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.

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.

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.

How should FV Company measure the fair value of the asset?

As 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.

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.

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?

Yes. 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.

While 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.

The ASC Master Glossary defines the unit of account as follows:

The unit of account represents what is being valued, based upon other relevant US GAAP for the asset or liability being measured, while the valuation premise determines whether the maximum value of the nonfinancial asset is on a standalone basis or in combination with other assets.

The unit of account determines what is being measured for purposes of recognition in the financial statements by reference to the level at which the asset or liability is aggregated or disaggregated when applying other applicable US GAAP. A reporting entity should go through the fair value framework to establish the principal, most advantageous, or hypothetical market based on the unit of account being valued.

Whether the valuation premise is in combination with other assets and liabilities or standalone is determined from the perspective of market participants. That is, a unit of account may be grouped with other units of account to achieve the highest and best use. In considering potential markets, a reporting entity may need to consider different groupings of nonfinancial assets to determine which grouping provides the highest value from the perspective of a market participant. However, a unit of account may not be included in more than one group in the final determination of fair value. ASC 820 requires the unit of account to be measured assuming that the market participant has, or has access to, the other assets in the group.

The valuation premise may also be on a disaggregated basis. Disaggregation is the process of determining the fair value of a unit of account based on the individual sale of the components of the group. This is applicable if a unit of account can be sold in components that would maximize the overall value of the unit of account from the perspective of market participants. As with asset groupings, the reporting unit must have access to the market into which components of a unit of account would be sold.

The guidance indicates that the unit of account for nonfinancial assets may differ from the unit of measurement. If the highest and best use of an asset is that it should be combined with other assets, the fair value is determined for the asset in combination with those other assets. This may require the value of the group to be allocated to the components in a systematic and rational manner.

When applying the concepts of both aggregation and disaggregation, the valuation should be allocated to the individual components such that the ultimate valuation relates solely to the unit of account.

A business is an example of assets and liabilities used in combination. Separate assets often work together or complement each other. Liabilities associated with the complementary assets can include liabilities that fund working capital. However, liabilities used to fund assets other than those within the group of assets cannot be included in the valuation.

Unlike a financial liability, which requires only a cash transfer for settlement, satisfying a performance obligation may require the use of other operating assets.

A performance obligation may be contractual or noncontractual, which affects the risk that the obligation is satisfied. These differences affect the variability and magnitude of risks and uncertainties that can influence the settlement or satisfaction of the obligation and its fair value. Therefore, it is important to be aware of these differences when measuring the fair value of performance obligations. This is particularly critical when considering future cash flow estimates and applicable discount rates when using the income method to measure fair value.

ASC 820 includes five examples to illustrate the measurement of liabilities. Refer to ASC 820-10-55-57 (Case A) through ASC 820-10-55-85 (Case E) for further details.

The value of a liability measured at fair value is the price that would be paid to transfer the liability to a third party. The amount that would be required to pay a third party (of equivalent credit or nonperformance risk) to assume a liability may differ from the amount that a reporting entity would be required to pay its counterparty to extinguish the liability.

For example, a financial institution transferee may be willing to assume non-demand-deposit liabilities for less than the principal amount due to the depositors because of the relatively low funding cost of such liabilities. However, in other instances, an additional risk premium above the expected payout may be required because of uncertainty about the ultimate amount of the liability (e.g., asbestos liabilities or performance guaranties). The risk premium paid to a third party may differ from the settlement amount the direct counterparty would be willing to accept to extinguish the liability. In addition, the party assuming a liability may have to incur certain costs to manage the liability or may require a profit margin.

In application, there may be significant differences between settlement value and transfer value. Among the differences is the impact of credit risk, which is often not considered in the settlement of a liability, as demonstrated in Example FV 4-4.

EXAMPLE FV 4-4
Transfer value compared to settlement value

A debt obligation is held by a bank with a face value of $100,000 and a market value of $95,000. The interest rate is at market; however, there is a $5,000 discount due to market concerns about the risk of nonperformance.

What is the presumed settlement value and transfer value of the note?

Absent exceptional circumstances, the counterparty (Counterparty A) would be required to pay the full face value of the note to settle the obligation, as the bank may not be willing to discount the note by the credit risk adjustment. Therefore, the settlement value would be equal to the face amount of the note.

Under ASC 820, reporting entities should adopt an approach to valuing liabilities that incorporates the transfer concept. There is no exemption from or practical expedient for this requirement.