1 Great and Complete Check – Identification of markets and transactions

Identification of markets and transactions

Many measurements in financial reporting are, or purport to be, based on current market values. The case for such measurements is strongest where values can be taken from active markets and can therefore be objectively verified. Identification of markets and transactions

Identification of markets and transactionsAn active market is described in IFRS 13, as one where ‘transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.’ This definition is very universal, every transaction can be part of it.

The Application Guidance to IAS 39 Financial Instruments: Recognition and Measurement, described active market, as one where ‘quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency, and those prices represent actual and regularly occurring market transactions on an arm’s-length basis.’

The range of assets for which active markets (defined in this way) was a narrow one, and the majority of market transactions did not take place in active markets in this sense. Identification of markets and transactions

But even with the broader definition, much of the economic process takes place within firms rather than through market transactions. To the extent that this is the case, there are many assets that one would not expect to be traded in the form and condition in which they exist at the date of a company’s balance sheet.

For example, a manufacturing business buys in a number of different items – raw materials, part-manufactured goods, labor services, and so on – and sells them on in a transformed condition when the manufacturing process has been completed. Between these two points, there are no market transactions and markets would not be expected to exist for partially transformed inputs (unless other manufacturers buy or sell at alternative stages of the production cycle). Part-manufactured goods and part-used fixed assets that are not normally sold can be sold, but their value will not be constantly evidenced by market quotes and transactions. Identification of markets and transactions

Further, where items held for business purposes that are not normally sold are sold, the value they realise is liable to be significantly lower than either what they cost in the first place or their value to the business.Identification of markets and transactions

The reason for this is again that economic processes take place to a large extent within firms, and assets that have entered an in-firm process are typically, to a significant degree, particular to that business. They are of limited use (and therefore limited value) to other parties, unless those parties buy the business.

Similar problems arise for the provision of services – and there are perhaps even greater difficulties in this context. The provision of a service (a consultancy service, for example) is developed within a business by bringing together and combining the various factors of production. Identification of markets and transactions

There is rarely a market for a service in the course of being provided (i.e, a contract on which the work is incomplete). Services are completed within firms, not sold part-finished for completion by another provider. Identification of markets and transactions

Markets are also conspicuously absent for some classes of liability. For example, there are no markets to assume the liabilities of active defined benefit pension schemes. The benefits under such schemes are usually defined in terms of future salaries, which are as yet not merely unknown but partly under the control of the company that sponsors the pension scheme.

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Why would anyone take on a liability that the party they are acquiring it from can subsequently decide to make larger? Similarly, there are no markets to take on liabilities for reinstatement costs or, to move to a more mundane example, to take on businesses’ liabilities to trade creditors. As a generalisation, markets for liabilities are thinner and scarcer than markets for assets.

Lack of active markets is a problem not only for the reliability of measurement information, but also for its relevance. One of the arguments for measuring assets at current values is that ‘the market price of an asset is an equilibrium price that reflects the expectation that the asset will earn the current available market rate of return for equivalent risk’, and that knowing this value therefore helps users to predict the business’s future cash flows. Identification of markets and transactions

But this is only true in an efficient market. The less active a market is, the less it matches the ideal of an efficient market, and the less market prices possess the characteristics that are supposed to render them especially informative in predicting a business’s future cash flows. Identification of markets and transactions

In redefining IFRS standards and the introduction of IFRS 9 Financial Instruments and IFRS 13 Fair value measurement the definition of ‘active market’ was re-adressed following above mentioned criticism, into the following one (as per above): An active market is ‘A market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis‘.  Identification of markets and transactions

As per IFRS 13 Identification of markets and transactions is now done under the following requirements::

IFRS 13 requirement to market and transaction Additional explanations/food for thought
Unit of account – The determination of the unit of  account must be established prior to determining fair value and is defined as the level at which an asset or a liability is aggregated or disaggregated in an IFRS for recognition purposes.

The unit of account is determined under the IFRS applicable to the asset or liability (or group of assets and liabilities) that requires fair value measurement.

Unit of Account

This is about identifying the transaction.
  • The item for which fair value is determined may be a single asset or liability such as a derivative instrument or a share in a publicly traded entity or it may be a group of assets (i.e. a portfolio of receivables), group of liabilities (i.e. a portfolio of deposits) or group of assets and liabilities (e.g. a cash-generating unit, a business or an asset group which is held for sale).
  • IFRS 13 does not generally provide specific guidance on the determination of the unit of the account – rather it directs preparers to other IFRSs to make this determination. IFRS 13 does specifically address one area relating to the unit of account in the form of guidance for financial assets and financial liabilities with offsetting positions. Here IFRS 13 includes a “portfolio exception” allowing a specified level of grouping when a portfolio of financial assets and financial liabilities are managed together with offsetting markets risks or counterparty credit risk. This exception is subject to your entity meeting certain eligibility criteria. (IFRS 13.48-52).

identifying the transaction

Market – Fair value measurement under IFRS 13 assumes that a transaction to sell an asset or to transfer a liability takes place in the principal market (or the most advantageous market in the absence of the principal market).

The principal market is the market with the greatest volume and level of activity for the asset or liability.

The most advantageous market is the market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability, after taking into account transaction costs and transport costs.

This is about identifying the market (and bits related of the transaction are mentioned).
  • If there is a principal market, the price in that market must be used, either directly or as an input into a valuation technique. IFRS 13 does not permit the use of a price in the most advantageous market if a principal market price is available!
  • This said, it is not necessary to perform an exhaustive search of all possible markets to identify the principal market (or, in the absence of a principal market, the most advantageous market). However, all information that is reasonably available should be considered and the basis for your conclusions should be documented.
  • There is a presumption in the standard that the market in which the entity normally transacts to sell the asset or transfer the liability is the principal or most advantageous market unless there is evidence to the contrary.
  • Where your entity transacts in various markets (such as when assets are sold on multiple commodity and/or equity exchanges), your entity should document which particular market price is used and what process was followed to determine the appropriate market to use for determining fair value.
Market participant assumptions – A fair value measurement under IFRS 13 requires an entity to consider the assumptions a market participant, acting in their economic best interest, would use when pricing the asset or a liability.

Market participants are defined as having the
following characteristics:

  • Independent of each other (i.e. unrelated
    parties).
  • Knowledgeable and using all available information.
  • Able of entering into the transaction.
  • Willing to enter into the transaction (i.e. not a forced transaction).

Forced transaction

  • The key concept here is that the standard requires your entity to put itself in the place of a market participant and exclude any entity-specific factors that might impact the price that your entity is willing to accept in the sale of an asset or be paid in the transfer of a liability.
  • So, for example, relevant characteristics of an asset might include or relate to:
    • The condition and location of the asset; and
    • Restrictions, if any, on the sale or use of the asset.
  • Here, you would need to consider the extent to which a market participant would take the above characteristics into account when pricing the asset or liability at the measurement date. The extent to which restrictions on the sale or use of the asset should be reflected in fair value are very much contingent on where the source of the restriction comes from and whether or not the restriction is separable from the asset.
  • Depending on the particular item that is the subject of the fair value measurement, the analysis of determining exactly what a market participant would consider may, in some cases, prove to be challenging. As such, in more challenging cases, consultation with your auditors and advisors is recommended.
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Also read: Fair value framework

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Identification of markets and transactions

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