Measuring Financial Instruments at Fair Value: The Potential Pitfalls of Electing the Cost Practical Expedient

Read Valuation Insights, Second Quarter 2018 

 

Background

In January 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2016-01, Financial Instruments-Overall: Recognition and Measurement of Financial Assets and Financial Liabilities (the “ASU”). The ASU modifies certain aspects of recognition, measurement, presentation and disclosure of financial instruments and is now effective for public business entities and will be applicable for all other entities in 2019.

Key Changes to the Measurement of Equity Investments

Equity Investments Must be Measured at Fair Value

The ASU requires equity investments (other than those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value, with changes in fair value reflected in net income. The ASU removes the trading or available-for-sale classifications for equity investments and eliminates reporting changes in fair value in other comprehensive income.

Investments with readily determinable fair values are now required to be measured at fair value, in accordance with FASB ASC Topic 820, Fair Value Measurement (“ASC 820”), with changes in fair value reported in net income. 

Pursuant to the ASU, an entity (except for Investment Companies) may elect to measure equity investments without readily determinable fair values, and that do not qualify for the Net Asset Value (NAV) practical expedient in ASC 820, at cost.

If the cost election is made, decreases in value resulting from impairment, or changes in value (upward or downward) indicated by observable price changes in orderly transactions must be reflected currently, with the change in value reported in net income. The election can be made on an instrument-by-instrument basis and must be applied consistently, until such time that the investment’s fair value becomes readily determinable.

If the cost election is not made, investments without readily determinable fair values must be measured at fair value, with subsequent changes in fair value reported in net income.

The impairment assessment has been simplified to requiring the assessment of qualitative indicators of impairment. If the qualitative assessment indicates an impairment, then the investment must be measured at fair value. Qualitative indicators of impairment include, but are not limited to:

  • A significant deterioration of the earnings performance, credit rating, asset quality, or business prospects of the investee;
  • A significant adverse change in the regulatory, economic, or technological environment of the investee;
  • A significant adverse change in the general market conditions of either the geographical area or the industry in which the investee operates;
  • A bona fide offer to purchase, an offer by the investee to sell, or a completed auction process for the same or similar investment for an amount less than the carrying amount of the investment; or 
  • Factors that raise significant concerns about the investee’s ability to continue as a going concern.

Observable Prices for Identical or Similar Investments

An entity that has elected the measurement alternative at cost for equity investments without readily determinable fair values must make upwards or downwards adjustments to their carrying values if there are observable price changes resulting from orderly transactions for identical or similar investments of the same issuer. The entity must make a reasonable effort (without incurring undue cost and effort) to identify observable transactions that occurred on or before the balance sheet date that are known or can reasonably be known.

 Valuation Insights Second Quarter 2018 - Tech Notes

Internal Control Process Implications

Entities must now enhance their fair value estimation process to ensure that qualifying equity securities are appropriately measured at fair value. In addition, for equity securities without a readily determinable fair value whereby the entity has made the measurement election at cost, the internal control process may need to be enhanced to identify and make informed judgments about identifying similar instruments, reasonably known or knowable observable orderly transactions, and qualitative impairment indicators.

Unintended Consequences of Electing Cost for Equity Securities Without Readily Determinable Fair Values

Since the cost measurement election can be made on a security-by-security basis, an entity may need to consider the potential volatility introduced to net earnings by electing cost as a measurement alternative.

If cost is elected, greater volatility can result from the less frequent impairment write-downs, or pricing changes based on observable transactions for similar securities. If cost is not elected, the impact on earnings from changes in fair value measured on a quarterly basis may be significantly less. Depending upon the significance of the equity investment less extreme volatility in reported earnings may be more useful to financial statement users, and may more accurately reflect the financial position of the company, compared to the cost election.

Conclusion

The new requirements for measuring non-consolidated/non-equity method investments at fair value should enhance comparability and provide users of financial statements with more useful information. The cost election, while seemingly advantageous, will require additional steps for assessing impairment, identifying orderly transactions, and additional disclosures. In all cases, there will likely be a need to enhance an entity’s processes and procedures to measure fair value for investments without a readily determinable fair value, whether using internal or external resources. Further, ASU 2018-03 was recently released which clarifies certain points noted above and may require additional analysis and consideration.

For more information contact David Larsen, Managing Director, at +1 415 693 5330 or Matthew Stariha, Vice President, at +1 415 693 5377.

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