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 instruments 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: Held to Collect (HTC), measured at fair value on first-time recognition and at amortized cost afterwards Fair Value Through Other Comprehensive Income (FVTOCI), measured at fair value with changes in fair value recorded in an equity reserve Fair Value Through Profit & Loss (FVTP&L), measured at fair value with changes in fair value recorded in the profit and loss statement 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.