ASC 820 or Accounting Standards Codification 820 – Fair Value Measurement
ASC 820 is an accounting standard that states that an investment must be reported at its fair value.
Investors regularly invest to make profits. For them to invest in companies, it is important to determine their business value. This value that investors determine will help the negotiation process and affect the profit they make on their investment. Many decisions are affected by the financial reports, which is why while managing your investment portfolio, you need to be accurate. Additionally, you need to keep your LPs (limited partners) notified about the current state of the investments. This is where ASC 820 fair value comes in.
ASC 820 valuation is an accounting standard that demands that the investment is valued at a fair value. By measuring an investment at fair market value, there is less risk of loss associated with the investment and more certainty of potential profits.
What is ASC 820?
ASC 820 is an accounting standard that states that an investment must be reported at its fair value. Accounting Standards Codification 820 is a part of the guidance of GAAP (Generally Accepted Accounting Principles) and FASB (Financial Accounting Standards Board’s). Assets are classified based on their level of liquidity in this standard. If an asset is more liquid, it will be easy to determine the value and vice-versa. Level 1 assets are considered to be the most liquid assets, and Level 3 the least. For example, in NASDAQ, publicly traded shares are a Level 1 asset, and preferred stock in venture capital or privately backed business will be classified under a Level 3 asset.
There are some key terms you need to know before learning more about ASC 820.
According to ASC 820, fair value is the amount that will be received to sell an asset or transfer a liability. Both parties should formally do the transaction at the specified date. Doing so will establish a framework for determining the fair value and will expand the disclosures. This is also applicable to any accounting pronouncements which either permit or require a fair value measurement.
For example, Zero Inc. sells its stock to Space Ltd. at $60 per share. The owner of Space Ltd thinks that they will be able to further sell the same share at $100 once it is in his hand. The owner believes that this assumption is correct and buys 2 million shares at $60 per share. Despite the assumption of the owner of Space Ltd. and the huge potential of the shares, the sale is made on the price that is considered to be the fair value of $60. This is so because both parties agreed to this and both also benefited from this sale.
ASC 820 fair value follows an exit price approach because an entry price can not be considered to be a representation of the fair value. Let’s take an example when there is a transaction between two parties as a forced sale, the initial transaction will take place in a different market from one that others could access through their funds. In this case, both parties are brokers, and the transaction occurring between them is not accessible to anyone else. An entry price is the amount of the transaction and the costs incurred for completing the transaction, such as fees, etc. During this transaction, there is a possibility the entry fee is not recovered in the exit price.
This principle recognizes the potential losses or gains on the first day of the transaction. Additionally, while determining the fair value, assumptions such as participant’s risk are included by marketplace parties. Under vindicate scenarios, the measurement will assume an orderly transaction while providing further guidance.
A principal market is a market where there is a vast activity level for the concerned asset or liability. Unless there is any contrary evidence showing another market, the principal market is considered to be the place a fund will typically enter into a transaction. If the fund cannot access or determine the principal market, it should be applied in the market where there is an advantage of getting a better fair value. The most advantageous market is a place where an asset is given the highest fair value and liability is given the lowest fair value for the transaction while considering all the costs. The FASB intends for investors to use the most advantageous market in a multiple market scenario even though doing so will mean going against the fabric of orthodox.
Fair Value Hierarchy
For the classification of inputs in the measurement of the fair value, the most important element of the ASC 820 fair value hierarchy is the utilization of the three-level hierarchy. This is made as inputs that refer to the assumptions that participants in the market would use in the assumption of risk, and pricing of liabilities and assets. In order to increase the level of consistency and comparability in the fair value measurement, this hierarchy was created. The hierarchy gives the lowest priority to the assets that are unobservable and the highest to the assets that are identical and active or are highly traded in the market. The three levels of hierarchy are:
- Level 1 – This is the most noticeable input through which you can determine fair value. This level consists of the most liquid investments in the active market, including the current quoted price for similar liabilities or assets. According to ASC 820, an active market is one where the asset or liability is regularly traded in high volume and frequency, providing information regarding the price of an asset continuously.
- Level 2 – Level 2 consists of an observable input other than the Level 1 quoted prices of securities. Here other than the directly observable quoted prices, identical assets & liabilities in the market are inactive. Private investments in public companies or inactive market inputs are considered to be Level 2. Generally implied volatilities, yield curves, interest rates at quoted intervals, and other market inputs are frequently used in combination with the valuation models.
- Level 3 – A Level 3 asset or liability includes those that are not observable as it is not a frequently traded asset in the market. This is the lowest level of liquidity in the hierarchy for fair value measurement. While estimating the fair value of such investment, you should consider the level of liquidity. To determine the fair value of a Level 3 asset, you will have to consider all the factors that are specific to the asset that is being valued. Using unrelated assets with the same investment and observable inputs will lead to different valuations. Ultimately, estimating the fair value of a low liquid asset depends on thorough research and fine judgment.
This provides the framework and tools to help define, manage and measure the fair value level. It further helps in meeting all the requirements for disclosure. The fair value disclosure will provide comparability and consistency for a fair value measurement to shareholders so that they can be confident in doing business with your company.
Here is a list with examples of the various levels:
|Fair Value Hierarchy||Examples|
For full-term the quoted prices for identical liabilities and assets in an active market
Actively traded debt
Inputs here other than level 1 which are directly or indirectly observable include:
1. Quoted prices for similar assets/liabilities
2. Inputs other than quoted prices that can be observed.
|Plain Vanilla interests
Inputs that are unobservable, are developed by the use of assumptions and estimates that participants in the market would use.
|Complex and long-dated derivatives.|
ASC 820 Approach to Fair Value Measurement
The fair value measurement ASC 820 was made mandatory on November 15, 2007. To comply with the GAAP, a company must follow ASC 820 fair value for the reporting periods. The ASC 820 approach to fair value measurement provides a framework for valuing investments in the financial plan, discusses the inputs for valuation techniques, the acceptable techniques, and also establishes a hierarchy to prioritize the inputs. This requires huge financial disclosures about the investment or assets value. Here is the step by step process to determine the value:
Calculate enterprise value
ASC 820 valuation shifted the definition of value from the purchase price to the selling price, or in other words, from an entry price to the exit price. The value is now the expected returns from the sale of an asset. Before 2007 the purchase price of an asset was utilized as a reporting measurement. But the ASC 820 fair value has changed that, and now it needs the exit value of an asset or liability.
The fair value measurement ASC 820 also emphasizes the fact that the fair value is not an entity measurement with accurate results but a market-based measurement. It also specifies that the exchange price is the transaction price between the two parties in the most advantageous market for the asset. It is an important component of valuation as it helps evaluate the shares of a business. To calculate it, multiply the share price by the outstanding shares in the enterprise. While measuring the fair value of an enterprise, the transaction to sell it is hypothetical. If the company is a Level 1 then compare it to similar businesses to determine the fair value. If the entity is a Level 2 or Level 3, research and determine the fair value by focusing on the price that you would receive in the most advantageous market to sell it.
ASC 820 Valuation Methods
There are three types of valuation methods under ASC 820. They are:
- Income approach – The Income approach is also known as capitalized cash flow analysis or discounted cash flow. In the income approach, you convert the potential future amount into the current amount. This method shows the current market value for future assets. By using this method, you might have to consider techniques such as option pricing model or present value technique.
- Market Approach – The market value approach utilizes all the information gathered from the market where similar transactions occur to determine the fair value. In this approach, there may be the use of market multiples from similar companies in the same industry and quotes for similar traded securities. This method is used when the company to be valued has an active market, this is so because this approach is based on the comparisons made to similar assets that are traded in the market. Using this data and some other adjustments, the value is determined. Because the market approach relies on comparisons to similar assets, it is most useful when there is substantial data available regarding recent sales of comparable assets.
- Asset approach – In asset approach, the asset’s fair value is estimated by calculating the total value of the company’s assets. This is the best approach for companies in their early stages and startups without revenue.
Allocate the value across all share class
The next step in deriving the fair value of an asset is to allocate the value of the business across the share classes using these methods:
- Waterfall method – This method accounts for all of the preferences and rights of the equity shareholders. If the company is potentially near an acquisition or has a complicated capital table, this is the best method for calculating the fair value.
- Option pricing model (OPM) – When considering all different outcomes, the OPM takes into account all the rights of preference shareholders, the market volatility, and the expected exit time. This is the best option for early-stage businesses that have lower visibility of a future exit.
- Common stock equivalent (CSE) – This method does not consider the preferences and rights. It assumes that all the preferred shares are converted into common shares and allocates a value. When a business is near an initial public offering, this is the method used to determine the value.
- Probability weighted expected return method (PWERM) – This method focuses on the potential outcomes, including the exit dates, values, etc. Then it assigns each of the values according to their weightage.
Need any Assistance in ASC 820 Valuation
Valuing a company might prove to be a complex process without sufficient knowledge. Measuring the ASC 820 will remove the need for you to estimate a fair value for each liability and asset. Whether you have to determine the ownership interests held by your company or estimate the fair value of a private company, you will require a professional with the needed knowledge. Having the right professional that can efficiently and effectively help you out by using professional tools to smooth out the process is a must. You can evaluate your entity with compliance with the ASC 820 valuation through Eqvista.
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