The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Under ASC 820, fair value is based on the exit price (the price that would be received to sell an asset or paid to transfer a liability), not the transaction price or entry price (the price that was paid for the asset or that was received to assume the liability). Conceptually, entry and exit prices are different. The exit price concept is based on current expectations about the sale or transfer price from the perspective of market participants. In accordance with ASC 820-10-35-9, a fair value measurement should reflect all of the assumptions that market participants would use in pricing an asset or liability.
ASC 820-10-35 provides guidance to determine:As described in ASC 820-10-35-2B through ASC 820-10-35-2E, a fair value measurement relates to a particular asset or liability. Thus, the measurement should incorporate the asset or liability's specific characteristics, such as condition, location, and restrictions, if any, on sale, transferability, or use, if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. Refer to FV 4.8, which further notes that restrictions that are not part of the unit of account of an equity security are not considered in measuring fair value.
In some cases, the fair value measurement will be applied to a standalone asset or liability (e.g., a financial instrument or a nonfinancial asset) or a group of related assets and/or liabilities, such as a business or a reporting unit. How the fair value measurement applies to an asset or a liability depends on the unit of account.
The unit of account is determined based on the level at which the asset or liability is aggregated or disaggregated in accordance with US GAAP applicable to the particular asset or liability being measured.
ASC 820 addresses how to measure fair value and not what is being measured. Accordingly, ASC 820 does not change the unit of account prescribed by other standards.
ASC 820 emphasizes the unit of account (as defined in other guidance), generally requiring that the fair value of financial instruments be measured based on the level of the unit of account, rather than at an aggregated or disaggregated level. In some cases, the unit of account may not be clear. There are few instances in which the unit of account is explicitly defined. Often, it is inferred from the recognition or measurement guidance in the applicable standard and/or from industry practice. For example, it is clear that the unit of account for evaluating goodwill impairment is the reporting unit. On the other hand, the guidance on accounting for securities by investment companies is not explicit as to the unit of account. Also, there are times when the unit of account varies depending on whether one is considering recognition, initial measurement, or subsequent measurement, including impairments.
A prominent example of when the application of unit of account has been problematic relates to the fair value of investments in listed subsidiaries (referred to as the "P*Q" issue). The problem specifically is whether the unit of account is the investment as a whole or each share.
Some believe that the unit of account for associates, joint ventures, and subsidiaries is the investment as a whole, and others believe that the fair value of a listed investment quoted in an active market is the product of the share price at the date of measurement and the number of shares held (P x Q).
Entities should disclose clearly in the financial statements the fair value model that they have used. Significant implied premiums or discounts are likely to be scrutinized by regulators.
ASC 820-10-35-5 through ASC 820-10-35-6C discuss the concepts of principal market and most advantageous market. In accordance with these concepts, the transaction to be fair valued should take place either in:
The principal market is the market with the greatest volume and level of activity for the asset or liability, not necessarily the market with the greatest volume of activity for the particular reporting entity. This concept emphasizes the importance of considering the market participant’s perspective.
In evaluating the principal or most advantageous markets, ASC 820-10-35-6A restricts the eligible markets to only those that the entity can access at the measurement date.
If there is a principal market for the asset or liability, ASC 820-10-35-6 states that fair value should be based on the price in that market, even if the price in a different market is potentially more advantageous at the measurement date. It is only in the absence of the principal market that the most advantageous market should be used.
To determine the principal market, the reporting entity needs to evaluate the level of activity in various markets. However, the entity does not have to undertake an exhaustive search of all possible markets in order to identify the principal or most advantageous market; it should take into account all information that is readily available. In the absence of evidence to the contrary, the market in which an entity normally transacts is presumed to be the principal market, or the most advantageous market in the absence of a principal market.
In many cases, a reporting entity may regularly buy and sell a particular asset and may have clearly identified exit markets. For example, a company engaged in trading natural gas may buy and sell financial gas commodity contracts on the New York Mercantile Exchange and in bilateral markets. In determining the principal market, the company would need to evaluate the level of activity in various markets. The reporting entity's principal market will be the market in which the gas commodity contracts have the greatest activity, even if the prices in other markets are more advantageous or if the reporting entity itself has greater trading volume in another market. Assuming the reporting entity has access, the fair value measurement will be based on the price in the asset's principal market.
Example FV 4-1 illustrates the framework for identifying the principal or most advantageous market. EXAMPLE FV 4-1Producers intend to sell all of the production they can in the export market and, when they do not have any further authorization to export, will sell the remaining production in the domestic market.
What is the principal market? AnalysisAlthough the most advantageous market is the export market in that it gives the higher benefits to the producers, the domestic market is the principal market as it can handle all of the volume that producers have to sell.
Question FV 4-1
Assume a company in the business of refining oil into gasoline enters into a contract to purchase a quantity of crude oil and the contract qualifies as a derivative instrument under ASC 815, Derivatives and Hedging. When determining the fair value of the contract for crude oil, is the company permitted to consider the market for gasoline products as the principal market into which the crude oil is sold?
No. We do not believe that the gasoline market is an appropriate principal market in this fact pattern.
The unit of account for the crude oil contract is established by ASC 815 as the entire contract. The price of gasoline would not provide an appropriate valuation, because the price considers the process of converting crude oil to gasoline. In this example, we would expect the potential markets for the crude oil contract to be based on the wholesale markets in which the crude oil can be sold.
Definition from the ASC Master Glossary
Orderly transaction: A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale).
ASC 820-10-35-6C addresses the use of market participant assumptions.Even where there is no observable market to provide pricing information about the sale of an asset or the transfer of a liability at the measurement date, a fair value measurement shall assume that a transaction takes place at that date, considered from the perspective of a market participant that holds the asset or owes the liability. That assumed transaction establishes a basis for estimating the price to sell the asset or to transfer the liability.
The definition emphasizes the use of market participant assumptions in the determination of fair value. In addition, the concept of an orderly transaction excludes a distressed sale or a forced liquidation as an input in the determination of fair value. For example, assume the normal lead time for sale of an operating asset is approximately three months, which allows for marketing and sufficient due diligence by market participants. However, if a company needed to raise cash quickly due to a liquidity crisis, it may agree to a distressed sale of certain operating assets at lower-than-market prices. These transactions would not be representative of the fair value for the related assets. In a forced liquidation, the transaction price may not equal the fair value of the asset or liability at initial recognition (see further discussion in FV 4.3).
Reporting entities have the responsibility to determine the principal market, and in the absence of a principal market, the most advantageous market. This allows for differences in markets used among entities with different activities, even those that are party to the same transaction. ASC 820-10-55-47 through ASC 820-10-55-49 describes a dealer that enters into an interest rate swap with a retail customer. From the perspective of the dealer, the principal market for the swap is the dealer market; however, the principal market for the retail customer is the retail market because the customer does not have access to the dealer market.
In addition, different operating units within a reporting entity may have access to different markets and each separate unit should individually consider the principal market, and in the absence of a principal market, the most advantageous market. Therefore, the same reporting entity could have different fair value measurements for identical or similar assets or liabilities, depending on the operating units holding the assets or liabilities and differences in the markets to which they have access and the differences in assumptions of the market participants in those markets. For example, a reporting entity’s operating units located in Asia, Europe, and the US may each hold investments in the same debt and equity securities. The fair value measurements reported by the operating units may differ at times due to differences in the markets to which they have access and the level of activity for the asset in each market. ASC 820 requires that each reporting unit consider the facts and circumstances appropriate to its valuation of the asset or liability being valued and follow the framework, independent of other reporting units that may be valuing an identical or similar asset or liability.
With the adoption of ASU 2022-03, as described in FV 4.8, ASC 820-10-35-6B will be updated to note that a contractual sale restriction does not change the determination of the principal (or most advantageous) market. In other words, the reporting entity would still follow considerations within ASC 820 to determine the principal (or most advantageous) market without regard to the contractual restriction, as a contractual restriction is not part of the unit of account of the asset.
Secondary markets exist when investors trade among themselves, rather than investing directly through the issuer of a financial instrument in the primary market. In secondary markets, sometimes called “aftermarket,” the issuer of the instrument is typically not involved in the transaction, as the instrument has already been issued. The New York Stock Exchange is a type of liquid secondary market for stocks of publicly traded companies. Secondary markets also exist for private equity investments, where both current funded private equity investments as well as any remaining unfunded commitments are traded. However, this type of secondary market tends to be less liquid than those of publicly traded instruments. Therefore, similar to any other asset or liability, when determining the fair value measurement of an instrument traded in a secondary market with limited activity, it is necessary to consider all available trade data in developing market participant assumptions, including from thinly traded secondary markets.
ASC 820 emphasizes that a fair value measurement should be based on the assumptions of market participants; it is not an entity-specific measurement. Market participants are buyers and sellers in the principal (or the most advantageous) market for the asset or liability. They are interested in and could benefit from ownership of a specific asset or liability.
The ASC Master Glossary provides characteristics of market participants.Partial definition from the ASC Master Glossary
Market participants: Buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics:
The term “related parties” is used consistent with its use in ASC 850, Related Party Disclosures. ASC 820-10-35-9 includes factors to consider when identifying market participants.
Excerpt from ASC 820-10-35-9
…[T]he reporting entity shall identify characteristics that distinguish market participants generally, considering factors specific to all of the following:
The reporting entity is not required to identify specific market participants, but instead to develop a profile of potential market participants. The determination of potential market participants is a critical step in the overall determination of fair value due to the emphasis on the use of market participant assumptions. In some cases, the identification of market participants may be straightforward, as there may be general knowledge of the types of entities that transact in a particular market. However, in certain other cases, a reporting entity may need to make assumptions about the type of market participant that may be interested in a particular asset or liability. The determination of the appropriate market and market participants may have a significant effect on the fair value measurement.
Question FV 4-2
How should a reporting entity assess multiple markets (and therefore, multiple market participants) when determining fair value?
In some cases, a reporting entity may have more than one potential exit market and many market participants in each exit market. ASC 820-10-35-54J states that the reporting entity need not undertake an exhaustive search of possible markets to identify the principal market, or in the absence of the principal market, the most advantageous market, but it should consider information that is reasonably available. Therefore, the reporting entity can use the price in the market in which it normally enters into transactions, unless there is evidence to the contrary. Consistent with this guidance, a reporting entity should use information that is reasonably available to it when developing its profile of market participants.
There may be situations when there is no observable market for an asset or liability, or a reporting entity may not have access to any markets. For example, there may be no specific market for the sale of an intangible asset. In such cases, the reporting entity should identify potential market participants (e.g., strategic or financial buyers).
Another example is an existing market for buying and selling internet domain names. Although it may not be a principal or most advantageous market for a reporting entity, if the reporting entity has no principal market, the market may provide data for the valuation of domain names.
A reporting entity should determine the characteristics of a market participant to which it would hypothetically sell the asset if it were seeking to do so. Once the market participant characteristics have been determined, the reporting entity would identify the assumptions that those market participants would consider when pricing the asset. The reporting entity should construct a hypothetical or “most likely” market for the asset based on its own assumptions about what market participants would consider in negotiating a sale of the asset or transfer of the liability.
If there are no apparent exit markets or if the reporting entity does not have access to any known or observable markets, activity in inaccessible known markets may be considered in developing the inputs that would be used in a hypothetical market. However, the information from the inaccessible market may need adjustment for any differences in the characteristics of the asset or liability being measured and the price observed within a market. That is, the need to adjust the inputs applies even when the inputs are observable.
Some common characteristics that may prevent an entity from accessing a particular price within a market are:
The applicable market participants may change over time; therefore, a reporting entity should reconsider potential market participants each time a fair value measurement is performed. For example, financial buyers may have been identified as market participants in a previous fair value measurement because they were active in a specific market, such as the purchase of a retail business. However, if strategic buyers become active in acquiring the assets or liabilities being measured, they may become appropriate market participants to consider in the fair value measurement as it becomes more likely that they would transact in the current market.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (that is, an exit price) regardless of whether that price is directly observable or estimated using another valuation technique.
Definition from the ACS Master Glossary
Transaction costs: The costs to sell an asset or transfer a liability in the principal (or most advantageous) market for the asset or liability that are directly attributable to the disposal of the asset or the transfer of the liability and meet both of the following criteria:
Excerpt from ASC 820-10-35-9B
The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. Transaction costs shall be accounted for in accordance with other Topics.
While transaction costs are not included in the fair value of the asset or liability under ASC 820, these amounts are included when assessing the net transaction proceeds to determine the most advantageous market, as illustrated in Example FV 4-2.
If location is a characteristic of the asset or liability being measured (e.g., in the case of a physical commodity), the fair value measurement should incorporate transportation costs. The cost of transporting a physical asset from its current location to the market should be considered in the computation of fair value that is based on the price in that market. For example, assume a company intends to sell corn by using a corn futures contract on the Chicago Board of Trade. The contract calls for physical delivery to the Chicago Switching Yard; therefore, because the location of the corn is an attribute of the contract, the company should deduct the cost of physically transporting the corn to the sale location in the calculation of fair value.
Example FV 4-2 demonstrates the impact of transportation costs and transaction costs on fair value and market identification.
EXAMPLE FV 4-2
The impact of transportation costs and transaction costs on fair value and market identification
FV Company has an asset that is sold in two different markets, Market A and Market B, with similar volumes of activities, but with different prices. FV Company enters into transactions in both markets and can access the price in those markets for the asset at the measurement date. There is no principal market for the asset. Information from both markets is presented as follows.
Market A Market B Transport costs Transaction costs Net amount received How should FV Company measure the fair value of the asset? AnalysisAs a principal market for the asset does not exist, FV Company should measure the fair value of the asset using the price in the most advantageous market. The most advantageous market is the market that maximizes the amount that would be received to sell the asset, after taking into account transaction costs and transport costs (that is, the net amount that would be received in the respective markets).
FV Company would receive greater net proceeds in Market B ($22) than in Market A ($21). As a result, the fair value of the asset should be measured using the price in that market ($25), less transport costs ($2), resulting in a fair value measurement of $23.
If either Market A or Market B had been the principal market for the asset (that is, the market with the greatest volume and level of activity for the asset), FV Company would measure the asset’s fair value using the price that would be received in that market, after taking into account transport costs.
Bid-ask price quoting is common within markets for certain securities and commodities. In these markets, dealers stand ready to buy at the bid price and sell at the ask price. If an input is based on bid and ask prices, the fair value measurement should represent the price within the bid-ask spread at which market participants would transact on the measurement date.
A reporting entity may establish a policy to use bid prices for long positions (assets) and ask prices for short positions (liabilities). Alternatively, ASC 820-10-35-36D does not preclude the use of mid-market pricing (i.e., the midpoint between the bid and the ask prices) or other pricing convention that is used by market participants within the bid-ask spread as a practical expedient for fair value. Many reporting entities use the mid-market convention because it simplifies some of the necessary calculations and allows the use of the same quotes and prices when calculating the fair value of both assets and liabilities. However, use of the mid-market convention as a practical expedient may result in a measurement that is less precise than use of the price at which the reporting entity expects to trade. When electing mid-market pricing, a reporting entity does not need to evaluate mid-market pricing against expectations of where it actually would trade within the bid-ask range.
There are times when use of bid-ask pricing is appropriate, and times when reporting entities should consider using valuation techniques. Use of bid-ask pricing and therefore, the mid-market practical expedient, is presumed appropriate for inputs within a bid-ask spread that fall within Level 1 of the fair value hierarchy (i.e., unadjusted observable quoted prices for identical assets or liabilities). Beyond that, judgment is required.
Generally, the less observable the input, the less probable it is subject to a bid-ask spread and, therefore, the less likely that use of bids, asks, or a mid-market convention would be appropriate. For example, it may not be appropriate to apply bid-ask pricing or a mid-market convention when the bid-ask spread is wide. A wide bid-ask spread could indicate the inclusion of a pricing element other than transaction costs (e.g., a liquidity reserve).
Under US GAAP, bid-ask spread pricing methods appropriate under ASR 118, Accounting for Investment Securities by Registered Investment Companies, are appropriate for determining fair value. ASR 118 states: “Some companies as a matter of general policy use the bid price, others use the mean of the bid and asked prices, and still others use a valuation within the range considered best to represent the value in the circumstances; each of these policies is acceptable if consistently applied.” The bid-ask pricing described in ASC 820 is consistent with ASR 118, which is only applicable to registered investment companies. ASR 118 was intended to establish board practices to determine the fair value of securities when market quotations were not readily available, such as when only a bid or asked price are available on the valuation date, the spread between bid and ask is substantial, or the security is thinly traded. However, in December 2020 the SEC passed Rule 2a-5, Good Faith Determinations of Fair Value, whose implementation has rescinded the ASR 118 standard effective March 8, 2021. The release of this rule by the SEC is the first to address registered investment companies’ valuation practices since the original release of ASR 118 back in 1970. The rule outlines new procedures required of registered investment companies and business development companies for estimating the fair values of their investments in good faith under the Investment Company Act of 1940. Note that SEC Rule 2a-5 is applicable only to registered investment companies and business development companies and does not impact GAAP practices under ASC 820.
Once established, a reporting entity should apply its convention consistently.Question FV 4-3
Can a reporting entity change its use of a mid-market practical expedient pricing convention?
While there may be circumstances when reporting entities may need to reconsider their use of the mid-market practical expedient, we generally believe that it should be applied consistently.
Example FV 4-3 illustrates recording a gain or loss at the inception of a contract as a result of the use of a mid-market pricing convention.
EXAMPLE FV 4-3
Recording a gain or loss at the inception of a contract as a result of the use of a mid-market pricing convention
FV Company enters into a six-month forward contract for the purchase of natural gas at an actively traded location (its principal market for that type of transaction) and the contract is accounted for at fair value under ASC 815.
The bid-ask spread is $1 (bid: $99; ask: $100). Use of the midpoint ($99.50) convention will result in a $0.50 loss at initial recognition assuming FV Company purchased at the ask price and recorded the contract using the mid-price convention.
Is it appropriate to record a loss at inception on the forward contract? AnalysisYes. Because the contract is actively traded and was entered into in FV Company’s principal market, the transaction price would be expected to be the same as the exit price. For Level 1 inputs, it is expected that differences between the mid-market pricing and the transaction prices would be due to transaction costs and should be minimal. Thus, use of the mid-market pricing results in recognition of an initial loss.
However, if the bid-ask spread were significant, FV Company would evaluate it to determine whether the midpoint is truly indicative of the fair value of the contract.
Question FV 4-4While conceptual and/or economic arguments can be made that transaction costs represent a component of the bid-ask spread, we do not believe a reporting entity needs to bifurcate the bid-ask spread to identify and account separately for transaction costs, which are typically not included in fair value measurements. In other words, the unadjusted bid, ask, or mid-prices, depending on the reporting entity’s convention, are considered fair value.