On June 30, 2022, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2022-03, amending a longstanding, albeit somewhat diverse fair value measurement practice with respect to equity securities subject to contractual sale restrictions. The change prohibits taking into account contractual restrictions on the sale of an equity security when estimating its fair value—on the basis that such restrictions are not part of the equity security itself. Recognizing and measuring the contractual sale restriction as a separate unit of account (as a contra-asset or a separate liability) is also prohibited.
The change impacts all equity securities measured at fair value that are subject to contractual sale restrictions but will likely impact investors in alternative asset funds the most.
Under the prior FASB fair value rules—and current International Financial Reporting Standards (IFRS) rules, which have not been amended—fair value is the amount that would be received in an orderly transaction using market participant assumptions as of the measurement date. When an equity security is contractually restricted from sale, a hypothetical sale (the premise used by FASB ASC Topic 820 to measure fair value) would consider a market participant’s assessment of that restriction, including whether a buyer of the equity security would be obligated to abide by the same restriction. As a simple example, if an equity security without a restriction is valued at $100 (based on the traded price on an exchange) but because of the restriction a buyer would only pay $90 (as the buyer/seller cannot trade the security on an exchange due to the restriction), fair value under the prior FASB rules would be $90.
Under the amended rules, using the example above, the rationale is that the contractual sale restriction is not part of the unit of account of the equity security, and therefore fair value will be $100, leading to a divergence with international standards and an overstatement of what would be received in an orderly transaction between market participants. Notably, the amendments apply not only to actively traded securities (Level 1) but to all securities, including those categorized in Level 2 and Level 3.
The amendments do not apply to unregistered securities under Rule 144 or similar SEC rules, whereby the argument is that the restriction would be included in the unit of account of the equity security, and therefore its effect will be reflected in the fair value measurement.
Many private investors have investment agreements (Level 3 investments) with contractual language that could be deemed to prohibit sale. The impact of such embedded clauses could present challenges when a security is purchased at its “economic value,” inclusive of the effect of the restriction (i.e., at what would have been fair value under the prior FASB rules). As such, the purchase price may now have to be adjusted to remove the effect of the restriction (i.e., the illiquidity discount) under the new rule, resulting in a ‘day-one’ gain.
Investors who use the ‘practical expedient’ in valuing fund interests using net asset value (NAV) will need to consider the divergence in reported fair value-based NAV between funds reporting under the new U.S. Generally Accepted Accounting Principles (U.S. GAAP) fair value rules and the existing IFRS fair value rules. Does the FASB change mean that investors reporting under U.S. GAAP will now need to modify reported NAV for all funds reporting under IFRS to be compliant with the practical expedient?
ASU 2022-03, paragraph 820-10-35-6B clearly states that “[if] an entity cannot sell on the measurement date because of a contractual sale restriction [the equity security] shall be measured at fair value on the basis of the price in the principal (or most advantageous) market. A contractual sale restriction does not change the market in which that equity security would be sold.” Yet many could interpret the market in which an equity security with a restriction can be sold to be the private market, not an exchange traded market that cannot be accessed. How will this potential conflict be interpreted and applied?
These questions and others will likely be addressed through expected amendments to the AICPA accounting and valuation guide, Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies.
After adoption, the following will be required disclosures for equity securities subject to contractual sale restrictions:
Equity securities restricted from sale because they are pledged as collateral are not included in any of the above disclosures as they are subject to other existing U.S. GAAP disclosure requirements.
The impact of FASB’s change on the fair value of equity securities subject to contractual sale restrictions could be more pervasive than initially foreseen. Kroll has deep sector expertise to help evaluate the fair value implications as the changes to fair value are implemented.
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