ASC 321 The New World of Accounting for Equity Securities

ASC 321 The New World of Accounting for Equity Securities

Now that many companies have a year of ASC 321 behind them, how are the “similar investments” valuations and other provisions going?

October 10, 2019

Alphabet (NASDAQ:GOOGL) reported a $4 billion gain from it in 2018. Salesforce (NYSE:CRM) attributed more than half of its strong 2019 first-quarter earnings per share to it. But Berkshire Hathaway Chairman Warren Buffet hates it. “It” is the recent revision in accounting standards for equity investments. Buffet dedicated most of the first page of his 2019 shareholder letter to the effects of the new accounting requirements, which he says are not “sensible” and will cause “wild and capricious swings” in Berkshire’s bottom line.

Accounting Standards Update 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (ASU 2016-01), included big changes in the accounting requirements for equity investments. As codified in Accounting Standards Codification Topic 321, Investments – Equity Securities (ASC 321), the new rules are already in effect for most companies, which has caused them to pay closer attention to the value of non-consolidated equity interests not accounted for under the Equity Method. The change is fairly straightforward for investments in publicly traded equity but can be more involved for non-public investments, raising questions regarding the definition of “similar investments” and their use in marking to market a company’s equity investments.

Brief Summary of ASC 321

The key changes to equity investment accounting included in the new rules are elimination of the “trading” and “available for sale” balance sheet classifications and the need to wrestle with the concept of “other than temporary impairment.” For investments with a readily determinable fair value (RDFV), the new rules generally require the observable changes in fair value to be recognized in earnings. Simple enough. But what about all the private holdings (non-publicly traded equity securities) for which there is no RDFV? Assuming these shares do not qualify for the net asset value (NAV) expedient in ASC 820, generally accepted accounting principles (GAAP) now require fair value treatment for them, as well. However, as the fair value of these non-public shares may be somewhat difficult for companies to address, the Financial Accounting Standards Board (FASB) included a useful measurement alternative. Under this alternative, companies may elect to report the qualifying investment at cost, less impairment if any, plus or minus observable price changes in orderly transactions for an identical or similar investment of the same issuer. The key concepts of RDFV, NAV, and similar investments are all worthy of close attention for anyone wrestling with the new rules, as illustrated in Figure 1.

Equity Investments and ASC 321

Readily Determinable Fair Value

A common example of an investment with an RDFV is equity shares traded on one of the major exchanges. However, as explained in the following, the formal definition of RDFV as updated by ASU 2015-10 provides more detail.

An equity security has an RDFV if it meets any of the following conditions:

  1. The fair value of an equity security is readily determinable if sales prices or bid-and-asked quotations are currently available on a securities exchange registered with the U.S. Securities and Exchange Commission (SEC) or in the over-the-counter market, provided that those prices or quotations for the over-the-counter market are publicly reported by the National Association of Securities Dealers Automated Quotations systems or by OTC Markets Group. Restricted stock meets that definition if the restriction terminates within one year.
  2. The fair value of an equity security traded only in a foreign market is readily determinable if that foreign market is of a breadth and scope comparable to one of the U.S. markets referred to above.
  3. The fair value of an equity security that is an investment in a mutual fund or in a structure similar to a mutual fund (that is, a limited partnership or a venture capital entity) is readily determinable if the fair value per share (unit) is determined and published and is the basis for current transactions.

The NAV Practical Expedient

For certain types of investments, a company is permitted to use the NAV, as reported in the books of the investee, to measure the fair value of the investment. This expedient is available only if there is no RDFV for the investment and either:

  • The entity has the characteristics of an investment company, as listed in ASC 946

-or-

  • The entity is in an industry for which it is common practice to issue financial statements using guidance consistent with ASC 946

Note that the NAV expedient is optional, so companies may always choose to use the fair value of these investments if they prefer not to use the NAV.

So, What Is Similar?

First, note that the ASC 321 reference to price changes for similar investments does not contemplate investments in similar companies, as would be considered in a traditional Market Approach valuation analysis based on observed market multiples paid for comparable companies. The new rule specifies that the measurement alternative includes only price changes for an identical or similar investment of the same issuer. So, in the simplest case, if a company observes pricing for a transaction in the same shares as an equity investment it owns, the transaction pricing would be used directly in any measurement taken by the company under the measurement alternative.

The process becomes more complicated when a company observes transaction pricing for non-identical shares of the same issuer as its own equity investment shares. The non-identical shares could be of the same equity class (common, various classes of preferred, various membership interests, etc.) but with characteristic differences such as trading restrictions or voting rights differences, or they could be a different equity class. In the latter case, the transaction pricing would be used for measurement purposes only if the shares are considered similar. The question is what ASC 321 means by “similar.” Section 321-10-55-09 states:

Identifying Similar Investment of Same Issuer – To identify whether a security issued by the same issuer is similar to the equity security held by the entity, the entity should consider the different rights and obligations of the securities. Differences in rights and obligations could include characteristics such as voting rights, distributions rights and preferences, and conversion features. The entity should adjust the observable price of a similar security for the different rights and obligations to determine the amount that should be recorded as an upward or downward adjustment in the carrying value of the security measured in accordance with paragraph 321-10-35-2 to reflect the current fair value of the security.

Given the limited commentary in the guidance regarding exactly what constitutes similar and dissimilar equity characteristics, companies may have a difficult time determining whether a specific observable transaction provides evidence of pricing for a similar interest. Initial experience from 2018, while limited, indicates that investments in completely different classes of equity, such as common versus preferred shares, may be considered dissimilar in many cases. However, we have also seen dramatically different classes of preferred shares (e.g., preferred B versus preferred C) considered to be similar, even where significantly different rights and preferences caused a large value differential between the two issues. As potential for variance of practice exists in this somewhat subjective area, it should be a topic of early discussion with advisors whenever a possibly similar transaction is observed.

Observable Transactions

What are companies required to do to keep up with observable price changes for shares of an entity they have invested in? ASC 321-55-8 states:

Identifying Observable Price Changes – To identify observable price changes, an entity should consider relevant transactions that occurred on or before the balance sheet date that are known or can reasonably be known. To identify price changes that can reasonably be known, the entity should make a reasonable effort (that is without expending undue cost and effort) to identify any observable transactions that it may not be readily aware of. The entity need not conduct an exhaustive search for all observable price changes.

New share issuances from the investee often provide observable price change information, while private transactions in existing outstanding shares often do not.

Using Similar-Share Pricing

Example: Company ABC Observes Transaction

Company ABC owns shares of Startup Co. Preferred B equity at $100 book value (cost). Startup’s shares are not publicly traded, but ABC management observes that Startup has completed a financing round for new Preferred C shares at $110 per share. The terms of the B and C rounds differ in preference order (B has preference over C) and preference amount per share, and while both are convertible, the conversion ratio of the B shares is twice that of the C shares. ABC management believes the transaction in the C shares was arm’s length and orderly.

This example, which reflects the general nature of a recent client project, presents ABC management with several challenges. First, they must decide whether the new Preferred C funding round provides observable pricing for shares similar, in the ASC 321 meaning of the word, to the Preferred B investment carried on their balance sheet. Then, if the shares are deemed to be similar, how should management measure the implied fair value of the B shares to provide the required adjustment to the carrying value?

Management should consider a number of factors in determining the similarity of the shares for ASC 321 purposes. These considerations should include, among other possible items:

  • The significance of the difference in key terms of the B and C shares (preference rights and conversion prices)
  • The relative importance of the B share liquidation preference over the C shares (likelihood of the preference coming into play in a liquidation scenario, given the current capital structure and estimated value of Startup)
  • The size of the resulting adjustment from the C share observed price to the implied fair value of the B shares (a large required adjustment could be an indicator of relatively less similarity)
  • The analytical methods/assumptions necessary to support an appropriate determination of the B share value implied by the new transaction (Can the analysis be reliably performed using generally accepted methods? Are the required inputs easily verifiable, highly subjective, or unknowable?)

There is no clear answer regarding the similarity determination for this specific fact pattern. The characteristics should be considered in aggregate, as no single factor is likely to provide a definitive answer. For example, the liquidation preference order appears to be a significant difference, and the relative likelihood of the preference coming into play may be difficult to determine. However, if the indicated value of the company is high in comparison to the total preference, then the value differential may be clearly insignificant, as liquidation may be a remote possibility. Also, the interplay between the size of the adjustment from the observed price to the implied value of the investment share and the relative verifiability of the necessary supporting analytical inputs could be critical. A large required adjustment to the observed transaction price, which would tend to imply dissimilarity, may be offset by the easily verifiable assumptions needed to support the adjustment amount.

The Backsolve Method

Various methods are useful in measuring the implied fair value for the owned investment based on a similar-share transaction price. Some may be as simple as a small subjective adjustment for a lack of voting rights. In other cases, a much more detailed analysis may be needed. One tool commonly used to estimate an implied value for one class of equity from another within an entity’s capital structure is the Backsolve Method. This method works well to support the value differential in somewhat more complex cases, such as the preferred share rights and preference differences in the example above.

The Backsolve Method, a form of the Market Approach to valuation, derives the implied equity value for one type of equity security (e.g., Preferred B shares) from a contemporaneous transaction involving another type of equity security (e.g., Preferred C shares) through a modeling process that incorporates the specific terms of each class of interest in an entity’s capital structure. Two frameworks that are used to accomplish this task are the Probability Weighted Expected Return Method (PWERM) and the Option Pricing Method (OPM).

In a PWERM framework, the Backsolve Method involves selecting the future outcomes available to the enterprise and then calibrating the future exit values, the probabilities for each scenario, and the discount rates for the various equity securities such that the indicated value for the shares of the most recent financing equals the pricing from that financing.

In an OPM framework, the Backsolve Method involves making assumptions regarding the time to liquidity, volatility, and risk-free rates, and then, as in the PWERM analysis, solving for the equity value such that the indicated value for the shares of the most recent financing equals the pricing from that financing.

The resulting value from the analysis above may then require adjustment for any stated or unstated rights and privileges of the transacted investment relative to the investment being valued, including relative control and marketability attributes. In many cases, the application of these methods has the advantage of requiring a limited number of assumptions outside of those driven directly by the stated terms of the related shareholder documents. Additionally, many of the key assumptions that are typically required for this type of analysis, such as equity or asset volatility and risk-free rate, are often supportable by references to market data.

Creators and Users

Warren Buffet’s recent commentary on the ASC 321 matter gave his shareholders a simple suggestion regarding the unwelcome new rule: “Our Advice? Focus on operating earnings, paying little attention to gains or losses of any variety.” That is no doubt a comforting thought for some of the users of this famous man’s financial statements. Unfortunately, for the creators of financial statements, paying little attention to the volatility-causing new rule is not an option. In addition to operating earnings, creators will also have to focus on replacing old terms, such as “other than temporary impairment” and “trading vs. available for sale” investments, with new ones, such as “RDFV” and “similar shares.”