Modern sounds in fair value measurement

The European Securities and Markets Authority (ESMA) has issued a report on Review of Fair Value Measurement on the IFRS financial statements

The report “builds on a desktop review of the 2015 financial statements of a sample of 78 issuers from different industries, and on the evidence from enforcement actions taken by European enforcers relating to financial years 2013, 2014 and 2015.” On the whole, it found that the requirements of IFRS 13 Fair Value Measurement “have generally been well incorporated in the financial statements of the issuers in the sample. However, there is room for improvement in the level of compliance and comparability in the application of the IFRS 13 requirements.” The major item highlighted is no surprise – that disclosures were often considered unsatisfactory “in areas such as description of inputs and methodologies used, reasoning for transfers between Level 1 and Level 2 fair values and the description of sensitivities.” Canadian regulators have already made a similar point, as we mentioned here.

Perhaps a couple of other issues highlighted in the report are a bit more interesting. One of these relates to the unit of account:

  • Information on the unit of account with respect to whether or not any premiums or discounts have been included in the measurements was limited in the financial statements reviewed.
  • ESMA urges the IASB to provide clarity on the unit of account and recommends issuers to provide entity-specific disclosure on how they estimated fair value and to explain the rationale for the approach

The IASB has already acknowledged this general issue within its request for information in connection with its post-implementation review of IFRS 13. In a nutshell, the standard generally directs that “level 1” inputs should be used without adjustment when they’re available, and that the fair value of a quantity of level 1 instruments is simply that quantity multiplied by their price, regardless that the market’s normal daily trading volumes wouldn’t be sufficient to absorb such a quantity. However, the standard is also open, to some extent anyway, to applying an adjustment to recognize a control premium, or non-controlling interest discount (while noting, rather cryptically, that a fair value measurement can’t incorporate a premium or discount that is “inconsistent with the unit of account in the IFRS that requires or permits the fair value measurement).  The interaction of these principles seems to ESMA (and how could it not…?) to require greater clarity. As the IASB summarizes, a simple “price times quantity” approach to measuring such a holding has the virtue of being “objective and verifiable,” but in a situation where this approach doesn’t actually yield a relevant valuation of what’s being held, if regarded as a whole, then perhaps that virtue shouldn’t hold the upper hand…

Insofar as that issue depends on being able to identify a “level 1” price in the first place, it overlaps with this one:

  • There was limited evidence from the review that issuers departed from quoted prices as a result of a decrease in the level of market activity. When issuers provided disclosures in this respect, no additional information was provided as to how issuers concluded that the decrease in the level of market activity led them to conclude that fair value differed from quoted prices. Evidence from enforcement cases showed that often issuers automatically linked the existence of indications that market activity had decreased with the fact that the quoted price or transaction price did not represent fair value.
  • ESMA encourages issuers to disclose the processes followed and the specific situations where they have concluded that quoted prices or transaction prices did not represent fair value. ESMA also draws the attention of issuers to the requirement for further analysis before concluding that transaction prices and quoted prices do not represent fair value. Appendix B of the Standard provides factors to assess whether there has been a significant decrease in the level of market activity.

It’s a bit strange perhaps that IFRS 13 puts its primary emphasis on identifying whether the volume or level of activity for an asset or a liability has significantly decreased, because this is just a subset of the broader question, of whether a sufficiently active market exists to provide a level 1 input as of the measurement date, regardless of whether such a market existed in the past. This issue comes up quite often in relation to smaller Canadian issuers, and we’ve also looked at it in the ESMA context in the past. ESMA’s message for the IASB on this is that “additional examples could be helpful” in understanding how the analysis of these issues should proceed. This topic also made it into the IASB’s request for information, but didn’t seem to be occupying its attention quite as fully as the “price times quantity” issue.

Anyway, we’ll see what comes of the IASB’s review, but in the meantime, the ESMA report seems to confirm these as areas of particular sensitivity and risk in practice, and ones deserving particular care in crafting the accompanying disclosure.

The opinions expressed are solely those of the author

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