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?
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.
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 4-4
How should a reporting entity account for transaction costs in a bid-ask spread?
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.