands), there is a disconnect that requires explanation.

Valuation techniques under IFRS 13.61 through 13.66

IFRS 13.61 requires the entity to use valuation techniques appropriate in the circumstances and for which sufficient data is available. IFRS 13.62 identifies the market approach, the income approach, the cost approach, and combinations of these. IFRS 13.63 requires consistency in application from period to period, unless a change is justified by a change in circumstances.

The market approach (IFRS 13.B5 through B7) uses prices and other relevant information from market transactions involving identical or comparable items. For real estate, this means comparable sales. For unquoted equity, this means transaction multiples from comparable companies. The audit issue with the market approach is the comparability assessment. The client selects “comparable” transactions, but the auditor needs to evaluate whether those transactions are genuinely comparable in terms of size, location, condition, and timing. A property transaction from 2021 in a different municipality is not automatically comparable to a 2024 valuation.

The income approach (IFRS 13.B10 through B30) converts future amounts (cash flows or income) to a single present value. The two primary techniques are the DCF model and the capitalisation of earnings. IFRS 13.B12 requires the discount rate to reflect the risk inherent in the cash flows, which means it must match the cash flow basis. If cash flows are nominal, the discount rate is nominal. If cash flows are real, the rate is real. If cash flows are pre-tax, the rate is pre-tax. A mismatch between the cash flow basis and the discount rate basis invalidates the entire calculation, and it’s one of the most frequent valuation errors across all entity sizes.

The cost approach (IFRS 13.B8 through B9) reflects the amount required to replace the service capacity of an asset (current replacement cost). It’s less common in financial reporting but appears for specialised assets (a purpose-built manufacturing facility, a bespoke piece of equipment) where no market transactions or income streams exist to measure.

IFRS 13.65 permits using multiple techniques and requires the entity to evaluate and weight the results. If the client uses both a DCF and a market approach and arrives at €14.2M and €12.8M respectively, the final fair value should reflect a considered weighting, not simply the average. Your audit should challenge the weighting rationale.

Worked example: Groenveld Vastgoed B.V.

Client scenario: Groenveld Vastgoed B.V. is a Dutch real estate company with €28M revenue from commercial property rentals. It holds an investment property (office building in Utrecht) carried at fair value under IAS 40. The property was valued at €14.2M by an external valuer using the income approach (capitalisation method). Groenveld has no other assets measured at fair value.

Step 1. Confirm the measurement basis and hierarchy level

IAS 40.33 permits the fair value model for investment property. Groenveld elected this model in its accounting policies. The external valuer used a capitalisation rate of 5.8% applied to net rental income of €823K, producing €14.2M. The capitalisation rate is the key input. No active market quote exists for this specific property (it is not Level 1). The capitalisation rate was derived from comparable office transactions in the Utrecht market (observable), adjusted by the valuer for the building’s age and lease profile (partially unobservable). Preliminary classification: Level 3, because the adjustment for building-specific factors is significant to the measurement.

Step 2. Evaluate the valuation technique

The income capitalisation method divides net rental income by a capitalisation rate. Verify that net rental income (€823K) agrees to the audited rental income per the general ledger, adjusted for vacancy and non-recoverable operating costs. The valuer’s rental income assumption of €823K compares to audited rental income of €831K. Difference of €8K relates to the valuer’s adjustment for a market vacancy rate of 4%, which the building does not currently experience but which a market participant would factor in (IFRS 13.B2, market participant assumption).

Step 3. Test the key input: capitalisation rate

The valuer’s report states a 5.8% capitalisation rate. Comparable transactions from the NVM (Nederlandse Vereniging van Makelaars) database show Utrecht office transactions in the past 18 months at capitalisation rates between 5.4% and 6.9%. The weighted average of the four most comparable transactions (similar size, location, lease term) is 6.1%. The valuer’s rate of 5.8% sits below this average, reflecting the building’s recently upgraded energy label (A++) and long remaining lease term (8 years). Audit assessment: the difference between 5.8% and 6.1% changes the fair value by approximately €740K (€14.2M at 5.8% versus €13.5M at 6.1%). Document whether this difference is within an acceptable range.

Step 4. Perform sensitivity analysis for IFRS 13.93(h)(ii) disclosure

Stress-test the capitalisation rate at +/- 50 basis points. At 5.3%: €15.5M. At 6.3%: €13.1M. This €2.4M range confirms that the capitalisation rate is a sensitive input. Verify that the entity’s IFRS 13 disclosure includes this sensitivity analysis with specific figures per IFRS 13.93(h)(ii).

Conclusion: The working paper traces from the IAS 40 measurement basis through hierarchy classification, valuation technique assessment, key input testing against market data, and sensitivity analysis. A reviewer sees the IFRS 13 paragraph basis at each step, external market evidence supporting the capitalisation rate assessment, and a quantified sensitivity analysis.

Practical checklist for your current engagement

1. Before auditing any fair value figure, confirm which standard requires (or permits) fair value measurement for that asset or liability. IFRS 13 is the “how,” not the “whether.” If the measurement basis is wrong, the fair value work is wasted.
2. Classify the hierarchy level independently. Do not accept the client’s classification without testing which inputs are significant to the measurement per IFRS 13.73. If any significant input is unobservable, the measurement is Level 3 regardless of what else feeds into the model.
3. For Level 2 measurements, identify every adjustment made to the observable input and assess whether any adjustment uses unobservable data per IFRS 13.84. One significant unobservable adjustment migrates the entire measurement to Level 3.
4. For Level 3 measurements, test the key assumptions against external evidence. Cash flow projections should reconcile to audited budgets or forecasts. Discount rates and capitalisation rates should be benchmarked against observable market data for comparable items.
5. Check that the entity’s IFRS 13 disclosure includes a sensitivity analysis for every Level 3 measurement per IFRS 13.93(h)(ii), with specific figures showing how the fair value changes when unobservable inputs are varied.
6. Run the entity’s reported financial metrics through the ciferi Financial Ratio Calculator as a reasonableness check. If the fair value of an investment property implies a yield that’s materially out of line with the entity’s reported rental income, investigate before concluding.

Common mistakes

• Classifying a measurement as Level 2 when the adjustment to the observable input uses an unobservable input significant to the measurement. The FRC’s thematic review on fair value measurement noted that incorrect hierarchy classification was a recurring deficiency, particularly where valuations combined observable market data with entity-specific adjustments that auditors did not separately assess.
• Accepting a valuation report conclusion without evaluating whether the inputs reflect market participant assumptions per IFRS 13.B2. An external valuer’s report does not discharge the auditor’s responsibility under ISA 500.A35 to evaluate whether the expert’s work is adequate for audit purposes.

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Further reading and source references

• IFRS 13, Fair Value Measurement: the complete measurement framework including the hierarchy, valuation techniques, and disclosure requirements.
• IAS 40, Investment Property: the standard that permits the fair value model for investment properties measured under IFRS 13.
• ISA 540, Auditing Accounting Estimates and Related Disclosures: the auditing standard governing audit procedures on fair value estimates.
• ISA 500.A35: the requirement to evaluate whether an expert’s work is adequate for audit purposes.
• Fair value measurement: Ciferi glossary entry covering the IFRS 13 framework.