We recently rolled out our annual investment companies update in both online, self-study and live webinar formats and have been offering it this fall to accounting firms worldwide. While there has not been a huge amount of recently issued ASUs impacting investment companies under ASC 946, there has been a ton of practice issues that have arisen as a result of COVID-19 and other recent developments. One of these relatively recent developments is the issuance of the AICPA Guide, Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (the “Guide”) in 2019. While the Guide is non-authoritative for purposes of applying U.S. GAAP, it does provide practical and interpretative guidance for determining the fair value under ASC 820 of investments typically held by private equity funds and other similar investment companies who follow ASC 946.

One area of interpretive guidance relates to underwriters’ lock-ups on certain equity securities. It’s proven to be one of the bigger “eye openers” in our webinars. As we will see, not only does the Guide provide interpretative guidance for this issue, but it also potentially changes the way ASC 820 has been viewed and interpreted by many organizations, including some of the Big 4 accounting firms! Let’s take a look at a scenario from our update course to illustrate:

When determining how a restriction impacts the fair value of a financial asset, ASC 820 has provided a key distinction when assessing the restriction:

• Restrictions tied to the instrument (i.e. instrument-specific restrictions)
• Restrictions tied to the holder (i.e. entity-specific restrictions)

Instrument-specific restrictions

As ASC 820 requires consideration of fair value from a market participant’s perspective, if a restriction is tied to the instrument being valued, it can be presumed that the restriction will pass from one market participant to another. Therefore, it would be considered for purposes of establishing the price a market participant would be willing to pay to enter into a purchase transaction. Consequently, when utilizing the quoted price of an unrestricted equity security to estimate fair value, an entity would make an adjustment to this quoted price to account for the restriction tied to the instrument being valued for purposes of estimating its fair value. This fair value estimate would be considered a Level 2 (or Level 3) fair value as the estimate is based on the quoted price of a “similar” asset, not an identical asset.

Entity-specific restrictions

Unlike instrument-specific restrictions, entity-specific restrictions are imposed on the holder of the instrument and do not necessarily transfer to a market participant when the instrument is sold. Therefore, a market participant would not consider this restriction, and it should therefore not be factored into the estimate of fair value under ASC 820.

In our example above, Vaccination holds equity shares in companies that have recently gone public. We assume the shares held by Vaccination are typical common shares being sold in the market; however, due to the arrangement between Vaccination and the underwriters that recently took the start-ups public, Vaccination is unable to sell its equity instruments for a period of 9-months from the date of the IPO. Is this restriction security-specific or entity-specific?

View 1 – Entity-specific restriction

Because Vaccination holds common shares that are currently sold in the marketplace, they are able to obtain a quoted price in an active market for shares that are identical to the ones they hold. The restriction from selling these common shares are Vaccination’s restriction alone. A market participant that theoretically were to acquire these shares would not be restricted in the way Vaccination currently is and therefore, clearly the restriction does not transfer to the market participant and is therefore entity-specific. As a result, the quoted price should be utilized, unadjusted, to represent fair value.

This view was commonly accepted by many accounting firms and was often considered to be best practice when determining fair value of equity shares with underwriters’ lock-ups.

View 2 – Security-specific restriction

Because Vaccination is restricted from selling these equity securities for a period of 9-months, any sale to a market participant during this lock-up period would only be possible if the restriction was accompanied with the equity shares. As a result, a theoretical market participant during the lock-up period would take this restriction into account when valuing the security and discount the unrestricted quoted price accordingly (i.e. the restriction would be considered security-specific until the restriction is lifted).

While this second view was generally less supported in practice by the Big 4 accounting guides, it is acknowledged that diversity in practice exists for these types of restrictions.

And along comes the AICPA Guide!

The Guide covers various valuation issues surrounding development stages to recently public entities and suggests some guidance that may impact how underwriter lock-ups are viewed when estimating fair value under ASC 820. Specifically, the Guide states the following:

• “Fundamentally, the assumptions that a market participant would take into account drive the determination of fair value. A restriction under the SEC's Rule 144A or an underwriter's lock-up that effectively prevents the sale of the securities is considered a characteristic of the asset because the hypothetical transaction could only take place if the restriction or lock-up accompanies the shares when they are sold to a market participant. Thus, the restriction or lock-up would be considered in valuing the asset. Such market participants typically would not pay the full traded price for locked up shares and, therefore, an adjustment typically would be necessary.”

This guidance within the Guide was noted by the AICPA Expert Panel for Investment Companies in its November 2019 meeting, where they acknowledged how there was diversity in practice and how the guidance in the Guide may fundamentally change how underwriters’ lock-ups may impact fair value.

Let’s settle this

Given this diversity in practice and seemingly contradictory guidance from accounting “experts”, the issue has been referred to the FASB for clarification. On July 29, 2020, the FASB decided to add a project to its technical agenda to address the effect of underwriter restrictions on fair value measurements. The FASB also decided to add a project to its research agenda to evaluate the effects of other types of sale restrictions on fair value measurements. To date, no further developments have been noted on the FASB’s website, so stay tuned. And if you don’t follow this issue with the FASB, you’ll be sure to learn all about it next year in our U.S. GAAP Update for the Investment Management Industry (2021)!

Need help understanding the unique accounting challenges associated with investment companies under ASC 946? We've got you covered in this post!

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