Fair value measurement
Financial instruments and derivatives valuation
Instruments that look like debt on the term sheet often behave like a package of options in the accounts. Getting the fair value right means modelling what the contract actually does — conversion, redemption, reset, participation and credit — rather than what it is called.
- Standards
- SFRS(I) 9 SFRS(I) 13 SFRS(I) 1-32
- Instruments
- Convertible notes and bonds, preference shares, warrants, FCN and structured notes, options, swaps, earn-outs
- Modelling
- Binomial and trinomial lattices, Monte Carlo simulation, closed-form option pricing, credit-adjusted discounting
- Frequency
- At issuance and at every reporting date while the instrument is outstanding
- Fair value hierarchy
- Level 2 and Level 3 inputs, with sensitivity disclosure support
- Related tool
- Valtech convertible bond calculator
Convertible notes, convertible bonds and convertible preference shares
A convertible instrument is a bond plus a set of embedded options, and each of those options has to be identified before anything can be valued. In practice the contested features are usually conversion price reset clauses, issuer call and holder put rights, mandatory conversion triggers, and anti-dilution adjustments.
What the accounting requires
- Classification first. Whether the instrument is a liability, equity, or a compound instrument with both, depends on whether settlement is in a fixed number of shares for a fixed amount of cash. Reset clauses and variable conversion ratios frequently break that test, pushing the whole instrument into liability measurement — an outcome that surprises issuers who thought they had raised equity.
- Separation. Compound instruments are split between their liability and equity components at issuance, and embedded derivatives may need separating where they are not closely related to the host.
- Subsequent measurement. Instruments held at fair value through profit or loss are remeasured at each reporting date, so the valuation is recurring, not one-off. Movements flow through earnings, which makes the volatility assumption a live issue for management as well as the auditor.
How we model them
Lattice models handle most convertibles with call, put and conversion features, with the credit-risky and equity-linked cash flows discounted at different rates to reflect their different risk. Where the instrument has path dependency — averaging, knock-in or knock-out barriers, or a reset tied to future prices — Monte Carlo simulation is used. Inputs that draw the most review are the credit spread applied to the debt component, the volatility of the underlying share, and the expected timing of conversion or redemption.
The main site covers this service in more depth at valuation of convertible notes, bonds and preference shares.
Preference shares and hybrid capital
Redeemable preference shares, participating preference shares and instruments with step-up dividends or cumulative arrears each carry a different economic profile. The valuation has to reflect the redemption schedule, the dividend entitlement and whether it accumulates, priority on liquidation, any conversion right, and the issuer’s realistic capacity to pay. For private companies this analysis feeds directly into the ordinary share value used for employee share plans and shareholder transactions.
Structured notes, FCN and equity-linked products
Fixed coupon notes, accumulators, autocallables and other yield-enhancement structures are sold as income products but are, economically, short option positions. Holders carrying them at fair value need the embedded optionality valued properly — including the knock-in and autocall features that determine whether principal is returned in cash or in shares. Where a counterparty valuation is available, an independent check is often required because a broker quote alone is rarely sufficient audit evidence for a Level 3 position.
More detail sits at FCN valuations and derivatives valuation.
Derivatives, earn-outs and contingent consideration
- Options and warrants issued to investors, lenders, advisers or partners, including those with performance or milestone triggers
- Interest rate and currency swaps held for hedging or otherwise, valued on curve-based methodology with credit valuation adjustment where material
- Earn-outs and contingent consideration arising from acquisitions, where the payout profile is usually non-linear and the correct treatment is simulation across the range of outcomes rather than a probability-weighted point estimate
- Profit guarantees and vendor undertakings, which are financial liabilities even though they read as commercial reassurance
- Embedded derivatives in supply, offtake, lease or licensing contracts, which are frequently missed until an auditor asks
Level 3 inputs and disclosure
Where an instrument is valued using significant unobservable inputs, the disclosure burden rises: the valuation technique and inputs used, quantitative information about those inputs, a reconciliation of opening to closing balances, and a sensitivity analysis showing the effect of reasonably possible alternative assumptions. We prepare that supporting analysis alongside the valuation so the note can be drafted without a second round of work.
Related measurements we handle
- Expected credit loss on loans, receivables and debt investments
- Incremental borrowing rate determination for lease accounting
- Tokenised instruments and security tokens
- Investment in key man insurance policies
- Independent review of instrument valuations prepared by counterparties or other advisers
Frequently asked questions
Why is our convertible note classified as a liability when we raised it as equity?
Classification turns on the settlement terms, not the label. An instrument is only equity where it will be settled by delivering a fixed number of shares for a fixed amount of consideration. Conversion price resets, discounts to a future round price, variable ratios and cash settlement options break that condition, and the instrument is then measured as a financial liability -- often at fair value through profit or loss, which introduces earnings volatility.
How often does a convertible instrument need revaluing?
At initial recognition and then at each reporting date while it remains outstanding, where it is measured at fair value. For an instrument outstanding across a financial year with interim reporting, that is a recurring engagement, and we normally scope it as such so the model and assumptions stay consistent between dates.
Is a counterparty or broker valuation enough for our auditor?
For an actively traded instrument it may be. For a bespoke or structured position valued using unobservable inputs, a single counterparty quote is generally not sufficient audit evidence, both because the counterparty is not independent and because the quote is not accompanied by testable methodology. An independent valuation or an independent review of the counterparty's figure is the usual resolution.
What is an embedded derivative and why does it matter?
It is a feature inside a non-derivative contract that behaves like a derivative -- a price linked to a commodity index, a foreign currency clause unrelated to either party's functional currency, a conversion right inside a loan. Where it is not closely related to the host contract, it may have to be separated and measured at fair value through profit or loss. These are commonly identified late, during the audit, because the contract was never reviewed with that question in mind.
How is an earn-out valued?
Because the payout is usually contingent and non-linear -- thresholds, caps, tiered rates -- the appropriate method is normally a simulation across the distribution of outcomes for the underlying metric, discounted at a rate reflecting both the risk of the metric and the credit risk of the payer. A single probability-weighted estimate applied to a point forecast tends to misstate the value where the structure has thresholds or caps.
Instrument outstanding at your reporting date?
Send the term sheet or subscription agreement and the reporting dates involved. We will confirm the classification question and the modelling approach before quoting.