Valuation techniques used to measure fair value must maximize the use of relevant observable inputs and minimize the use of unobservable inputs. The best indication of fair value is a quoted price in an active market.
Sometimes whether a market is active or not is self-evident. For example, an entity with shares quoted on an exchange (for example, the Toronto Stock Exchange) may have regular trading frequency and volume to provide pricing information on an ongoing basis. However, for entities in a start-up phase or a specific industry, their shares may have low frequency of trading and, in some cases, there could be no daily or monthly trading. Even if trading took place, the volume of shares traded could be low.
Extract, IFRS Discussion Group Report on Meeting – May 31, 2016
On July 1, 2015, Entity A acquired an investment of 125,000 shares in Entity B for a total cost of $10,000 (at $0.08 per share). Entity B is a start-up company listed on Exchange Y. The investment is not deemed to be an associate nor a subsidiary of Entity A.
Entity B has issued 5,000,000 ordinary shares. Entity B’s closing price at December 31, 2015 on Exchange Y is $0.10 per share. Based on the December 31, 2015 closing price, Entity A’s total investment in Entity B was $12,500 (at $0.10 per share). Shares of Entity B have traded on Exchange Y on four occasions during the year ended December 31, 2015 as follows:
- March 31, 2015 – 5,000 shares at $0.15 per share
- July 1, 2015 – 125,000 shares at $0.08 per share (i.e., Entity A’s acquisition of the shares in Entity B)
- August 3, 2015 – 10,000 shares at $0.06 per share
- September 30, 2015 – 2,000 shares at $0.10 per share
Entity B has not issued any shares by way of a private placement or any other means during the year ended December 31, 2015.
Issue 1: What are some common characteristics used in assessing whether an investment is traded in an active market?
The definition of an active market requires an entity to consider both the frequency of trades and the volume of those trades.
In assessing frequency and volume of trades, an entity may consider whether:
- there are recent buy-sell transactions;
- there has been a significant decline in the frequency and volume of transactions from what it previously experienced;
- the last trade date is close to the measurement date in order to determine whether current information is available; or
- there is a significant movement or variance in the quoted prices over a period of time.
The Group’s Discussion
Group members made various observations regarding other characteristics that entities can look at in assessing whether the investment is traded in an active market. For example, an entity could look at the bid-ask spread because generally if there are multiple participants in the market, the differential should be small. Also, an entity could consider economic indicators (for example, the price of oil) that could be correlated with the price of the security.
One Group member observed that entities could start with the presumption that an investment traded on an exchange is an active market, but then consider whether evidence exists to rebut that presumption. Another Group member pointed out that IFRS 13 is clear that assessing whether a market is active or inactive is not a function of the size of the investor’s holding. The unit of account is the share and not the investment as a whole.
One representative from the Canadian Securities Administrators (CSA) noted that National Policy 12-203, Cease Trade Orders for Continuous Disclosure Defaults, also considers the concept of an active liquid market. Although this policy is in a different context from IFRS 13, the regulators have concluded that there is not an active liquid market for securities traded a few times in small volumes over a period of a month or two.
Another CSA representative commented that generally they start with looking at the security and understanding the trading pattern, including when the last trade occurred, and the type of trade (for example, whether it is a forced trade or a related party trade). If trading is sporadic, an entity should consider whether there is a Level 2 input and if some sort of adjustment can be made for the illiquidity value, or whether a Level 3 valuation technique is needed.
View A – An entity is required to measure fair value using a valuation technique.
As the equity instrument is not quoted in an active market, the entity needs to use a valuation technique that might incorporate Level 2 or Level 3 inputs. Under this view, Entity A would look to use one or more of the following Level 2 inputs and adjust Entity B’s exchange quoted price:
- quoted prices for similar assets or liabilities in active markets;
- quoted prices for identical or similar assets or liabilities in markets that are not active;
- market-corroborated inputs (for example, an observable index); and/or
- broker quotes or pricing services (depending on how the information is developed).
View B – An entity is permitted to measure fair value using the last quoted price.
Paragraph 82 of IFRS 13 sets out Level 2 inputs and specifically refers to quoted prices for identical or similar assets or liabilities in markets that are not active. Under this view, when a current transaction can be observed in the same instrument, that price is used unless there is evidence that it does not represent fair value. Absent any observable evidence supporting a change in value, an entity is permitted to use the last quoted price as an indicative fair value, accompanied by a disclosure that the price is categorized within Level 2 of the fair value hierarchy.
Furthermore, proponents note that adjustments to the last quoted price would require significant assumptions and estimates. Hence, the last quoted price (even when the instrument is trading thinly or not at all) would be more indicative of the share’s fair value than any other Level 2 or 3 valuation, especially when the equity instrument being valued is that of a start-up or similar type of entity.
The Group’s Discussion
Group members noted that understanding why the market is assessed as being inactive is important. Some Group members thought it would be difficult to accept, or default to, the last quoted price if the entity reached the conclusion that the instrument is traded in an inactive market. An old value cannot be presumed to represent fair value, and thus, other valuation techniques should be used to derive a more reasonable estimate.
One Group member observed that IFRS 13 requires measuring fair value from a market participant’s perspective. In this fact pattern, if an entity starts with the December 31, 2015 closing price of $0.10, further work is needed to understand how a market participant would view that price in order to determine whether any adjustments are needed.
A representative from the Canadian Securities Administrators observed that the inactive trade could be a useful reference point. Also, consideration should be given as to how long ago the last trade occurred relative to the measurement date, and whether using that price will produce a misleading result for investors. Valuation techniques produce estimates as well. Therefore, it is important to assess the reasonableness of the valuation techniques and the inputs used.
Some Group members noted that even if the December 31, 2015 closing price is determined to approximate its fair value based on an examination of all the facts and circumstances, such price is not a Level 1 measure under the fair value hierarchy because it has been concluded that the market is inactive.
The Group’s discussion raises awareness about this item. No further action was recommended to the AcSB.
Why is market data important?
Many current and emerging regulatory or reporting regimes use the ideas of fair value or market-consistent value of assets and liabilities – Solvency II Technical Provisions, MCEV, IFRS.
The long-term nature of life insurance contracts means that often the relevant instruments for valuation may not traded in „liquid‟ markets – There may be questions over the price reliability of these assets
The decision whether-or-not to include these assets can affect the results of a valuation exercise
Solvency II – Deep, Liquid & Transparent Markets
- “A deep market is a market in which a large number of assets can be transacted without affecting the price of the financial instruments used in the replications
- A liquid market is a market where assets can be easily converted through an act of buying or selling without causing a significant movement in the price
- A transparent market is a market in which current trade and price information is readily available to the public”
Many of the OTC derivates currently used in market-consistent valuations don’t satisfy this definition – what impact will this have?
Example of different markets/Data sources
|Traditional data sources |
– Excellent source of information if good turnover
– Typically limited to short-dated near ATM
– Each exchange may have a different method to settle contracts
– Last trade may be manipulated
– Settlements can have model-based assumptions
– In illiquid markets, settlements can be stale
– Quote size may be small and not relevant for OTC markets
Model-based pricing services
– Based on limited publicly available information
– No benchmark or validation process
– A single unqualified view of the market
– “Black Box” approach
– Automated process and “best fit” curves may be away from actual prices
– Model assumptions and smoothing techniques may lack transparency
Counter party valuations
– Lack of independence
– No benchmark or validation process
– A single view of the market
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