A European example of interpreting one of the key concepts in measuring fair values under IFRS 13
Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 16th edition:
- “The issuer is a holding company created to acquire, through a merger, company A, incorporated in country 1, and company B, listed in country 2. Company A had investments in company B and in four subsidiaries of company B, all listed in country 2. Following the merger, the issuer intended to be listed in country 1.
- While preparing the IFRS pro-forma financial information, the issuer viewed the transaction as a reverse acquisition, with company B being identified as the acquirer for accounting purposes. The consideration was paid in shares of the acquiring company (share-for-share transaction). Therefore, the consideration transferred was measured at fair value of the equity interests issued by the accounting acquiree, in accordance with paragraphs 37 and B19 of IFRS 3. In its measurement of the fair value of the consideration transferred, the issuer believed that country 2’s stock market was no longer active because a press release issued by an index provider argued that this stock market should be classified as an ‘emerging market’ on the basis of restrictions on in-kind transfers, off-exchange transactions, as well as the absence of stock lending and short-selling.
- The issuer also believed that the significant decrease in the average daily trading volume of all the shares under consideration in country 2 over the last 5 years, the limited average daily trading volume ranging over the last 17 months from 0.03% to 0.14% in comparison with the total outstanding shares and the difference over the last 17 months between minimum and maximum prices, ranging from 270% to 502%, gave a clear indication of an improperly functioning stock market. The issuer’s judgement was reinforced by a 60% decrease of the stock market index of country 2 and a 70% reduction of country 2 stock market capitalization over the last 5 years, as well as the fact that since 2007 no entity had sought a listing on this market while a number of issuers had asked to be delisted.
- On the basis of the limited volume, high volatility and improper functioning of the stock market, the issuer concluded that the quoted prices of the entities listed in country 2 were not a good indication of the fair value of the shares under consideration and decided to value these entities on the basis of level 3 inputs in accordance with paragraph 79 of IFRS 13. This calculated fair value was significantly higher than the quoted price at the acquisition date.”
The enforcer (as ESMA likes to term it) disagreed with the issuer’s assessment that there was no active market for shares of entities listed in country 2, concluding it should have determined the fair value of the consideration paid in shares on the basis of the quoted price. It concluded that the criterion used by the index provider differed from the concepts of IFRS 13; that investors in country 2’s stock market (taking into account information provided by that country’s enforcer) were regularly and sufficiently informed; and that despite the statistics cited above, transactions of these shares occurred on a daily basis and therefore represented a volume sufficient to determine the price on a continuous basis.
I imagine some readers may feel a certain disquiet about this consensus. I doubt any of us would want to undermine the overriding rule, that quoted prices in an active market provide the most reliable evidence of fair value where available, and should be used without adjustment where available, except in limited and defined circumstances. But it might seem a bit naïve to conclude that the measure of an active market is simply one in which some kind of pricing information is provided on an ongoing basis. For example, I just looked up one of the securities traded on Canada’s NEX exchange, Based on a trade of 1,000 shares (out of over 2.6 million shares outstanding; some 2 million of them in escrow), the quoted price per share rose today from 65 cents to 80 cents, or by 23%. Should a financial statement preparer feel as comfortable using the new price today as she might have felt using the old one yesterday? It’s hard to imagine that whatever capricious mixture of whim and semi-rationality drives such markets should rank above all other considerations, in assessing what constitutes reliable and relevant information for users of financial statements.
On the other hand, one wouldn’t want to preclude any possibility of the NEX ever constituting an active market (it seems clear from IFRS 13.B37 that a market might be assessed as active for some of the assets traded within it, but not for others). It would be appealing if more clarity were available on how to make this determination, but perhaps it will necessarily remain a matter of judgment. The ESMA example suggests that regulators might sometimes cast a skeptical eye on these judgments, although one suspects the enforcer might not have been quite as motivated to pursue the matter if the issuer’s “level 3” calculation resulted in a lower price than that indicated by the market, rather than a significantly higher one…
The opinions expressed are solely those of the author.