Breaking it down
Determining fair value
On June 30, 2022, the FASB issued ASU 2022-03, “Fair Value Measurement (Topic 820): Fair Value Measurement of Equity Securities Subject to Contractual Sale Restrictions,” to clarify that contractual sale restrictions should not be considered in the measurement of the fair value of an equity security.
The basis for this conclusion is that a contractual restriction prohibiting the sale of an equity security is not part of the unit of account of the equity security. Under Topic 820, the unit of account when measuring an equity security is the individual equity security. A contractual restriction – for example, an underwriter-imposed lock-up period – is a characteristic of the holder of the equity security rather than a characteristic of the equity security itself and therefore should not be considered in measuring the equity security’s fair value. In addition, an entity should not recognize and measure the contractual sale restriction as a separate unit of account.
Contractual versus regulatory sale restrictions
The ASU also clarifies the difference between a contractual sale restriction and a regulatory sale restriction. A contractual sale restriction is imposed on a specific holder or holders of the equity security (that is, it is an entity-specific restriction) and therefore should not be considered in measuring the security's fair value. Conversely, a regulatory sale restriction is a characteristic of the equity security itself (that is, it is an asset-specific restriction) and thus should be considered when measuring the security's fair value.
Crowe observation: To properly apply Topic 820 fair value measurement guidance, one must distinguish between asset-specific restrictions (restrictions that are characteristics of the asset) and entity-specific restrictions (those that are characteristics of the holder of the asset).
A restricted security that cannot be sold on a national securities exchange or an over-the-counter market is an example of an equity security with an asset-specific restriction. The restriction characteristic is included within the equity security's unit of account; thus, the restriction should be considered in measuring the security's fair value since the inability to sell the restricted security does not differ based on which entity holds the security.
On the other hand, an equity security that cannot be sold due to a lock-up period agreement is an example of an equity security with an entity-specific restriction. In this situation, the restriction should not be considered in measuring the security's fair value.
Disclosure
ASU 2022-03 introduces new disclosures for entities with investments in equity securities subject to contractual sale restrictions. Specifically, reporting entities with such investments must disclose:
- The nature and remaining duration of the restriction
- The circumstances that could cause a lapse in the restriction
- The fair value of equity securities subject to contractual sale restrictions
Transition and effective date
ASU 2022-03 is effective for public business entities for fiscal years beginning after Dec, 15, 2023, and interim periods within those fiscal years. For all other entities, it is effective for fiscal years beginning after Dec, 15, 2024. Early adoption is permitted.
Entities other than investment companies as defined by Topic 946 must adopt the changes prospectively for all equity securities and recognize any adjustments that result from application of the amendment on the date of adoption in current period earnings.
The following example demonstrates the transition provisions of the ASU:
Example 1
Company A (not an investment company) holds an equity security subject to a lock-up period agreement. Prior to adopting ASU 2022-03, Company A has historically incorporated the effects of the lock-up period agreement into the fair value of its equity security. As of the effective date of ASU 2022-03, the fair value is as follows:
Fair value of equity security $1,000
Discount for contractual sale restriction (250)
Carrying value of equity security $750
Upon the adoption of ASU 2022-03, Company A must determine the fair value of the equity security without considering the effect of the contractual sale restriction. As a result, on the adoption date, Company A records the following entry:
Dr. Equity security $250
Cr. Earnings $250
Investment companies are required to adopt ASU 2022-03 on a prospective basis. Consequently, for equity securities purchased before the effective date of the ASU, investment companies must continue to apply their existing accounting policy until the contractual sale restriction expires or is modified.
Example 2
Assume the same fact pattern as example 1, except that Company A is now considered an investment company under Topic 946.
Because Company A is an investment company under Topic 946, it does not record a transition adjustment upon adoption of ASU 2022-03. That is, Company A will continue to apply its existing accounting policy until the contractual sale restriction expires or is modified.
Crowe observation: The reason for the different transition guidance between investment companies and noninvestment companies stems from the impact the ASU’s provisions would otherwise have on an investment company’s calculation of net asset value (NAV). The calculation of NAV can affect, among other things, fees paid to asset managers and the amount paid or received by investors upon entering or exiting an investment fund. The FASB expressed that it wanted to “avoid introducing non-market-based volatility that would disproportionately affect transaction values on the date of adoption if investment companies applied the amendments to all equity securities on the date of adoption.” While the FASB also considered having investment companies use a retrospective or modified retrospective transition approach, the FASB determined those transition methods would complicate the recalculation of NAV or the determination of management fees.
