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Introduction

Before the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2022-03, the guidance (FASB ASC 820-10-55-51 through 55-52A) needed to be clearer on how to treat sale restrictions when determining the fair value of a security held as an asset. Generally, entities were required to consider all factors that affect the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. In principle, this meant that if a sale restriction was a part of the security itself, it should be considered in determining the fair value of the security. However, if the sale restriction was part of a separate contractual arrangement, it should not be considered. The lack of clarity often led to confusion and inconsistencies in how different entities applied the guidance, especially regarding the distinction between security-specific and holder-specific restrictions.

ASU 2022-03: Updated Guidance

In June 2022, the FASB issued ASU 2022-03, Fair Value Measurement of Equity Securities Subject to Contractual Sale Restrictions. This update provides clear guidance on determining  the fair value of securities issued by a public company and subject to sale restrictions. It clarifies that security-specific restrictions should be reflected in fair value, while holder-specific restrictions should not. Additionally, the value of a contractual restriction that is not considered part of the security should not be carried as a separate liability or valuation account, instead, it should not be considered in the accounting.

When Fair Value Should Reflect an Adjustment

1. Sale Restrictions Inherent to the Securities:

• Reflect in Fair Value: If the sale restriction is inherent to the securities themselves and not to the holder, the fair value measurement should reflect an adjustment for the restriction. This is because the restriction is considered a characteristic of the security itself.
• Example (ASC 820-10-55-52): Unregistered PIPE securities cannot trade on the same market as registered shares of the same entity. As such, the restriction should be considered until the shares are registered on an exchange.

2. Sale Restrictions Specific to the Holder:

• Do Not Reflect in Fair Value: If the sale restriction is contractual and specific to the investor (holder), the fair value measurement should not reflect an adjustment for the restriction. This is because the restriction is a characteristic of the security holder and not the security.
• Example (ASC 820-10-55-52A): Post-IPO lock-up provisions or merger agreement terms that stem from separate contractual arrangements are considered characteristics of the holder, not the security.

Unique and Counterintuitive Situations

This guidance can lead to unique and often counterintuitive situations. For example,if Company XYZ issues unregistered PIPE shares, those shares would be sale restricted because there is no active market for unregistered shares. Despite XYZ being a publicly traded entity, the valuation of the unregistered shares held as assets would reflect any appropriate adjustment for this restriction until the shares become registered.

At the same time, and as part of the same PIPE transaction, the PIPE sponsor may hold registered shares in XYZ that they have contractually agreed to not sell over a 180-day window. Since a public market equivalent exists for these shares and the restriction is tied to a separate contractual agreement, no adjustment is applied to the restricted but registered shares. This can result in a purchaser or shares subject to a contractual lock-up arrangement recognizing an immediate gain if they purchase the shares for less than the quoted market price due to the contractual lock-up.

Effective Date and Transition

1. Effective Dates:

• Public Companies: ASU 2022-03 guidance already applies for fiscal years beginning after December 15, 2023, and interim periods within those fiscal years.
• All Other Entities: The guidance goes into effect for fiscal years beginning after December 15, 2024, and interim periods within those fiscal years. Early adoption is permitted for both interim and annual financial statements that have not yet been issued or made available for issuance.

2. Application of ASU 2022-03:

Securities Acquired After Applying ASU 2022-03:

• Immediate Application: For securities acquired after the adoption of ASU 2022-03, the new guidance should be applied immediately to determine the fair value of these securities.
• Consistent Application: Entities should consistently apply the new guidance to all securities acquired after the effective date.

Securities Held Before Applying the New Guidance:

• No Restatement: Entities are not required to restate prior periods, but they should disclose the impact of the change on the fair value of the securities in the period of adoption.
• Prospective Application: For equity securities with a contract containing a sale restriction that was executed before the adoption date, entities other than investment companies should apply the guidance from the adoption date. Any initial adjustment to remove the effect of a contractual restriction on the measurement of fair value should be reflected in current period earnings.
• Investment Companies: For equity securities with a contract containing a sale restriction that was executed before the adoption date, investment companies should continue to apply their legacy accounting policy for measuring such securities until the contractual restriction expires.If the accounting policy includes applying a discount to equity securities that are subject to contractual sale restrictions, investment companies must disclose the following information in each period until the contractual restrictions expire:

1. 1. The fair value of such equity securities that were executed before the adoption date and to which the entity continues to apply a discount.
   2. The nature and remaining duration of the contractual sale restrictions.
   3. The circumstances that could cause the restrictions to lapse.

Summary

ASU 2022-03 clarifies that fair value measurements for securities subject to sale restrictions should reflect adjustments for security-specific restrictions but not for holder-specific restrictions. The guidance is effective for private companies for fiscal years beginning after December 15, 2024, and should be applied prospectively to existing securities and immediately to new acquisitions.

VRC’s Portfolio Valuation Practice Group and our valuation team have extensive experience in valuing complex securities, including credit/debt instruments, derivatives, equity, and structured products. For more expert insights and assistance with any questions, please contact the article authors Frank Mainville and John Swiatkowski, or any VRC professional.