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
An 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. 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. 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. 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. 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.