Still no dead parrot – assessing an active market (part two)

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 17th edition:

  • “The issuer invested in shares of listed and unlisted entities. They were accounted for as AFS financial assets and represented over 50% of its total assets. The issuer measured the fair value of the listed securities on the basis of stock exchange prices when the shares were listed on an active market or based on valuation techniques when there was no active market.
  • In order to assess the existence of an active market, the issuer calculated a number of ratios and compared them against the following benchmarks:
  •    daily % of average value of trades / capitalization lower than 0.05%;
  •    daily equivalent value of trades lower than CU 50,000 ;
  •    daily bid-ask spread higher or equal to 3%;
  •    maximum number of consecutive days with unvaried prices higher than 3;
  •    % of trading days lower than 100%.
  • On the basis of this analysis and the limited trading volume of the shares, the issuer considered that its investments in listed companies A, B and C were not traded in active markets (defined, you’ll recall, as one in which transactions take place with sufficient frequency and volume to provide pricing information on an ongoing basis) and measured the fair value of these investments using a valuation technique on the basis of level 3 inputs.”

The enforcer (as ESMA likes to term it) disagreed with this assessment, taking the view that the issuer should have used quoted prices of financial assets to measure fair value. It considered “that the indicators used by the issuer were insufficient to conclude that the transaction price did not represent fair value or that transactions occurred with insufficient frequency and volume” and that “the issuer did not gather sufficient information to determine whether transactions were orderly or took place with sufficient frequency and volume to provide pricing information. Therefore, based on available data, it was not possible to conclude that the markets, where the investments were listed, were not active and further analysis should have been performed to measure fair value.”

A previous ESMA report chronicled another case on a similar issue – I summarized that here (among other things, the issuer in that case cited “a 60% decrease of the stock market index…and a 70% reduction of…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.”) Because versions of this issue will certainly keep arising in Canadian practice, I think it’s worth repeating the comments I made then:

  • I doubt any of us would be inclined 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 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 sentiment and semi-rationality drives such markets should rank above all other considerations, in assessing what constitutes reliable and relevant information.
  • On the other hand, one wouldn’t want to preclude any possibility of the NEX constituting an active market for a particular stock (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…

Based on the facts summarized above, it seems reasonable to conclude that the issuer in this case placed too much weight on self-generated criteria which, although not irrelevant, were perhaps more rigid than IFRS 13 envisages. Still, in this case as in the previous one, it’s hard not to think the enforcer might have been less motivated to pursue the matter if the issuer’s “level 3” calculation had 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

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