Fair value is used to measure a variety of assets and liabilities in U.S. GAAP; therefore it is a key concept, or as the FASB refers to it, a “broad transaction” that is defined by a single standard, ASC 820. This standard defines fair value and provides a framework for measuring fair value. There are lots of nuances in this framework, many of which are addressed in the “Implementation and Illustration Guidance” section of the standard. One of those nuances involves restrictions on the sale of an asset and is illustrated by several examples. This guidance has been recently amended by ASU 2022-03, Fair Value Measurement (Topic 820): Fair Value Measurement of Equity Securities Subject to Contractual Sale Restrictions to address diversity in practice. This post will illustrate the new guidance through an example.
So, can Gose include a discount to reflect the effect of contractual sale restrictions when determining the fair value of such investments? The answer is no. ASU 2022-03 clarifies that a “contractual sale restriction prohibiting the sale of an equity security is a characteristic of the reporting entity holding the equity security” and, therefore, the entity should not consider the contractual sale restriction when measuring the equity security’s fair value, meaning the entity should not apply a discount related to the contractual sale restriction. Therefore, Gose should measure the fair value of such investments using the price of an identical security in its principal market that is not subject to such a contractual sale restriction (i.e., price x quantity).
With respect to restrictions on the sale of equity securities, the guidance within ASC 820 has always stated that if the restriction was security specific, meaning the restriction would transfer to a market participant, then the effect of the restriction should be considered when determining fair value. ASU 2022-03 added an example of a security specific restriction involving shares issued through a private placement that are not registered and are legally restricted from being sold on a national securities exchange or over-the-counter market.
Conversely, the effects of entity-specific restrictions are not reflected in a fair value measurement since such restrictions would not transfer to a market participant. However, there was diversity in practice on whether the effects of a contractual restriction that prohibits the sale of an equity security, such as the one in our example, should be considered in measuring that equity security’s fair value. ASU 2022-03 clarifies that a contractual restriction on the sale of an equity security is not considered part of the unit of account of the equity security and, therefore, is not considered in measuring fair value. Examples of such restrictions include lock-up agreements and market standoff agreements that are often found in capital-raising and other transactions such as business combinations.
This guidance applies to all entities that have investments in equity securities measured at fair value that are subject to contractual sale restrictions. The biggest impact of this new guidance will be on investment funds and other similar entities that have been following guidance in the AICPA Accounting and Valuation Guide. Many entities following this guide treated an underwriter’s lock-up provision as a security-specific characteristic and considered it when measuring the fair value of equity securities. ASU 2022-03 clearly states that such lock-up provisions are entity-specific and, therefore, should not be considered when measuring fair value.
Finally, ASU 2022-03 includes several new disclosures related to equity securities that are subject to contractual sale restrictions, such as:
- The fair value of equity securities subject to contractual sale restrictions
- The nature and remaining duration of the restriction(s)
- The circumstances that could cause a lapse in the restriction(s)
ASU 2022-03 is effective for public business entities for fiscal years beginning after December 15, 2023, and for all other entities beginning after December 15, 2024. Early adoption is permitted, and the guidance is applied prospectively with certain special transition provisions.
Want to learn more about ASU 2022-03 and all the other new guidance applicable in 2022 and beyond? Check out our U.S. GAAP Update 2022 course.
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