There are significant changes coming to the way public companies account for their investments in equity securities. Be ready to understand them and put the right procedures in place before it’s too late.
In early 2016, the Financial Accounting Standards Board (FASB) issued its accounting standards update (ASU) 2016-01, effective December 15, 2017. Under the update, public companies will need to book their equity investments at fair value through net income.
Under current U.S. GAAP, marketable equity securities are classified as either Held for Trading or Available for Sale (AFS). Companies record their AFS equity securities, adjusted for impairments and observable price changes, on the balance sheet under Other Comprehensive Income (OCI). For those equity securities that do not have readily determinable fair values, companies apply the cost method to determine their fair value.
The FASB pronouncement no longer allows companies to carry their investments in equity securities through OCI, nor can companies use the cost method to determine fair values. The ASU eliminates the Available for Sale classification of equities and generally requires equity investments to be measured at fair value through earnings(except those accounted for under the equity method of accounting). This may pose a dilemma for public companies and their auditors that are unprepared.
Under the new FASB rule (ASU 2016-01), companies can elect a practicability exception, in which they choose to update the value of their securities either quarterly or when there is a market-driven valuation event. Any changes in fair value will need to flow through and be recognized in net income, which may result in volatility in earnings that is unrelated to the company’s core business. Public companies should make this clear to investors and point them to a line item like “adjusted net income” that eliminates these fluctuations for a more accurate way to view earnings.
What if an equity security does not have a readily determinable fair value?
Determining fair value when one does not exist can be a complex and time-consuming process. According to the FASB update, investments that do not have readily determinable fair values need to be measured at “cost, minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.” A qualitative assessment considering impairment is required at each reporting period.
(ASU) 2016-01 states that impairment indicators to consider, include, but are not limited to, the following:
- A significant deterioration in 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 condition 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 that investment.
- Factors that raise significant concerns about the investee’s ability to continue as a going concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements or debt covenants.
The amendments to the rule also require enhanced disclosures about those investments, including:
- The carrying value of such investments;
- The total amount of adjustments resulting from impairment; and
- The total amount of adjustments for observable prices.
While the updated rule is meant to provide more transparency of investments to shareholders of public companies, it can also put a strain on company accounting functions. Many companies are turning to third-party professionals when faced with determining fair market value when one does not currently exist. Independent valuation providers are seen as a valuable asset in the complex task of obtaining the necessary information to ensure accurate valuation and appropriate disclosures in accordance with ASC820.
Houlihan Capital is a leading valuation advisory firm whose clients include some of the largest asset managers, hedge funds, family offices, and public companies in the world. We are SOC-compliant and committed to the highest levels of professional ethics and standards.
For more information on independent third-party valuation services or further information regarding the contents of this article, please contact:
Jules Pomerantz
j.pomerantz@houlihancapital.com
Direct: 312‐450‐8607
