In 2006 the Financial Accounting Standards Board (FASB) established a framework for fair value measurements and disclosures, which is now known as Accounting Standards Codification Topic (ASC) 820. The framework outlined in ASC 820 applies whenever the phrase “fair value” is referenced in a codification topic. ASC 820 defines fair value as:
“'the price that would be received to sell an asset or would be paid to transfer a liability in an orderly transaction between market participants at the measurement date'.
Prior to the FASB’s pronouncement in 2006, assets and liabilities were reported at an entry price commonly referred to as its cost. Fair value reporting altered this concept by requiring the utilization of market-based measurements founded on the notion of an exit price. An exit price requirement in financial reporting gave rise to a hierarchy of inputs when determining the fair value of an asset or a liability:Level 1, Level 2, and Level 3.
◘ Level 1 - Quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date
◘ Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly
◘ Level 3- Unobservable inputsfor the asset or liability
Though not exhaustive, the following ASC topics contain some of the more common references to “fair value” within the FASB’s codification, and as a result, the framework outlined in ASC 820 must be adhered to when addressing these topics:
◘ ASC 718, Compensation – Stock Compensation
◘ ASC 805, Business Combinations
◘ ASC 852, Reorganizations
◘ ASC 350, Intangibles – Goodwill and Other
◘ ASC 470, Debt
◘ ASC 815, Derivatives and Hedging
◘ ASC 321, Investments – Equity Securities
◘ ASC 946, Financial Services – Investment Companies
Valuing securities under ASC 820can be a time-consuming process when done internally, and may result in additional audit fees associated with the review and documentation of fair value conclusionsto ensure internal bias is not dictating the outcome when valuation best practices are not followed. There are many third-party valuation firms with the requisite experience and expertise, including B. Riley Advisory Services, that can make the process of fair value measurement simple and efficient. If you choose to perform the fair value analysis internally, some unexpected challenges with level 1 and level 2 inputs can manifest. For instance, a security may be priced on an exchange, but it may be thinly traded such that the quotes you observe, are not representative of the price that you would receive if sold on the exchange. Owning five million shares of a security that trades two hundred shares a day on an exchange may not be able to be liquidated in a timely fashion at a price close to the current quote. In cases such as this, you may need to think about applying a liquidity discount or using another valuation method as if the security were a level 3asset, rather than a level 1 or Level 2 asset.
“Auditors will want to review supporting financial statements, and reports and understand what level of research and analysis was performed in determining the fair value of the asset or liability”
Level 3 assets and liabilities can present several challenges when determining their fair value given their unobservable nature. One challenge is determining the appropriate valuation method to employ. This selection requires both a technical understanding of valuation theory as well as the experience to know what is acceptable in the framework of fair value as outlined in ASC 820. For instance, utilizing comparable transactions is often an acceptable methodology, but how does one define “recent”? This assumption is subject to interpretation, and what becomes most important is documenting the reasoning for the selection and having the selection be based on valuation best practices. In many instances there may not be a recent transaction to compare to, which means additional assumptions and professional judgement must be utilized. I have found that one efficient way to utilize professional judgment is to analyze comparable transactions of public companies in the same industry. For example, if you are valuing a position based on a multiple of EBITDA, you would want to know what other public companies in the same industry are trading at when selecting an appropriate multiple. A subscription to a data service is often required to gain access to reliable market data. In addition, the selection of a valuation multiple also requires professional judgement and expertise. In following best practices, the logic and reasoning utilized to select a multiple must be documented and supported. Simply selecting an average EBITDA multiple from a handful of publicly traded comparable companies may not be appropriate if the subject company is not comparable to the average in terms of financial and operational performance. Once you have navigated the pitfalls of picking the valuation method and determining the fair value of the subject asset or liability,it becomes necessary to document your work. Third-party valuation firms will conveniently provide a detailed report that discusses relevant risks, market conditions, and probabilities involved in the determination of fair value along with a write up on the specific characteristics of the underlying asset or liability. While it is difficult to match this level of documentation without spending more time than you may have available on it, you will need to consider and document all of these factors in your analysis if you plan to perform this work yourself. Auditors will want to review supporting financial statements, and reports and understand what level of research and analysis was performed in determining the fair value of the asset or liability. For many financial executives, performing this work without the assistance of professional expertsis technically possible, but is not feasible given the constraints on time and requisite expertise regarding the fair value framework discussed in ASC 820.
There are many factors to consider when determining how you want to value securities under ASC 820, and often using a third-party valuation firm to perform this service is the most cost effective and efficient option due to their understanding of the fair value framework and hierarchy outlined in ASC 820 paired with the expertise and experience of utilizing valuation best practices thereby enabling a simple and efficient audit reviewprocess