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What does the following mean in a nutshell? Don’t really understand.
The fair value measurement of a liability, or the entity’s own equity, assumes that it is transferred to a market participant at the measurement date. In many cases there is no observable market to provide pricing information and the highest and best use is not applicable. In this case, the fair value is based on the perspective of a market participant who holds the identical instrument as an asset. If there is no corresponding asset, then a corresponding valuation technique may be used. This would be the case with a decommissioning activity. The fair value of a liability reflects the non performance risk based on the entity’s own credit standing plus any compensation for risk and profit margin that a market participant might require to undertake the activity. Transaction price is not always the best indicator of fair value at recognition because entry and exit prices are conceptually different.
I owe someone $1,000, due in 10 years. Interest rate is 1% and I am a very bad payer.
What is the FV of the liability if I transfer it to someone else?
Fair value is $250. Now, I’ve made this figure up, because you don’t have to calculate FV, but the FV will be less than $1,000, because from the lender’s perspective it’s a rubbish investment. Why?
1. The interest rate is dreadful as bank rates are (say) 5%.
2. I’m not very likely to pay off all the debt.In terms of decommissioning liability: if I have to dismantle a power station, the liability will take into account how much it would cost me to pay a contractor to dismantle the power station, even if the contractor plans to do it themself
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