6. Amend paragraph 820-10-00-1, by adding the following items to the table, as follows:
820-10-00-1 The following table identifies the changes made to this Subtopic.
Paragraph |
Action |
Accounting Standards Update |
Date |
Equity Security (1st def.) |
Added |
2022-03 |
06/30/2022 |
820-10-35-6B |
Amended |
2022-03 |
06/30/2022 |
820-10-35-16D |
Amended |
2022-03 |
06/30/2022 |
820-10-35-36B |
Amended |
2022-03 |
06/30/2022 |
820-10-50-6B |
Added |
2022-03 |
06/30/2022 |
820-10-55-51 |
Amended |
2022-03 |
06/30/2022 |
820-10-55-52 |
Amended |
2022-03 |
06/30/2022 |
820-10-55-52A |
Added |
2022-03 |
06/30/2022 |
820-10-55-90 |
Amended |
2022-03 |
06/30/2022 |
820-10-65-13 |
Added |
2022-03 |
06/30/2022 |
7. Amend paragraph 940-820-00-1, by adding the following item to the table, as follows:
940-820-00-1 The following table identifies the changes made to this Subtopic.
Paragraph |
Action |
Accounting Standards Update |
Date |
940-820-30-1 |
Amended |
2022-03 |
06/30/2022 |
The amendments in this Update were adopted by the affirmative vote of four members of the Financial Accounting Standards Board. Messrs. Cannon, Jones, and Kroeker dissented.
Messrs. Cannon, Jones, and Kroeker dissent from the issuance of this Update because they do not support the conclusion that precludes all entities from incorporating the effects of a contractual sale restriction in determining fair value. They recognize that Topic 820 differentiates between contractual restrictions that may be considered characteristics of an asset and those that are characteristics of an entity (or the holder of the asset). They also recognize that many (but not all) stakeholders have concluded that contractual sale restrictions on equity securities should be treated as characteristics of a holding entity and, thus, excluded when measuring fair value. However, they believe that for an equity security, the distinction of whether a legal or contractual restriction on a sale is asset specific or entity specific is not meaningful from an economic point of view because the value of an equity security typically can be fully realized only through sale. Furthermore, in that case, the distinction is not meaningful because the restriction precludes transfer or any realization of the value of the asset and, thus, a determination of whether the restriction would transfer with a sale of the equity security is only hypothetical. As discussed below, contractual sale restrictions have economic substance, and that substance should not be disregarded for accounting purposes.
Consistent with research performed in the development of the amendments in this Update, Messrs. Cannon, Jones, and Kroeker note that restrictions on sale because of underwriter lock ups (and other similar contractual sale restrictions) are primarily put in place to enhance share price performance during the restricted period and are designed to add value to the unrestricted shares. Underwriters put in place restrictions on shares to reduce supply during the initial period of trading. Because the market is aware of that lock up, the bid-offer quotes during the lockup period reflect that limitation of supply. Notwithstanding other idiosyncratic factors for a particular stock, the market price generally declines as the lock-up expiration date approaches and then stabilizes in the days after the expiration. That occurs regardless of whether there are actual sales of the securities subject to the lock-up agreement. The potential of the additional available float appears to put downward pressure on the price. Academic research identified by the FASB staff generally supports that view on how the market prices consider lock-up agreements. Thus, the contractual sale restrictions appear to have an impact on the price of equity securities not subject to the sale restriction. However, such restrictions clearly have a differential impact from an economic point of view on the owners of restricted shares that are precluded from realizing value for the shares during the restricted period.
Messrs. Cannon, Jones, and Kroeker note that using an unadjusted market price for shares subject to contractual sale restrictions, without giving any recognition to contractual sale restrictions, has the potential to reduce decision-useful information for users of financial statements. Furthermore, they believe that the conclusion in this Update will result in the establishment of a clear disconnect between economic fair value and accounting fair value when an equity security is subject to such a restriction (other than in connection with being pledged as collateral) that is not included in the unit of account for purposes of measuring the asset at fair value. Valuation specialists point out that equity securities subject to contractual lock ups are exposed to liquidity and volatility risk in a manner that differs when compared with an equity security that is not subject to a contractual sale restriction. That economic fair value impact is consistent with the impact on economic fair value of restrictions in a security that cannot be offered to the public for sale without first being registered under the Securities Act of 1933, referred to by the U.S. Securities and Exchange Commission (SEC) as a “restricted security.”
Typical underwriter contractual sale restrictions have severe restrictions on realizing value, often more limiting than the restrictions in a restricted security. For example, the contractual terms of underwriter sale restrictions often also limit the holder’s ability to reduce liquidity and volatility risk by precluding hedging of the equity security through short sales or derivative purchases. The security also cannot be borrowed against. Restricted securities may not include similar preclusions on monetization of value and can often be sold, albeit to a more limited class of potential buyers. However, Messrs. Cannon, Jones, and Kroeker note that existing GAAP clearly indicates that in the case of a restricted security, the impact of the restriction(s) is considered a characteristic of the asset and, thus, is reflected in the determination of value. That results in a lower value compared with an unrestricted security with a readily determined value. While recognizing the challenge of estimating the appropriate discount, and the ease of applying the current market price, Messrs. Cannon, Jones, and Kroeker do not believe that difficulty in measurement is a compelling reason to ignore the economics of the contractual restrictions on sale.
In the view of Messrs. Cannon, Jones, and Kroeker, systematically overstating the accounting fair value of equity securities subject to contractual sale restrictions is particularly problematic for investment companies. As described in Topic 946, one of the fundamental elements of an investment company is that it is managed on a fair value basis. Specifically, Topic 946 states:
An investment company’s activities typically demonstrate that fair value is the primary measurement attribute used to evaluate the financial performance of and to make investment decisions for substantially all of its investments. Also, an investment company typically transacts with investors on the basis of net asset value per share and incurs asset-based fees, both of which are based on the fair value of its investments. [paragraph 946-10-55-27]
Unlike with most entities, the valuation of securities directly affects the price at which the shares of the investment company are sold to or redeemed from investors, in particular, individual investors. In addition to an overstatement of investments and, thus, net asset value (NAV), that conclusion has the potential to result in excess compensation to investment managers and may result in less meaningful reporting of investment company performance. Investment companies report NAV on a periodic basis, including many that report NAV daily, and investors use that information to make portfolio allocation decisions. Under the amendment in this Update, that information will not reflect economic fair value and could skew investment decisions in the view of Messrs. Cannon, Jones, and Kroeker.
An issue similar to the one noted in the preceding paragraph was addressed by the SEC in ASR No. 113, Restricted Securities. ASR 113 directly addresses the valuation of restricted securities (specifically addressing those securities that cannot be offered to the public for sale without first being registered with the SEC). ASR 113 was issued in response to an increase in the net assets invested in restricted securities by investment companies and established the following:
- Restricted securities are similar but not identical to unrestricted securities of the same class; therefore, the market quote for an unrestricted security is not the equivalent of a market quote for a restricted security.
- Valuation of restricted securities at the market quotations for unrestricted securities would, except for most unusual circumstances, be improper. As a general principle, the current fair value of restricted securities would appear to be the amount that an owner might reasonably expect to receive for the restricted securities upon their current sale. That depends on the restricted securities’ inherent worth, without regard to the restrictive feature, adjusted for any diminution in value resulting from the restrictive feature.
- The discount factor used to reflect diminution in value attributable to the restrictive feature should not be based on an arbitrary percentage or an amortization of the initial difference in price between the transaction price for the restricted securities and the unrestricted market price. The discount factor should be an amount that changes over time because of how relevant inputs change, such as the length of time remaining on the restriction.
While the guidance in ASR 113 addresses a narrower fact pattern and does not mention contractual sale restrictions, Messrs. Cannon, Jones, and Kroeker see no reason that such contractual restrictions on sale should be viewed as having an economically different impact on determining fair value (and, thus, the NAV of an investment company) and, in turn, a similar potential detrimental impact on investors. Perhaps most notably, in ASR 113 the SEC cautioned against overvaluation of restricted securities because of the direct connection to the impact on investors:
1. The Problems of Valuation
It is critically important that an investment company properly value its portfolio securities. It is obvious, for example, that any distortion in the valuation of a restricted security held by an investment company will distort the price at which the shares of the investment company are sold or redeemed. It is also clear that investment managers who are compensated on the basis of net asset value or performance may be unduly compensated if a restricted security, purchased at a discount from the market quotation for unrestricted securities of the same class, is overvalued. In such a case, investors may also be misled by the reported performance of the investment company.
Accordingly, while Messrs. Cannon, Jones, and Kroeker do not support the conclusion in this Update, they do support an alternative approach that would incorporate the effects of contractual sale restrictions (other than restrictions imposed on equity securities as a result of an entity pledging such securities as collateral because in that case, such restrictions are generally reflected in the pricing of the related debt) in determining fair value. They believe that accounting for the economic impacts resulting from the sale restrictions would provide information that financial statement users would consider relevant and decision useful. They note that requiring entities to ignore contractual obligations by prohibiting recognition of the restrictions, either as part of the value of the equity security or as a separate obligation, results in a requirement for entities to value such security at initial measurement at an amount that exceeds the economic value (the price paid) in an observable exchange transaction—resulting in a day one gain equal to the value of the restriction. Furthermore, in the case of investment companies, Messrs. Cannon, Jones, and Kroeker believe that the obligations imposed by the restrictions directly affect the economics of transactions with investors.
Specifically, they support an approach that would amend Topic 820 (to address the types of restrictions within the scope of the amendments in this Update) to require that such restrictions be incorporated in the determination of fair value. They point out that the guidance that differentiates between restrictions that are asset specific versus entity specific contained in Topic 820 is not immutable and would, in their view, be improved by an amendment to Topic 820.
Alternatively, they also would support an approach that amends Topic 321, Investments—Equity Securities, to require (1) recognition of contractual obligations imposed by contractual sale restrictions as a separate unit of account from an individual equity security and (2) accounting for both the equity security and a contractual sale restriction agreement (if one exists). Under that approach, contractual sale restrictions would be treated as a separate obligation, rather than as a characteristic of the equity security, and thus the fair value measurement for the equity security would, as the majority of the Board supports, not be affected by such restrictions. That approach would reflect the view that a contractual sale restriction imposes obligations that have economic substance, and those obligations should be recognized and measured, albeit under this view, as a unit of account separate from the value of the equity security. The contractual sale restriction could be presented as a contra-asset or as a liability, reflecting the obligation to refrain from selling the related asset during the period of the restriction. The Board also rejected that view and provided guidance prohibiting accounting for contractual sale restrictions as a separate obligation. Messrs. Cannon, Jones, and Kroeker note that the guidance in Topic 820 does not address what assets and liabilities should be recognized (including the identification of performance obligations) or how recognized items should be measured. Rather, the guidance in Topic 820 provides a definition and sets out a framework for measuring fair value.
Either approach would result in the de facto conclusion that a contractual sale restriction must be considered along with an equity security for purposes of determining the appropriate accounting, and Messrs. Cannon, Jones, and Kroeker would support either approach for all entities. However, because the Board rejected an amendment to the guidance under Topic 820 and also rejected providing separate unit of accounting guidance as an amendment to Topic 321, a third alternative that would address situations in which this issue is likely most prevalent would be to provide industry-specific guidance for entities that report their activities and/or all investments on a fair value basis (for example, investment companies, broker dealers, and pension plans—“fair value entities”). Thus, alternatively, Messrs. Cannon, Jones, and Kroeker would as a third alternative support an approach that treats such contractual sale restrictions as a separate unit of account from the equity security, but those separate contracts nonetheless would have an economic value (or would reduce the economic value of other assets). Under that approach, they would support an amendment to existing industry-specific guidance for “fair value entities” to specifically require that such contractual sale restrictions be recognized and measured at fair value, consistent with the reporting of all investments at fair value.
Members of the Financial Accounting Standards Board:
Richard R. Jones, Chair
James L. Kroeker, Vice Chairman
Christine A. Botosan
Gary R. Buesser
Frederick L. Cannon
Susan M. Cosper
Marsha L. Hunt