IFRS 13 and ASC 820 (“the Standards”) provide several examples of situations where an adjustment to the quoted price of the corresponding asset may be required when measuring the fair value of a liability or equity instrument from the perspective of the reporting entity. In addition to those examples, the Standards originally stipulated that a reporting entity should ensure that the price of the asset “does not reflect the effect of a restriction preventing the sale of that asset”. It should be noted that the Standards discuss quite extensively restrictions placed on a transfer both by the creditor and by the debtor, but did not explain the meaning of the additional provision quoted above.
In our view, under IFRS the above provision may be given a relatively broad interpretation or a more limited interpretation, as described below. However, it should be noted that codification improvements issued for US GAAP in July 2018 amended the paragraph to state the opposite: When the asset held by another party includes a characteristic restricting its sale, the fair value of the corresponding liability or equity instrument would also include the effect of the restriction. The explanation to this was that ASC 820’s and IFRS 13’s original wording, as mentioned above, did not reflect the Boards’ discussions.
According to the broader interpretation of IFRS 13, it can be assumed that when the reporting entity issues restricted shares (for example, shares that were issued in a private offering as part of the consideration paid by the reporting entity in a business combination transaction), or when the reporting entity issues bonds which are not listed for trading, the fair value of the consideration should be measured based on shares which are unrestricted or bonds which are listed for trading, as the case may be. This should be the case even if the restriction is clearly a characteristic of the corresponding asset and is transferred along with this asset. There is no doubt that in economic terms, the buyer will take into account the fact that the consideration includes restricted shares. Thus, in our view, this broad but simplistic approach will inflate the consideration paid in the business combination and as a result will also inflate the goodwill.
Indeed, in our view, the approach described above is not trivial at all. Clearly, when measuring the fair value of the corresponding asset, the level of liquidity or any transfer restrictions that form part of the asset’s characteristics should be taken into account. Therefore, the above approach results in a difference between the fair value of the corresponding asset and the fair value of the issued liability or equity instrument, even though their unit of account is identical. The notion of liquidity for liabilities suggests that the more illiquid liabilities are from the debtor’s perspective (i.e., the more expectable the date and amount of future settlement), the greater the ability of the debtor to hold and manage illiquid investments in order to cover such liabilities as they become due. Since illiquid assets supposedly provide more return than liquid assets, illiquid liabilities that allow for more flexibility in investments should theoretically be valued at lesser amounts than more liquid liabilities (i.e., liabilities that carry more risk of early or unknown prepayment, such as on-demand bank balances or bonds with tight financial covenants). In other words, it may well be that while from the creditor’s perspective two similar assets may have different levels of liquidity and hence different fair values (such as two series of bonds with significantly different trading volumes), these assets may actually correspond to liabilities with an identical liquidity profile for the debtor (same maturity date and financial covenants). Hence, it could be argued that the fair values of the liabilities should be the same even though there is a difference between the fair values of the corresponding assets. A similar argument can be made for issued equity instruments. However, the explanatory notes of IFRS 13 specifically note that illiquidity should not result in a difference between the fair value of liabilities or equity instruments and the fair value of the corresponding assets, and it is worthwhile noting here that a restriction on the transfer of an asset is a specific case of illiquidity. The explanatory notes also state that it is difficult to separate the effect of illiquidity on fair value from the effect of the general credit risk on fair value, and that they should both be taken into consideration when measuring the fair value of the liability or equity instrument. Therefore, in our view, the approach described below will be more reasonable under IFRS, which means that illiquidity of equity instruments and liabilities is measured and treated from the perspective of the corresponding asset rather than from that of the reporting entity.
For the sake of argument, let us assume that the reporting entity has issued two series of bonds with identical characteristics, except for the fact that one series is listed for trading and is traded in an active market, whereas the other series is a private series with lower trading volumes. At least theoretically, there may be a price difference between the two series, since the first series has a higher level of liquidity from the perspective of the holder. In such a situation, in our view, the Standards will recognize that the fair value of the liabilities from the perspective of the reporting (issuing) entity will also be different because of the liquidity characteristic, particularly since there may be observable market inputs (such as prices of transactions involving the corresponding asset) to support this conclusion. Therefore, with respect to the above approach, the question is why the reporting entity should adjust the price of restricted instruments in order to exclude the effect of the restriction, but it is not required to carry out a theoretical adjustment to the quoted price of the second series in order to reflect its value under an assumption that it was listed for trading. Clearly, how to make such an adjustment requires reporting entities to exercise judgment, particularly in situations where the reporting entity does not have any tradable liabilities.
Under our approach, the effect of the restriction should be excluded from the price of the corresponding asset, only if the said restriction is not a characteristic of the asset itself (for instance, the restriction is not transferred with the asset), but did affect its price. With no clear guidance, in our view, this approach will be more consistent with the other provisions of the Standards. This means that according to this approach, if the reporting entity issues restricted shares, and the restriction is a characteristic of the shares, this matter will actually be taken into consideration not only when measuring the fair value of the shares from the perspective of those who invest in the shares, but also when measuring their fair value from the perspective of the reporting entity. This conclusion is further reinforced by the recent amendments to ASC 820, as mentioned above.
(*) an excerpt from “FAIR VALUE IN ACCOUNTING: FROM THEORY TO PRACTICE”, The Complete Handbook for Fair Value Measurement (IFRS & US GAAP), by Shlomi Shuv and Yevgeni Ostrovsky (December 2019, Final Draft)