Investment companies: Note new rules for measuring restricted equity securities’ value

Changes are coming to how securities that have a contractual restriction on sales are accounted for. No longer can entities take a discount on the fair value of investments that have lock ups or certain other contractual restrictions on transfer.

The Financial Accounting Standards Board (FASB) recently issued Accounting Standards Update (ASU) No. 2022-03, Fair Value Measurement of Equity Securities Subject to Contractual Sale Restrictions. This alert discusses the impact of ASU No. 2022-03 on investment companies pursuant to Topic 946.

The amendments required by ASU No. 2022-03 “clarify that a contractual restriction on the sale of an equity security is not considered part of the unit of account of the equity security and, therefore, is not considered in measuring fair value,” the ASU summarizes. “The amendments also clarify that an entity cannot, as a separate unit of account, recognize and measure a contractual sale restriction.” The ASU also lists the following disclosures as required for equity securities subject to contractual sale restrictions:

1. “The fair value of equity securities subject to contractual sale restrictions reflected in the balance sheet

2. “The nature and remaining duration of the restriction(s)

3. “The circumstances that could cause a lapse in the restriction(s).”

Pursuant to new additions to paragraph 820-10-35-36B, “a discount applied to the price of an equity security because of a contractual sale restriction is inconsistent with the unit of account being the equity security. A contractual sale restriction is a characteristic of the reporting entity holding the equity security rather than a characteristic of the asset and, therefore, is not considered in measuring the fair value of an equity security.”

Takeaway:

This updated guidance hinges on which restrictions are characteristics of the asset, and which  are restrictions on the entity that holds the asset. For example, a lock up on shares of a publicly traded company that recently completed an IPO would be considered a contractual restriction on the holder of the security, and no discount for the lock up would be allowed. This is a change from the way many entities currently account for this type of restriction. In current practice, many investment companies calculate a discount on the publicly traded price of the security when determining fair value. This discount would no longer be allowed under the new guidance.

In addition, the new disclosures noted above are required.

This concept is further explained in the Implementation Guidance and Illustrations of ASU 2022-03, which indicate that when shares issued through a private placement are legally restricted from being sold on a national security exchange until they have been registered or the conditions necessary for the exemption from registration have been satisfied, “a market participant would consider the inability to resell the security on a national securities exchange or an over-the-counter market when pricing the equity security; therefore, the reporting entity that holds the … shares acquired through a private placement transaction would consider that restriction a characteristic of the asset.”

Takeaway:

Unregistered shares of an entity (for example, shares registered under Rule 144A) would be considered a characteristic of the equity security and part of the unit of account. Therefore, this characteristic would be considered in measuring the fair value of the security.

An entity that qualifies as an investment company under Topic 946 should apply these amendments to an investment in an equity security subject to a contractual sale restriction that is executed or modified on or after the date of adoption, the ASU states. If the restriction was executed before the date of adoption, the company should continue to account for the equity security “until the contractual restrictions expire or are modified using the accounting policy applied before the adoption of the amendments (that is, if an investment company was incorporating the effects of the restriction in the measurement of fair value, it would continue to do so).”