10.2 Definition of Fair Value

10.2.1 General

ASC 820-10

Definition of Fair Value

35-2 This Topic defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. . . .

35-2A The remainder of this guidance is organized as follows:

The asset or liability
The transaction
Market participants
The price
Application to nonfinancial assets
Application to liabilities and instruments classified in a reporting entity’s shareholders’ equity
Application to financial assets, financial liabilities, and nonfinancial items accounted for as derivatives under Topic 815 with offsetting positions in market risks or counterparty credit risk.

The Fair Value Measurement Approach

55-1 The objective of a fair value measurement is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. A fair value measurement requires a reporting entity to determine all of the following:

The particular asset or liability that is the subject of the measurement (consistent with its unit of account)
For a nonfinancial asset, the valuation premise that is appropriate for the measurement (consistent with its highest and best use)
The principal (or most advantageous) market for the asset or liability
The valuation technique(s) appropriate for the measurement, considering the availability of data with which to develop inputs that represent the assumptions that market participants would use when pricing the asset or liability and the level of the fair value hierarchy within which the inputs are categorized.

As discussed in Section 1.2, the definition of fair value is based on an exit price notion. An asset, liability, or equity instrument is measured at fair value on the basis of market-participant assumptions; such measurement is not entity-specific. Entities must consider all the characteristics of the asset, liability, or equity instrument that a market participant would consider in determining an exit price in the principal or most advantageous market. The measurement of the asset, liability, or equity instrument at fair value for recognition purposes is at the level of the unit of account, which may differ from the unit of valuation. The concepts underlying the definition of fair value are discussed in the subsections below.

10.2.2 The Asset or Liability

10.2.2.1 General

ASC 820-10

The Asset or Liability

35-2B A fair value measurement is for a particular asset or liability. Therefore, when measuring fair value a reporting entity shall take into account the characteristics of the asset or liability if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. Such characteristics include, for example, the following:

The condition and location of the asset
Restrictions, if any, on the sale or use of the asset.

35-2C The effect on the measurement arising from a particular characteristic will differ depending on how that characteristic would be taken into account by market participants. Paragraph 820-10-55-51 illustrates a restriction’s effect on fair value measurement.

35-2D The asset or liability measured at fair value might be either of the following:

A standalone asset or liability (for example, a financial instrument or a nonfinancial asset)
A group of assets, a group of liabilities, or a group of assets and liabilities (for example, a reporting unit or a business).

35-2E Whether the asset or liability is a standalone asset or liability, a group of assets, a group of liabilities, or a group of assets and liabilities for recognition or disclosure purposes depends on its unit of account. The unit of account for the asset or liability shall be determined in accordance with the Topic that requires or permits the fair value measurement, except as provided in this Topic.

Depending on the unit of account, which is generally determined in accordance with other Codification topics, the asset or liability being measured at fair value might be a stand-alone asset or liability, a group of assets, a group of liabilities, or a group of assets and liabilities. See Chapter 4 for further discussion of the unit of account.

In addition to applying the appropriate unit of account to a fair value measurement, entities may need to consider other asset-specific characteristics that affect fair value. According to ASC 820-10-35-2B, examples of potential asset-specific characteristics that may affect a fair value measurement include (1) the condition and location of the asset (see Section 10.2.5.4) and (2) restrictions on the sale or use of the asset (see Section 10.2.2.2).

10.2.2.2 Restrictions on the Sale or Use of an Asset

ASC 820-10

Example 6: Restricted Assets

Pending Content (Transition Guidance: ASC 820-10-65-13)

55-51 The effect on a fair value measurement arising from a restriction on the sale or use of an asset by a reporting entity will differ depending on whether the restriction would be taken into account by market participants when pricing the asset. When the restriction is included within the unit of account of the asset, the restriction is a characteristic of the asset and should be considered in measuring the fair value of the asset. Cases A and B illustrate the effect of restrictions when measuring the fair value of an asset. . . .

Case A: Restriction on the Sale of an Equity Instrument

Restriction Taken Into Account

55-52 A reporting entity holds an equity instrument (a financial asset) for which sale is legally or contractually restricted for a specified period. (For example, such a restriction could limit sale to qualifying investors, as may be the case in accordance with Rule 144 or similar rules of the Securities and Exchange Commission [SEC].) The restriction is a characteristic of the instrument and, therefore, would be transferred to market participants. In that case, the fair value of the instrument would be measured on the basis of the quoted price for an otherwise identical unrestricted equity instrument of the same issuer that trades in a public market, adjusted to reflect the effect of the restriction. The adjustment would reflect the amount market participants would demand because of the risk relating to the inability to access a public market for the instrument for the specified period. The adjustment will vary depending on all of the following:

The nature and duration of the restriction
The extent to which buyers are limited by the restriction (for example, there might be a large number of qualifying investors)
Qualitative and quantitative factors specific to both the instrument and the issuer.

Pending Content (Transition Guidance: ASC 820-10-65-13)

Editor’s Note: The content of paragraph 820-10-55-52 will change upon transition, together with a change in the heading noted below.

Case A: Restriction on the Sale of an Equity Security

55-52 Company X issues Class A shares through a sale on a national securities exchange or an over-the-counter market as well as through a private placement transaction. Because the Class A shares issued through the private placement are not registered and are legally restricted from being sold on a national securities exchange or an over-the-counter market until the shares are registered or the conditions necessary for an exemption from registration have been satisfied, a market participant would sell the private placement Class A shares in a different market than the market used for registered Class A shares on the measurement date. Because that restriction would be included within the unit of account of the equity security, 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 Class A shares acquired through a private placement transaction would consider that restriction a characteristic of the asset. In that case, the reporting entity should measure the fair value of the equity security on the basis of the market price of the similar unrestricted equity security adjusted to reflect the effect of the restriction. The adjustment will vary depending on all of the following:

The nature and remaining duration of the restriction
The extent to which buyers are limited by the restriction (for example, there might be a large number of qualifying investors)
Qualitative and quantitative factors specific to both the instrument and the issuer.

55-52A A reporting entity holds Class A shares of Company X that are eligible for sale on a national securities exchange or an over-the-counter market. Separately, the reporting entity enters into a contractual arrangement in which it agrees that it will not sell the Class A shares for a certain time period. That arrangement may be referred to as a lock-up agreement or a market standoff agreement or may be the result of a provision within a separate agreement between certain shareholders (that is, separate from the legal documents that establish the rights and obligations of all holders of a particular class of stock). In that instance, the restriction is not included in the unit of account and therefore is not a characteristic of the asset. The equity security subject to the contractual sale restriction is identical to an equity security that is not subject to a contractual sale restriction. Therefore, consistent with the guidance in paragraphs 820-10-35-6B and 820-10-35-36B, the fair value of the equity security subject to the contractual sale restriction should be measured on the basis of the market price of the same equity security without the contractual sale restriction and should not be adjusted to reflect the reporting entity’s inability to sell the equity security on the measurement date.

55-53 As discussed in paragraph 820-10-15-5, this Topic applies for equity securities with restrictions that expire within one year that are measured at fair value in accordance with Subtopics 320-10 and 958-320.

Case B: Restrictions on the Use of an Asset

55-54 A donor contributes land in an otherwise developed residential area to a not-for-profit neighborhood association. The land is currently used as a playground. The donor specifies that the land must continue to be used by the association as a playground in perpetuity; however, the association is not restricted from selling the land. Upon review of relevant documentation (for example, legal and other), the association determines that the fiduciary responsibility to meet the donor’s restriction would not be transferred to market participants if the association sold the asset, that is, the donor restriction on the use of the land is specific to the association. Without the restriction on the use of the land by the association, the land could be used as a site for residential development. In addition, the land is subject to an easement (that is, a legal right that enables a utility to run power lines across the land). Following is an analysis of the effect on the fair value measurement of the land arising from the restriction and the easement:

Donor restriction on use of land. Because in this situation the donor restriction on the use of the land is specific to the association, the restriction would not be transferred to market participants. Therefore, the fair value of the land would be the higher of its fair value used as a playground (that is, the fair value of the asset would be maximized through its use by market participants in combination with other assets or with other assets and liabilities) and its fair value as a site for residential development (that is, the fair value of the asset would be maximized through its use by market participants on a standalone basis), regardless of the restriction on the use of the land by the association.
Easement for utility lines. Because the easement for utility lines is specific to (that is, a characteristic of) the land, it would be transferred to market participants with the land. Therefore, the fair value measurement of the land would take into account the effect of the easement, regardless of whether the highest and best use is as a playground or as a site for residential development.

55-55 The donor restriction, which is legally binding on the association, would be indicated through classification of the associated net assets and disclosure of the nature of the restriction in accordance with paragraphs 958-210-45-8 through 45-9, 958-210-50-1, and 958-210-50-3.

In some cases, it is appropriate to consider a restriction on the sale or use of an asset as a characteristic of the asset that affects its fair value. Only a legal or contractual restriction on the sale or use of an asset that is specific to the asset (an instrument-specific restriction) and that would be transferred to market participants should be incorporated into the asset’s fair value measurement. Thus, an entity should consider the effect of a restriction on the sale or use of an asset that it owns only if market participants would consider such a restriction in pricing the asset because they would also be subject to the restriction if they acquired the asset. Entity-specific restrictions that would not be transferred to market participants should not be considered in the determination of the asset’s fair value, since doing so would be inconsistent with the exit price notion underlying the definition of fair value. The table below gives examples of restrictions on the sale of assets and addresses whether they are instrument-specific or entity-specific. Section 5.2.3 discusses considerations related to the potential uses of nonfinancial assets that may affect the highest-and-best-use valuation premise for nonfinancial assets.

Table 10-1

Examples of Restrictions on the Sale of Assets
Nature of Restriction	Description of Restriction	Impact of Restriction on Fair Value
Restriction on the sale of securities offered in a private offering in accordance with Rule 144 of the Securities Act of 1933 or similar rules (private placements)	SEC Rule 144 legally restricts the sale of certain securities to buyers that meet specified criteria.	As discussed in ASC 820-10-55-52, this type of restriction is a characteristic of the security and would be transferred to market participants. Therefore, the fair value measurement of the security should take this instrument-specific restriction into account. An instrument-specific restriction on a security affects a fair value measurement by the amount that a market participant would demand because of the inability to access a public market for the security for the specified period. As discussed in ASC 820-10-55-52, that amount depends on the nature and duration of the restriction, the extent to which buyers are limited by the restriction, and qualitative and quantitative factors specific to both the instrument and the issuer. Quoted prices for such securities would reflect the resale restriction; therefore, there should be no further adjustment to reflect the restriction.
Founder’s shares in an initial public offering (IPO) of equity securities	Founders may be contractually restricted from selling their shares for a period after an IPO. Such restrictions may be outlined in the IPO prospectus.	If this restriction is not embedded in the contractual terms of the shares (which it generally is not) and thus would not be transferred in a hypothetical sale of the shares, the restriction is specific to the founders and not a characteristic of the security. Therefore, the founders should not consider this restriction in determining fair value.2
Security sale restriction related to a seat on the board of directors	An entity (Entity A) has an equity investment in another entity (Entity B) and is represented on its board of directors. Because officers of A are directors of B, A is restricted from selling any of its investment securities in B during each period that is two weeks before the end of each quarter through 48 hours after B’s earnings are released (also referred to as a “blackout period”).	Other market participants would not face this restriction. Because the restriction is entity-specific (i.e., it is not a characteristic of the security) and would not be transferred with the security, an entity should not consider the restriction in measuring the security at fair value.
Assets pledged as collateral	An entity has a borrowing arrangement in which assets must be pledged as collateral.	Other market participants would not face this restriction. Because the restriction is entity-specific (i.e., it is not a characteristic of the assets) and would not be transferred with the assets, an entity should not consider the restriction in measuring the assets at fair value.

The determination of whether a contractual or legal restriction on the sale or use of an asset is instrument-specific or entity-specific is sometimes straightforward; other times, an entity may need to exercise judgment or consult a legal specialist in making this determination.

Changing Lanes

In June 2022, the FASB issued ASU 2022-03, which clarifies that an entity would not consider contractual sale restrictions when measuring the fair value of equity securities subject to those restrictions. The ASU is effective for public business entities in fiscal years beginning after December 15, 2023, and interim periods within those fiscal years. For all other entities, it is effective in fiscal years beginning after December 15, 2024, and interim periods within those fiscal years. Early adoption of the ASU is permitted. See Deloitte’s July 1, 2022, Heads Up for further discussion.

10.2.3 The Transaction

ASC 820-10

The Transaction

35-3 A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under current market conditions.

35-5 A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place either:

In the principal market for the asset or liability
In the absence of a principal market, in the most advantageous market for the asset or liability.

35-5A A reporting entity need not undertake an exhaustive search of all possible markets to identify the principal market or, in the absence of a principal market, the most advantageous market, but it shall take into account all information that is reasonably available. In the absence of evidence to the contrary, the market in which the reporting entity normally would enter into a transaction to sell the asset or to transfer the liability is presumed to be the principal market or, in the absence of a principal market, the most advantageous market.

35-6 If there is a principal market for the asset or liability, the fair value measurement shall represent the price in that market (whether that price is directly observable or estimated using another valuation technique), even if the price in a different market is potentially more advantageous at the measurement date.

35-6A The reporting entity must have access to the principal (or most advantageous) market at the measurement date. Because different entities (and businesses within those entities) with different activities may have access to different markets, the principal (or most advantageous) market for the same asset or liability might be different for different entities (and businesses within those entities). Therefore, the principal (or most advantageous) market (and thus, market participants) shall be considered from the perspective of the reporting entity, thereby allowing for differences between and among entities with different activities.

35-6B Although a reporting entity must be able to access the market, the reporting entity does not need to be able to sell the particular asset or transfer the particular liability on the measurement date to be able to measure fair value on the basis of the price in that market.

35-6C Even when there is no observable market to provide pricing information about the sale of an asset or the transfer of a liability at the measurement date, a fair value measurement shall assume that a transaction takes place at that date, considered from the perspective of a market participant that holds the asset or owes the liability. That assumed transaction establishes a basis for estimating the price to sell the asset or to transfer the liability.

As discussed in ASC 820-10-35-5, in a fair value measurement, it is assumed that an orderly transaction to sell the asset or transfer the liability has occurred in the principal market for the asset or liability (or, in the absence of a principal market, the most advantageous market). While a fair value measurement is not entity-specific, the principal (or most advantageous) market for the asset or liability is determined from the perspective of the entity estimating fair value for recognition or disclosure purposes. See Chapter 6 for discussion of the concept of the principal or most advantageous market. Also see Example 10-9, which illustrates how to identify the most advantageous market for a nonfinancial asset.

10.2.4 Market Participants

ASC 820-10

Market Participants

35-9 A reporting entity shall measure the fair value of an asset or a liability using the assumptions that market participants would use in pricing the asset or liability, assuming that market participants act in their economic best interest. In developing those assumptions, a reporting entity need not identify specific market participants. Rather, the reporting entity shall identify characteristics that distinguish market participants generally, considering factors specific to all of the following:

The asset or liability
The principal (or most advantageous) market for the asset or liability
Market participants with whom the reporting entity would enter into a transaction in that market.

To reflect an exit price in accordance with the definition and objective of a fair value measurement, an asset or liability must be measured on the basis of assumptions that market participants would use in pricing the asset or liability. See Chapter 7 for further discussion of market-participant assumptions and Section 10.4 for information about inputs into a valuation technique.

10.2.5 The Price

10.2.5.1 General

ASC 820-10

The Price

35-9A Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (that is, an exit price) regardless of whether that price is directly observable or estimated using another valuation technique.

35-9B The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. Transaction costs shall be accounted for in accordance with other Topics. Transaction costs are not a characteristic of an asset or a liability; rather, they are specific to a transaction and will differ depending on how a reporting entity enters into a transaction for the asset or liability.

35-9C Transaction costs do not include transportation costs. If location is a characteristic of the asset (as might be the case, for example, for a commodity), the price in the principal (or most advantageous) market shall be adjusted for the costs, if any, that would be incurred to transport the asset from its current location to that market.

In the principal (or most advantageous) market, the price used to measure the fair value of an asset, liability, or instrument classified in an entity’s stockholders’ equity is determined as of the measurement date under current market conditions. This price should not be adjusted for transaction costs but may be adjusted for transportation costs.

10.2.5.2 Subsequent Information and Events

ASC 820-10-35-9A indicates that a fair value measurement represents “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction . . . at the measurement date under current market conditions.” In estimating fair value, an entity should develop inputs on the basis of the assumptions that market participants would make as of the measurement date, provided that such participants performed usual and customary due diligence procedures.3 In making assumptions about the inputs that market participants would use in estimating fair value, an entity is responsible for analyzing and considering “any relevant subsequent events and information to assess whether the fair value measurement reflects all relevant information and assumptions that market participants would have considered under the current conditions at the measurement date.”4

Relevant information related to the assumptions about the inputs used to estimate fair value may include general market and economic data, industry data, and investment-specific data. Relevant information obtained after the measurement date but before the financial statements are issued (or available to be issued) may serve as additional evidence of the assumptions that market participants would have made in developing inputs as of the measurement date after making usual and customary due diligence efforts. Conversely, such information may represent information that market participants would not have considered as of the measurement date after making these efforts. In all cases, a fair value measurement as of the measurement date should incorporate assumptions about risk, including risks inherent in (1) a particular valuation technique and (2) the inputs to the valuation technique.5 If uncertainty is inherent in the inputs used to estimate fair value as of the measurement date, the entity cannot disregard such uncertainty in estimating fair value even if the uncertainty is not resolved until after the measurement date. In some cases, it may be difficult to determine the appropriate risk adjustments that market participants may make to reflect the uncertainty inherent in the inputs used in a fair value measurement; however, the degree of difficulty is not a sufficient basis for excluding a risk adjustment.6

In evaluating how to consider relevant information obtained after the measurement date in estimating fair value as of the measurement date, an entity should consider the guidance in ASC 855, which distinguishes between recognized and unrecognized subsequent events. The definition of subsequent events in the ASC master glossary indicates that recognized subsequent events are those that “provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements.” Nonrecognized subsequent events, on the other hand, are those that “provide evidence about conditions that did not exist at the date of the balance sheet but arose subsequent to that date.” Entities should adjust their financial statements only to reflect the impact of recognized subsequent events. For nonrecognized subsequent events, entities should evaluate the completeness of their financial statement disclosures.

In applying ASC 855 to a fair value measurement, an entity must consider the following questions:7

Does the information obtained after the measurement date constitute evidence of a condition that existed as of the measurement date?

Subsequent events or transactions that reflect changes in circumstances occurring after the balance sheet date do not constitute evidence of the fair value measurement as of the balance sheet date. Only information obtained after the measurement date that constitutes evidence of a condition that existed as of the measurement date can be relevant to the determination of fair value.

If the information obtained after the measurement date constitutes evidence of a condition that existed as of the measurement date, go to question 2. If the information serves as evidence of a condition that did not exist as of the measurement date, the information obtained after the measurement date represents a nonrecognized subsequent event. Nonrecognized subsequent events do not result in adjustments of the financial statements; however, disclosures may be required under ASC 855-10-50-2 and 50-3.
Does the information obtained after the measurement date represent information that would have been available to market participants as of the measurement date (under an assumption that market participants performed usual and customary due diligence efforts)?

If the information obtained by an entity after the measurement date would have been available to market participants as of the measurement date, the entity should directly consider the information in developing the inputs into the fair value measurement as of the measurement date. If, however, the information obtained by the entity after the measurement date reflects only the resolution of a particular uncertainty that existed as of the measurement date, the information itself should not be used with certainty as an input into the fair value measurement as of the measurement date. However, the entity should ensure that the estimation of fair value as of the measurement date appropriately includes assumptions about risks related to the uncertainty that existed as of the measurement date.

The summary section of ASU 2012-07 further elaborates on how an entity considers information obtained after the measurement date that resolves an uncertainty that existed as of the measurement date:

[An] entity should include, in a valuation model, assumptions that market participants would have made about uncertainty in timing and amount of cash flows as of the measurement date. To the extent that uncertainties are resolved or other information becomes known after the balance sheet date, but before the financial statements are issued or available to be issued, such effects should not be incorporated with certainty into the fair value measurement as of the balance sheet date unless market participants would have made such assumptions.

The examples below illustrate the application of the guidance discussed above.

Example 10-1

Information Not Available as of the Measurement Date

Entity A holds marketable securities and records them at fair value in its balance sheet on the basis of a quoted market price. As of A’s year-end (i.e., the measurement date), these securities had a quoted price per share of $150. After the measurement date, the securities’ quoted price per share dropped to $120. In this example, it is assumed that the decline occurs after the measurement date; events that occur after market close but before the end of the measurement date are not considered subsequent events.

The decline in the quoted price is a nonrecognized subsequent event because it represents information that market participants would not have had as of the measurement date; therefore, A should not adjust its fair value measurement of the marketable securities as of the measurement date. However, if the investment in marketable securities or decline in their fair value is significant to A, A should consider the decline in determining whether its financial statement disclosures are adequate.

Example 10-2

Information Both Available and Not Available as of the Measurement Date

Entity B holds a limited partnership interest in Partnership Z, which is a nonpublic entity that invests in real estate in southeast Asia (the “investment”). Entity B recognizes the investment at fair value through earnings in its financial statements. Entity B’s fiscal year-end is December 31, 20X5, and it issues its financial statements on February 28, 20X6. Entity B receives a financial information package from the general partner (GP) of Z on a 30-day lag. The financial information received from Z includes financial statements as of the prior month-end and updated projections of Z’s future cash flows (the “cash flow projections”). Entity B estimates the fair value of Z by using a present value technique that incorporates the cash flow projections received from Z, which represent a significant unobservable input into the valuation technique. As part of its year-end closing process, B uses the cash flow projections received from Z as part of the November 30, 20X5, financial information package (the “original projections”) to estimate the fair value of the investment as of the December 31, 20X5, measurement date. On February 1, 20X6, B receives the December 31, 20X5, financial information package from Z, which includes revised cash flow projections (the “updated cash flow projections”). The updated cash flow projections are significantly revised downward from the original cash flow projections. The negative revisions in both the amount and timing of Z’s estimated future cash flows are primarily attributable to two factors: (1) adverse economic developments in the general real estate market in southeast Asia that occurred in December 20X5 and (2) a discrete decision made by the GP of Z on January 15, 20X6, to abandon two real estate projects in process. In the analysis below, it is assumed that as part of the usual and customary due diligence procedures that would be performed before a decision is made to invest in Z, market participants would (1) be knowledgeable about general economic conditions in the southeast Asian real estate market that would affect Z and (2) have access to the same financial information that B receives from Z. The GP of Z would not, however, provide access to confidential information that is not made available to existing investors in Z.

The receipt of the updated cash flow projections from Z constitutes evidence of both a condition that existed as of the December 31, 20X5, measurement date (i.e., the impact of adverse economic developments in the southeast Asian real estate market) and a condition that did not exist as of the December 31, 20X5, measurement date (i.e., the discrete decision to abandon two real estate projects in process). In determining a transaction price for the investment in Z as of the December 31, 20X5, measurement date, market participants would not have had access to the updated cash flow projections, although they would have been knowledgeable of the fact that deteriorating economic conditions in the southeast Asian real estate market would affect Z’s future business prospects. Therefore, while it would be inappropriate to directly incorporate the updated cash flow projections as an input into the valuation technique, B should appropriately incorporate assumptions about the risks that market participants would consider inherent in the original projections (including the compensation for bearing such risks). Given the usual and customary due diligence procedures that market participants would perform in determining a transaction price for the investment, the assumptions market participants would make about the risks inherent in the original cash flow projections would be expected to include risk adjustments pertaining to the adverse economic developments in the southeast Asian real estate market in December 20X5 as well as the execution risks involved in Z’s real estate projects in process. Market participants would have incorporated assumptions regarding the risks inherent in the original cash flow projections on the basis of judgments regarding the uncertainty in the timing and amounts of cash flows as of the measurement date without the benefit of any resolution of these uncertainties that may have been provided once the updated cash flow projections were made available.

Example 10-3

Observable Transaction After the Measurement Date

Entity C holds a common equity ownership interest in a private company, X, that C recognizes at fair value through earnings in its financial statements. Entity C’s fiscal year-end is December 31, 20X5, and it issues its financial statements on February 28, 20X6. In performing its year-end closing, C used both the market approach and the income approach to estimate the fair value of its investment in X. For both techniques, significant unobservable (Level 3) inputs were required because no observable market transactions for the asset occurred during the reporting period and no comparable market information was available. (See Section 10.3.2 for a discussion of the use of multiple valuation techniques.)

An observable market transaction in X’s common equity occurred between unrelated entities on January 15, 20X6. (Note that as discussed in Section 10.4.1, ASC 820-10-35-36 requires entities to maximize the use of relevant observable inputs [i.e., Level 1 and Level 2 inputs that do not need to be significantly adjusted] and minimize the use of unobservable inputs in their valuation techniques.) Entity C should evaluate significant differences between (1) its estimate of the fair value of its investment in X under the market approach and income approach and (2) the observable transaction price. The subsequent transaction and related information may constitute additional evidence of the fair value of C’s investment in X as of the measurement date, indicating that an adjustment would be appropriate.

However, in evaluating whether the subsequent transaction price is relevant to the fair value of C’s investment in X as of the measurement date, C should consider whether (1) significant events (e.g., market changes or changes in the investee’s business, including the industry in which X operates) have occurred between the measurement date and the subsequent transaction date and (2) the transaction represents an orderly transaction (as opposed to a forced liquidation or distressed sale). If significant events have occurred after the measurement date or C is unable to determine whether the transaction represents an orderly transaction, C should place less weight on the subsequent market transaction. In addition, the further from the measurement date that the market transaction takes place, the less weight C should place on the input. If it is determined that the subsequent transaction represented an orderly transaction that provides relevant information regarding the fair value of C’s investment in X as of the measurement date, C should consider whether it needs to adjust this input for the effect of significant events that occurred after the measurement date. See Section 10.7 for more information about identifying whether transactions are orderly transactions.

Such transactions may also represent an opportunity for an entity to calibrate its valuation technique (including the significant inputs into the valuation technique). In doing so, the entity may become aware that inputs it developed on the basis of its own assumptions differ significantly from inputs developed on the basis of market-participant assumptions. ASC 820-10-35-24C addresses such calibration:

Calibration ensures that the valuation technique reflects current market conditions, and it helps a reporting entity to determine whether an adjustment to the valuation technique is necessary (for example, there might be a characteristic of the asset or liability [or instrument classified within an entity’s shareholders’ equity] that is not captured by the valuation technique). After initial recognition, when measuring fair value using a valuation technique or techniques that use unobservable inputs, a reporting entity shall ensure that those valuation techniques reflect observable market data (for example, the price for a similar asset or liability [or own equity instrument]) at the measurement date.

10.2.5.3 Transaction Costs

10.2.5.3.1 General

ASC 820-10 — Glossary

Transaction Costs

The costs to sell an asset or transfer a liability in the principal (or most advantageous) market for the asset or liability that are directly attributable to the disposal of the asset or the transfer of the liability and meet both of the following criteria:

They result directly from and are essential to that transaction.
They would not have been incurred by the entity had the decision to sell the asset or transfer the liability not been made (similar to costs to sell, as defined in paragraph 360-10-35-38).

As noted in ASC 820-10-35-9B, a fair value measurement does not include the effects of transaction costs. As a result, as discussed in ASC 820-10-30-3A(c), the transaction price (i.e., the price paid) may not represent fair value at initial recognition. Because transaction costs may be embedded in the price paid (received) for an asset (liability), entities should use judgment in identifying transaction costs. Transaction costs are recognized in earnings as incurred when they are related to an item that is subsequently recognized at fair value, with changes in fair value reported in earnings.8

An entity should consider transaction costs in determining the most advantageous market in which to measure fair value when there is no principal market for an asset, liability, or equity instrument. Such costs may influence the net proceeds received or paid in a transaction and therefore the selection of the most advantageous market in which to transact. However, once the most advantageous market is determined, transaction costs do not result in adjustments to the price in this market. See Section 10.2.5.3.2 for discussion of the accounting for transaction costs.

Furthermore, although ASC 820-10-35-9B indicates that the price used to measure fair value is not adjusted for transaction costs, when an entity uses a discounted cash flow technique to measure the fair value of a nonfinancial asset, the entity may appropriately include the costs of disposing of the asset when these costs are one of the cash flow assumptions that market participants would use in pricing the asset (see the example below for an illustration). However, this approach would not apply to a fair value measurement of a financial asset or financial liability.

Example 10-4

Accounting for Selling Costs When a Discounted Cash Flow Model Is Used to Measure the Fair Value of a Nonfinancial Asset

Entity D uses a discounted cash flow model to measure the fair value of an investment property. In doing so, D develops a 10-year cash flow projection for the property’s operations, with an assumed sale at the end of the 10-year period because D believes that this is how market participants would price the investment property and has no knowledge of any available evidence to the contrary. The net cash inflow from the assumed sale would include the impact of selling costs (i.e., selling costs would be subtracted from the cash inflow of the estimated sales price). In measuring the fair value of its investment property, D would use an appropriate rate to discount the resulting cash flows to present value.

Transaction costs differ from transportation and installation costs. See Section 10.2.5.4 for discussion of transportation and installation costs. Also see Example 10-9, which illustrates how an entity would consider transaction, transportation, and installation costs in determining the most advantageous market and the fair value of a nonfinancial asset.

10.2.5.3.2 Accounting for Transaction Costs

Entities should consider other Codification topics in accounting for transaction costs. Although transaction costs are recognized in earnings as incurred for items subsequently measured at fair value through earnings, such recognition may not be appropriate when an item is subsequently measured by using an attribute other than fair value through earnings. For example, when an asset is recognized at amortized cost, it may be appropriate to capitalize transaction costs as part of the cost of the asset.

Furthermore, some Codification topics require the subsequent recognition of an asset at fair value less costs to sell (i.e., the subsequent measurement of the asset is reduced by anticipated transaction costs related to selling the asset). Thus, both the transaction costs incurred to acquire the asset and the transaction costs that will be incurred to sell the asset may be recognized in earnings while the entity owns the asset.

The subsections below discuss other Codification topics (not all-inclusive) that address the accounting for transaction costs.

10.2.5.3.2.1 Investments in Debt Securities

Under ASC 320, an entity may classify investments in debt securities as held to maturity, available for sale, or trading. The table below discusses the accounting for transaction costs incurred when a debt security is acquired.

Table 10-2

Accounting for Transaction Costs Incurred in Connection With Acquiring a Debt Security
Classification of Security	Accounting for Transaction Costs
Held to maturity	Capitalized. In accordance with ASC 310-20-15-2 and 15-3, nonrefundable fees and costs associated with acquiring debt securities classified as held to maturity are within the scope of ASC 310-20. ASC 310-20-30-5 states that the “initial investment in a purchased loan or group of loans shall include the amount paid to the seller plus any fees paid or less any fees received.” Because transaction costs associated with the acquisition of held-to-maturity debt securities are within the scope of ASC 320, fees paid to a third party that are directly related to the acquisition (e.g., brokerage fees paid to a broker-dealer) would be capitalized as part of the original carrying amount. In accordance with ASC 310-20, entities should separately expense any other costs incurred in connection with acquiring securities (e.g., internal costs, portfolio management fees, investment consultation, or due diligence costs paid to an adviser). Held-to-maturity debt securities are subsequently measured at amortized cost and are subject to evaluation for impairment.
Available for sale	Capitalized initially. In accordance with ASC 310-20-15-2 and 15-3, nonrefundable fees and costs associated with acquiring debt securities classified as available for sale are within the scope of ASC 310-20. ASC 310-20-30-5 states that the “initial investment in a purchased loan or group of loans shall include the amount paid to the seller plus any fees paid or less any fees received.” Because transaction costs associated with the acquisition of available-for-sale debt securities are within the scope of ASC 320, fees paid to a third party that are directly related to the acquisition (e.g., brokerage fees paid to a broker-dealer) would be capitalized as part of the original carrying amount. In accordance with ASC 310-20, entities should separately expense any other costs incurred in connection with acquiring securities (e.g., internal costs, portfolio management fees, investment consultation, or due diligence costs paid to an adviser). An entity must subsequently measure debt securities classified as available for sale at fair value, with changes in fair value recognized in OCI (provided that there is no impairment). This fair value should not include any transaction costs because ASC 820 indicates that such costs are not a characteristic of an asset or liability measured at fair value. Therefore, entities will immediately recognize an unrealized loss in OCI after the purchase of a debt security classified as available for sale. Given the security’s classification as available for sale, such a loss will be reported in accumulated other comprehensive income (AOCI) unless the security is subsequently impaired and measured at fair value on the basis of the entity’s conclusion that it is more likely than not that the security will be sold or that there is an intent to sell it.
Trading	Expensed as incurred. ASC 820 indicates that transaction costs are not a characteristic of an asset or liability measured at fair value. ASC 310-20-15-3(c) states that ASC 310-20 does not apply to securities that are subsequently measured at fair value through earnings.

10.2.5.3.2.2 Investments in Equity Securities Not Subject to the Equity Method

Unless the measurement alternative in ASC 321-10-35-2 is applied or the investment qualifies for the equity method of accounting, investments in equity securities must be initially and subsequently recognized at fair value, with changes in fair value reported in earnings. Since ASC 820 indicates that transaction costs are not a characteristic of an asset or liability measured at fair value, transaction costs incurred to acquire an equity security that is not measured under the measurement alternative in ASC 321-10-35-2 are immediately expensed. See Example 10-5 for an illustration of this concept.

ASC 321-10-35-2 indicates that when the measurement alternative is applied to an equity security without a readily determinable fair value, that security is measured at “cost minus impairment, if any,” and adjustments are also made for “observable price changes in orderly transactions for the identical or a similar investment of the same issuer.” Thus, securities measured according to this measurement alternative are initially measured at the transaction price, which includes incremental direct costs related to acquiring the security (i.e., transaction costs). However, these capitalized transaction costs would be subsequently expensed in earnings upon (1) a remeasurement event under ASC 321, which includes an impairment or an observable price change (as indicated in Section 2.3.2.1.2, such a change represents a fair value measurement accounted for under ASC 820); (2) a sale of the security; or (3) a reclassification of the security to fair value through earnings (see Section 12.3.2.1).

Example 10-5

Acquisition of Equity Security Subsequently Accounted for at Fair Value

Entity E acquires an investment in an exchange-traded equity security on December 31, 20X7. The asset will be accounted for at fair value through earnings on a recurring basis in accordance with ASC 321. Entity E paid $100 for the security (which was also the security’s closing price), plus a $1 broker commission, for a total transaction price of $101. Entity E transacted in its principal market for the security. However, in accordance with ASC 820-10-30-3A(c), E determines that the transaction price does not represent fair value at initial recognition because of the transaction costs. The closing price on December 31, 20X7, is $100. If E were to subsequently sell the security, it would incur a $1 broker commission.

The fair value of the security as of the December 31, 20X7, reporting date is the security’s $100 closing price. Since ASC 321 does not indicate otherwise, E should record a $1 expense for the broker commission paid to acquire the security. The broker commission is not a characteristic of the security and does not add value to it. Transaction costs are a separate unit of account and therefore do not enter into the fair value measurement of the security. The $1 broker commission indicates that the transaction price of $101 is not fair value at inception. Another market participant would not reimburse E for the broker commission; instead, it would pay E the closing market price of $100 for the security. In a manner consistent with ASC 820-10-35-9B and Example 4 in ASC 820-10-55-42 through 55-45A, E should not adjust the security for the $1 broker commission it would incur to sell the security. In other words, E should not write down the security to $99 (the net proceeds it would receive upon selling the security).

10.2.5.3.2.3 Investment Securities Owned by an Investment Company

ASC 946-320-35-1 states that “[a]n investment company shall measure investments in debt and equity securities subsequently at fair value.” In addition, ASC 946-320-30-1 states that “[a]n investment company shall initially measure its investments in debt and equity securities at their transaction price. The transaction price shall include commissions and other charges that are part of the purchase transaction.” According to this guidance, investment companies initially recognize investments in debt and equity securities at the transaction price, including related commissions and other direct costs incurred in connection with acquisition of the securities (i.e., an entry price and not fair value), and subsequently measure the investments at fair value under ASC 820. If any other potential differences between entry and exit prices are ignored, the capitalization of transaction costs into the initial measurement of investment securities by investment companies will result in a loss on initial recognition. For example, assume that Mutual Fund X purchases a publicly traded equity security for $99 immediately before the market closing (the fair value is therefore also $99). Also assume that X incurred a $1 commission in purchasing the security. Under ASC 946, the initial cost basis is $100 ($99 plus the $1 transaction cost). The fair value would be $99; therefore, a $1 loss would be recognized on the acquisition date. This loss on initial recognition is presented as a “net change in unrealized appreciation (depreciation) on investments” rather than as a separate expense in the investment company’s statement of operations.

Some have questioned whether ASC 820’s exit price notion and guidance indicating that transaction costs are not a characteristic of an asset measured at fair value conflict with the guidance in ASC 946-320-30-1. The implication is that investment companies would not be permitted to present transaction costs as part of the net change in unrealized appreciation (depreciation) on investments. However, we believe that investment companies that apply ASC 946 should present commissions and other charges that are directly related to the acquisition of investment securities in the net change in unrealized appreciation (depreciation) on investments. ASC 820-10-35-9B states, in part, “Transaction costs shall be accounted for in accordance with other Topics.” ASC 946-320-30-1 specifies that the initial amount recorded for investment purchases “shall include commissions and other charges that are part of the purchase transaction.” ASC 820 does not affect this guidance. Accordingly, ASC 946 continues to require investment companies to include commissions and other charges incurred as part of securities purchase transactions in the net change in unrealized appreciation (depreciation) on investments. After initial recognition, an investment company measures its investment at the exit price in accordance with ASC 820. The difference between the initial recognized amount and subsequent fair value measurement would be presented as a “net change in unrealized appreciation (depreciation) on investments” rather than as a separate expense in the statement of operations.

10.2.5.3.2.4 Plan Assets of Pension and Other Postretirement Benefit Plans

Unlike other fair value measurements, the fair value measurement of investments held by a pension or other postretirement plan should be reduced by the costs of disposing of the assets. ASC 715-30-35-50 states, in part:

The fair value of an investment shall be reduced by brokerage commissions and other costs normally incurred in a sale if those costs are significant (similar to fair value less cost to sell).

The example below illustrates the accounting for transaction costs of a defined benefit pension plan.

Example 10-6

Transaction Costs of Pension Plan

Entity F’s defined benefit pension plan owns a suburban office complex with an appraised value of $18 million. To recognize this real estate property in accordance with ASC 715-30-35-50, F would need to consider the estimated transaction costs (real estate broker fees) that would be incurred to dispose of the property. If the real estate broker fee is 6 percent of the transaction price ($1,080,000), the suburban office complex would be recognized at $16,920,000.

10.2.5.3.2.5 Assets Measured at Lower of Cost or Fair Value

Under certain Codification topics, assets, asset groups, or disposal groups must be measured at the lower of cost or fair value. Those Codification topics specify whether the fair value measurement should be reduced for transaction costs. For example, under ASC 310-10-35-48, nonmortgage loans classified as HFS must be reported at the lower of amortized cost or fair value. ASC 310-10-35-48 does not indicate that fair value should be reduced for anticipated costs to sell. Conversely, under ASC 310-10-35-23 (or ASC 326-20-35-4 for entities that have adopted ASU 2016-13), when a held-for-investment classified loan receivable is measured for impairment on the basis of the fair value of the collateral and repayment of the loan depends on the sale of the collateral, impairment measurement must be based on fair value less costs to sell. With respect to nonfinancial assets, ASC 360-10-35-17 requires that an impairment loss on a long-lived asset (or asset group) classified as held and used be measured on the basis of fair value without adjustment for costs to sell; however, an impairment loss on a disposal group is measured on the basis of fair value less costs to sell in accordance with ASC 360-10-35-40.

10.2.5.4 Transportation and Installation Costs

ASC 820-10 — Glossary

Transportation Costs

The costs that would be incurred to transport an asset from its current location to its principal (or most advantageous) market.

As noted above, the ASC master glossary defines transportation costs (e.g., freight costs, handling fees, or other similar costs) as the costs of moving an asset “from its current location to its principal (or most advantageous) market.” Like transaction costs, transportation costs may be embedded in the transaction price for an asset. However, transportation costs are treated differently than transaction costs for fair value measurement purposes.

Under ASC 820, an entity that is measuring fair value must consider the characteristics of an asset or liability, which, in the case of a nonfinancial asset (e.g., a commodity), may include the asset’s physical location. Thus, in determining the fair value of an asset for which location is a characteristic, an entity may need to adjust an observable price or input for the costs that would be incurred to transport the asset from its current location to the principal (or most advantageous) market. Similarly, in determining the fair value of a nonfinancial asset that must be customized or configured to be placed into service and ready for use, an entity may need to adjust an observable price or input to reflect the associated installation costs. Such an adjustment is appropriate when the degree of customization or configuration (i.e., installation) is a characteristic of the asset.9

Examples 10-7 and 10-8 illustrate how transportation costs may be added to or subtracted from a quoted price to arrive at a fair value measurement (e.g., how an observable market price may be adjusted to arrive at fair value in the principal or most advantageous market for an asset). While these examples focus on assets, a contract that is an asset from one party’s perspective will represent a liability from the counterparty’s perspective. In addition, note that these examples do not address whether it is appropriate to recognize inventories at fair value under U.S. GAAP.

Example 10-7

Location Is a Subtractive Input

Entity G has commodity inventory at Location 1. In performing its fair value measurement, G determines that Location 2 is the principal market for sale of this inventory. Location 2 is an active market for which pricing quotes are readily accessible. Entity G observes a price of $100 per unit of inventory at Location 2. Entity G determines that transporting the inventory from Location 1 to Location 2 would cost $5 per unit of inventory. The fair value of the inventory at its current location would thus be $95 per unit (i.e., $100 per unit at Location 2 less $5 per unit to bring the asset to the principal market at Location 2).

Example 10-8

Location Is an Additive Input

Entity H has commodity inventory at Location 1. In performing its fair value measurement, H determines that Location 1 is its principal market for sale of this inventory. However, no recent observable pricing information is available at Location 1. Accordingly, H uses a valuation technique to determine the fair value of the inventory at Location 1 on the basis of quoted prices at Location 2, from which a more recent price quote can be obtained. The valuation technique is used to adjust the quoted price at Location 2 for the cost of transportation from Location 2 to Location 1. As in the example above, the current price at Location 2 is $100 per unit of inventory. The transportation cost from Location 2 to Location 1 is $5 per unit of inventory. Entity H validates its valuation technique on the basis of past market transactions at Location 1. The fair value of the inventory at its current location would thus be $105 per unit (i.e., $100 per unit at Location 2 plus $5 per unit to bring the asset to H’s principal market at Location 1).

The example below illustrates how an entity would consider transaction, transportation, and installation costs in determining the most advantageous market and fair value for a nonfinancial asset.

Example 10-9

Transaction, Transportation, and Installation Costs for a Nonfinancial Asset

Entity I owns an uninstalled machine for which it is measuring fair value for impairment purposes. Entity I has determined the following:

There are observable prices for the machine on an installed basis in Market A and Market B.
Entity I has access to transact in both markets, although neither market is I’s principal market.
To sell the machine in either market, I would need to transport the machine to the market and configure and install the machine so that it is ready for use.
Entity I would also incur a commission (i.e., a transaction cost) to sell the machine on an installed basis in either market.
The observable prices and costs of selling the machine in Markets A and B on an installed basis are as follows:

ASC 820 specifies that an entity should make an adjustment for transportation and installation costs when measuring the fair value of an asset if location and condition are characteristics of the asset. Transaction costs are not part of a fair value measurement, but they do affect the determination of the most advantageous market when there is no principal market for an asset. (As discussed in Section 10.2.5.3.1, when the fair value of a nonfinancial asset is calculated by using a discounted cash flow technique, the cost of disposing of the asset, which represents a type of transaction cost, may reduce the cash flows used in the model to estimate fair value. However, that guidance does not apply to this example.)

Under ASC 820, the fair value of the machine is $22 in Market A ($28 observable price less the $4 transportation costs and $2 installation costs that would be incurred for I to obtain that price) and $23 in Market B ($26 observable price less the $1 transportation costs and $2 installation costs that I would incur to obtain that price). The net proceeds would be $21 in Market A (fair value of $22 less $1 transaction costs) and $20 in Market B (fair value of $23 less $3 transaction costs). Because the price in Market A results in greater net proceeds, from I’s perspective, Market A is the most advantageous market for the machine; therefore, the fair value of the machine is $22.

10.2.6 Application to Nonfinancial Assets

ASC 820-10

Highest and Best Use for Nonfinancial Assets

35-10A A fair value measurement of a nonfinancial asset takes into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use.

35-10B The highest and best use of a nonfinancial asset takes into account the use of the asset that is physically possible, legally permissible, and financially feasible, as follows:

A use that is physically possible takes into account the physical characteristics of the asset that market participants would take into account when pricing the asset (for example, the location or size of a property).
A use that is legally permissible takes into account any legal restrictions on the use of the asset that market participants would take into account when pricing the asset (for example, the zoning regulations applicable to a property).
A use that is financially feasible takes into account whether a use of the asset that is physically possible and legally permissible generates adequate income or cash flows (taking into account the costs of converting the asset to that use) to produce an investment return that market participants would require from an investment in that asset put to that use.

35-10C Highest and best use is determined from the perspective of market participants, even if the reporting entity intends a different use. However, a reporting entity’s current use of a nonfinancial asset is presumed to be its highest and best use unless market or other factors suggest that a different use by market participants would maximize the value of the asset.

35-10D To protect its competitive position, or for other reasons, a reporting entity may intend not to use an acquired nonfinancial asset actively, or it may intend not to use the asset according to its highest and best use. For example, that might be the case for an acquired intangible asset that the reporting entity plans to use defensively by preventing others from using it. Nevertheless, the reporting entity shall measure the fair value of a nonfinancial asset assuming its highest and best use by market participants.

Valuation Premise for Nonfinancial Assets

35-10E The highest and best use of a nonfinancial asset establishes the valuation premise used to measure the fair value of the asset, as follows:

The highest and best use of a nonfinancial asset might provide maximum value to market participants through its use in combination with other assets as a group (as installed or otherwise configured for use) or in combination with other assets and liabilities (for example, a business).
1. If the highest and best use of the asset is to use the asset in combination with other assets or with other assets and liabilities, the fair value of the asset is the price that would be received in a current transaction to sell the asset assuming that the asset would be used with other assets or with other assets and liabilities and that those assets and liabilities (that is, its complementary assets and the associated liabilities) would be available to market participants.
2. Liabilities associated with the asset and with the complementary assets include liabilities that fund working capital, but do not include liabilities used to fund assets other than those within the group of assets.
3. Assumptions about the highest and best use of a nonfinancial asset shall be consistent for all of the assets (for which highest and best use is relevant) of the group of assets or the group of assets and liabilities within which the asset would be used.
The highest and best use of a nonfinancial asset might provide maximum value to market participants on a standalone basis. If the highest and best use of the asset is to use it on a standalone basis, the fair value of the asset is the price that would be received in a current transaction to sell the asset to market participants that would use the asset on a standalone basis.

35-11A The fair value measurement of a nonfinancial asset assumes that the asset is sold consistent with the unit of account specified in other Topics (which may be an individual asset). That is the case even when that fair value measurement assumes that the highest and best use of the asset is to use it in combination with other assets or with other assets and liabilities because a fair value measurement assumes that the market participant already holds the complementary assets and associated liabilities.

35-14 Paragraph 820-10-55-25 illustrates the application of the highest and best use and valuation premise concepts for nonfinancial assets.

An entity must measure the fair value of nonfinancial assets (other than nonfinancial derivative assets) on the basis of the appropriate valuation premise. The unit of valuation (also referred to as the “valuation premise”) for nonfinancial assets (other than nonfinancial derivative assets) is the asset’s highest and best use. See Chapter 5 for more information about the valuation premise for nonfinancial assets, including the illustrations in ASC 820-10-55.

10.2.7 Application to Liabilities and Instruments Classified in Equity

10.2.7.1 General

ASC 820-10

General Principles

35-16 A fair value measurement assumes that a financial or nonfinancial liability or an instrument classified in a reporting entity’s shareholders’ equity (for example, equity interests issued as consideration in a business combination) is transferred to a market participant at the measurement date. The transfer of a liability or an instrument classified in a reporting entity’s shareholders’ equity assumes the following: . . .

b. A liability would remain outstanding and the market participant transferee would be required to fulfill the obligation. The liability would not be settled with the counterparty or otherwise extinguished on the measurement date.

c. An instrument classified in a reporting entity’s shareholders’ equity would remain outstanding and the market participant transferee would take on the rights and responsibilities associated with the instrument. The instrument would not be cancelled or otherwise extinguished on the measurement date.

35-16A Even when there is no observable market to provide pricing information about the transfer of a liability or an instrument classified in a reporting entity’s shareholders’ equity (for example, because contractual or other legal restrictions prevent the transfer of such items), there might be an observable market for such items if they are held by other parties as assets (for example, a corporate bond or a call option on a reporting entity’s shares).

35-16AA In all cases, a reporting entity shall maximize the use of relevant observable inputs and minimize the use of unobservable inputs to meet the objective of a fair value measurement, which is to estimate the price at which an orderly transaction to transfer the liability or instrument classified in shareholders’ equity would take place between market participants at the measurement date under current market conditions.

ASC 820-10-35-16 indicates that when a liability or instrument classified in an entity’s equity is measured at fair value, it is assumed that the instrument is transferred to a market participant as of the measurement date (i.e., the liability or equity instrument remains outstanding and is not extinguished or canceled). ASC 820-10-35-16A clarifies that this is the case even if (1) “there is no observable market to provide pricing information” regarding the transfer of a liability or equity-classified instrument or (2) there are “contractual or other legal restrictions” preventing a transfer. Further, in accordance with the general principles related to fair value measurements, ASC 820-10-35-16AA indicates that an entity should “maximize the use of relevant observable inputs and minimize the use of unobservable inputs.” An entity may estimate the fair value of a liability instrument or instrument classified in an entity’s equity on the basis of the fair value of the item when held by another party as an asset.

10.2.7.2 Liabilities and Instruments Classified in Equity That Are Held by Other Parties as Assets

ASC 820-10

Liabilities and Instruments Classified in a Reporting Entity’s Shareholders’ Equity Held by Other Parties as Assets

35-16B When a quoted price for the transfer of an identical or a similar liability or instrument classified in a reporting entity’s shareholders’ equity is not available and the identical item is held by another party as an asset, a reporting entity shall measure the fair value of the liability or equity instrument from the perspective of a market participant that holds the identical item as an asset at the measurement date. . . .

35-16BB In such cases, a reporting entity shall measure the fair value of the liability or equity instrument as follows:

Using the quoted price in an active market for the identical item held by another party as an asset, if that price is available
If that price is not available, using other observable inputs, such as the quoted price in a market that is not active for the identical item held by another party as an asset
If the observable prices in (a) and (b) are not available, using another valuation approach, such as:
1. An income approach (for example, a present value technique that takes into account the future cash flows that a market participant would expect to receive from holding the liability or equity instrument as an asset; see paragraph 820-10-55-3F)
2. A market approach (for example, using quoted prices for similar liabilities or instruments classified in shareholders’ equity held by other parties as assets; see paragraph 820-10-55-3A).

35-16D When measuring the fair value of a liability or an equity instrument held by another party as an asset, a reporting entity shall adjust the quoted price of the asset only if there are factors specific to the asset that are not applicable to the fair value measurement of the liability or equity instrument. When the asset held by another party includes a characteristic restricting its sale, the fair value of the corresponding liability or equity instrument also would include the effect of the restriction. Some factors that may indicate that the quoted price of the asset should be adjusted include the following:

The quoted price for the asset relates to a similar (but not identical) liability or equity instrument held by another party as an asset. For example, the liability or equity instrument may have a particular characteristic (for example, the credit quality of the issuer) that is different from that reflected in the fair value of the similar liability or equity instrument held as an asset.
The unit of account for the asset is not the same as for the liability or equity instrument. For example, for liabilities, in some cases the price for an asset reflects a combined price for a package comprising both the amounts due from the issuer and a third-party credit enhancement. If the unit of account for the liability is not for the combined package, the objective is to measure the fair value of the issuer’s liability, not the fair value of the combined package. Thus, in such cases, the reporting entity would adjust the observed price for the asset to exclude the effect of the third-party credit enhancement. See paragraph 820-10-35-18A for further guidance.

Pending Content (Transition Guidance: ASC 820-10-65-13)

35-16D When measuring the fair value of a liability or an equity instrument held by another party as an asset, a reporting entity shall adjust the quoted price of the asset only if there are factors specific to the asset that are not applicable to the fair value measurement of the liability or equity instrument. When the asset held by another party includes a characteristic restricting its sale, (see paragraphs 820-10-35-6B and 820-10-35-36B), the fair value of the corresponding liability or equity instrument also would include the effect of the restriction. Some factors that may indicate that the quoted price of the asset should be adjusted include the following:

The quoted price for the asset relates to a similar (but not identical) liability or equity instrument held by another party as an asset. For example, the liability or equity instrument may have a particular characteristic (for example, the credit quality of the issuer) that is different from that reflected in the fair value of the similar liability or equity instrument held as an asset.
The unit of account for the asset is not the same as for the liability or equity instrument. For example, for liabilities, in some cases the price for an asset reflects a combined price for a package comprising both the amounts due from the issuer and a third-party credit enhancement. If the unit of account for the liability is not for the combined package, the objective is to measure the fair value of the issuer's liability, not the fair value of the combined package. Thus, in such cases, the reporting entity would adjust the observed price for the asset to exclude the effect of the third-party credit enhancement. See paragraph 820-10-35-18A for further guidance.

Quoted prices for the transfer of a liability or instrument classified in stockholders’ equity are generally not available. Therefore, ASC 820-10-35-16B specifies that an entity should measure the fair value of liabilities and instruments classified in equity “from the perspective of a market participant that holds the identical item as an asset at the measurement date.” As with other measurements under ASC 820, the fair value of a liability or instrument classified in equity that is determined from the perspective of a market participant that holds the item as an asset should be measured by maximizing observable inputs and minimizing unobservable inputs. ASC 820-10-35-16BB provides the following hierarchy for such measurement:

Use “the quoted price in an active market for the identical item held by another party as an asset, if that price is available.” Otherwise, proceed to the next step.
Use “the quoted price in a market that is not active for the identical item held by another party as an asset,” if that price is available. Otherwise, proceed to the next step.
Use a valuation approach to measure the fair value of the identical item held by another party as an asset (i.e., an income or market approach).

An entity sometimes may need to adjust the quoted price of an asset to properly reflect factors that do not apply to the fair value of a liability or instrument classified in equity. As discussed in ASC 820-10-35-16D, the need for such an adjustment usually arises because either (1) the observed price is related to a similar, but not identical, asset that is used to measure the fair value of a liability or equity instrument or (2) the unit of account for the asset differs from the unit of account for the liability or equity instrument.10 ASC 820-10-35-16D also clarifies how restrictions preventing the sale of an asset should be considered when the quoted price of the asset is used to measure the fair value of a liability or equity instrument. See Section 10.2.7.4 for discussion of the incorporation of adjustments for risk and transferability restrictions into the measurement of the fair value of liability instruments. See Section 10.6 for discussion of situations in which the volume or level of activity for an asset or a liability has significantly decreased.

When any adjustment is made to a quoted price of an item held as an asset, the fair value measurement of the liability or equity instrument cannot be classified within Level 1 of the fair value hierarchy. Rather, the entity must evaluate the nature of any such adjustments to determine whether the fair value measurement in its entirety should be classified within Level 2 or Level 3 of the fair value hierarchy. See Chapter 8 for further discussion of the fair value hierarchy.

Case D of Example 7 in ASC 820 illustrates the measurement of the fair value of a liability on the basis of a quoted price of the identical item held by another party as an asset (see Section 10.2.7.5).

10.2.7.3 Liabilities and Instruments Classified in Equity That Are Not Held by Other Parties as Assets

ASC 820-10

Liabilities and Instruments Classified in a Reporting Entity’s Shareholders’ Equity Not Held by Other Parties as Assets

35-16H When a quoted price for the transfer of an identical or a similar liability or instrument classified in a reporting entity’s shareholders’ equity is not available and the identical item is not held by another party as an asset, a reporting entity shall measure the fair value of the liability or equity instrument using a valuation technique from the perspective of a market participant that owes the liability or has issued the claim on equity.

35-16I For example, when applying a present value technique, a reporting entity might take into account either of the following:

The future cash outflows that a market participant would expect to incur in fulfilling the obligation, including the compensation that a market participant would require for taking on the obligation (see paragraphs 820-10-35-16J through 35-16K).
The amount that a market participant would receive to enter into or issue an identical liability or equity instrument, using the assumptions that market participants would use when pricing the identical item (for example, having the same credit characteristics) in the principal (or most advantageous) market for issuing a liability or an equity instrument with the same contractual terms.

35-16J When using a present value technique to measure the fair value of a liability that is not held by another party as an asset (for example, an asset retirement obligation), a reporting entity shall, among other things, estimate the future cash outflows that market participants would expect to incur in fulfilling the obligation. Those future cash outflows shall include market participants’ expectations about the costs of fulfilling the obligation and the compensation that a market participant would require for taking on the obligation. Such compensation includes the return that a market participant would require for the following:

Undertaking the activity (that is, the value of fulfilling the obligation — for example, by using resources that could be used for other activities)
Assuming the risk associated with the obligation (that is, a risk premium that reflects the risk that the actual cash outflows might differ from the expected cash outflows; see paragraph 820-10-35-16L).

35-16K For example, a nonfinancial liability does not contain a contractual rate of return and there is no observable market yield for that liability. In some cases, the components of the return that market participants would require will be indistinguishable from one another (for example, when using the price a third-party contractor would charge on a fixed-fee basis). In other cases, a reporting entity needs to estimate those components separately (for example, when using the price a third-party contractor would charge on a cost-plus basis because the contractor in that case would not bear the risk of future changes in costs).

35-16L A reporting entity can include a risk premium in the fair value measurement of a liability or an instrument classified in a reporting entity’s shareholders’ equity that is not held by another party as an asset in one of the following ways:

By adjusting the cash flows (that is, as an increase in the amount of cash outflows)
By adjusting the rate used to discount the future cash flows to their present values (that is, as a reduction in the discount rate).

A reporting entity shall ensure that it does not double count or omit adjustments for risk. For example, if the estimated cash flows are increased to take into account the compensation for assuming the risk associated with the obligation, the discount rate should not be adjusted to reflect that risk.

ASC 820-10-35-16H through 35-16L address how to measure the fair value of a liability or instrument classified in stockholders’ equity when (1) “a quoted price for the transfer of an identical or [similar] instrument . . . is not available” and (2) “the identical item is not held by another party as an asset.” This guidance will generally apply only to nonfinancial liabilities because financial liabilities and instruments that an entity classifies in equity would be expected to be held by another party on an identical basis as an asset. However, an entity would not be precluded from estimating the fair value of a liability or equity instrument in accordance with ASC 820-10-35-16H through 35-16L so that it can calibrate the fair value measurement to the estimate in accordance with ASC 820-10-35-16BB(c).

As with other fair value measurements under ASC 820, a fair value measurement estimated in accordance with ASC 820-10-35-16H through 35-16L should maximize observable inputs and minimize unobservable inputs. Such measurement should also incorporate the entity’s nonperformance risk and relevant risk premiums (see Section 10.2.7.4 for more information). A fair value measurement in accordance with ASC 820-10-35-16H through 35-16L can never be classified as a Level 1 measurement in its entirety.

Case C of Example 7 in ASC 820 illustrates the use of a valuation technique to estimate the fair value of an ARO liability (see Section 10.2.7.5).

10.2.7.4 Adjustments for Risk and Transferability Restrictions

10.2.7.4.1 General

ASC 820-10

Liabilities and Instruments Classified in a Reporting Entity’s Shareholders’ Equity Not Held by Other Parties as Assets

Undertaking the activity (that is, the value of fulfilling the obligation — for example, by using resources that could be used for other activities)
Assuming the risk associated with the obligation (that is, a risk premium that reflects the risk that the actual cash outflows might differ from the expected cash outflows; see paragraph 820-10-35-16L).

By adjusting the cash flows (that is, as an increase in the amount of cash outflows)
By adjusting the rate used to discount the future cash flows to their present values (that is, as a reduction in the discount rate).

Nonperformance Risk

35-17 The fair value of a liability reflects the effect of nonperformance risk. Nonperformance risk includes, but may not be limited to, a reporting entity’s own credit risk. Nonperformance risk is assumed to be the same before and after the transfer of the liability.

35-18 When measuring the fair value of a liability, a reporting entity shall take into account the effect of its credit risk (credit standing) and any other factors that might influence the likelihood that the obligation will or will not be fulfilled. That effect may differ depending on the liability, for example:

Whether the liability is an obligation to deliver cash (a financial liability) or an obligation to deliver goods or services (a nonfinancial liability)
The terms of credit enhancements related to the liability, if any.

Paragraph 820-10-55-56 illustrates the effect of credit risk on the fair value measurement of a liability.

35-18A The fair value of a liability reflects the effect of nonperformance risk on the basis of its unit of account. In accordance with Topic 825, the issuer of a liability issued with an inseparable third-party credit enhancement that is accounted for separately from the liability shall not include the effect of the credit enhancement (for example, a third-party guarantee of debt) in the fair value measurement of the liability. If the credit enhancement is accounted for separately from the liability, the issuer would take into account its own credit standing and not that of the third-party guarantor when measuring the fair value of the liability.

Restriction Preventing the Transfer of a Liability or an Instrument Classified in a Reporting Entity’s Shareholders’ Equity

35-18B When measuring the fair value of a liability or an instrument classified in a reporting entity’s shareholders’ equity, a reporting entity shall not include a separate input or an adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the item. The effect of a restriction that prevents the transfer of a liability or an instrument classified in a reporting entity’s shareholders’ equity is either implicitly or explicitly included in the other inputs to the fair value measurement.

35-18C For example, at the transaction date, both the creditor and the obligor accepted the transaction price for the liability with full knowledge that the obligation includes a restriction that prevents its transfer. As a result of the restriction being included in the transaction price, a separate input or an adjustment to an existing input is not required at the transaction date to reflect the effect of the restriction on transfer. Similarly, a separate input or an adjustment to an existing input is not required at subsequent measurement dates to reflect the effect of the restriction on transfer.

ASC 820-10 — Glossary

Credit Risk

For purposes of a hedged item in a fair value hedge, credit risk is the risk of changes in the hedged item’s fair value attributable to both of the following:

Changes in the obligor’s creditworthiness
Changes in the spread over the benchmark interest rate with respect to the hedged item’s credit sector at inception of the hedge.

For purposes of a hedged transaction in a cash flow hedge, credit risk is the risk of changes in the hedged transaction’s cash flows attributable to all of the following:

Default
Changes in the obligor’s creditworthiness
Changes in the spread over the contractually specified interest rate or the benchmark interest rate with respect to the related financial asset’s or liability’s credit sector at inception of the hedge.

Nonperformance Risk

The risk that an entity will not fulfill an obligation. Nonperformance risk includes, but may not be limited to, the reporting entity’s own credit risk.

Risk Premium

Compensation sought by risk-averse market participants for bearing the uncertainty inherent in the cash flows of an asset or a liability. Also referred to as a risk adjustment.

A liability or equity-classified instrument may be subject to various risks, including instrument-specific (e.g., issuer-specific), industry-specific, and market risks (e.g., risks related to general economic conditions). ASC 820-10-35-16J through 35-18C address the incorporation of risk adjustments into the fair value of a liability or an instrument classified in stockholders’ equity. According to that guidance:

A risk premium should be incorporated into the fair value measurement of a liability to the extent that market participants would demand a premium as compensation for assuming the risk of uncertain cash flows. Risk premiums are also relevant to fair value measurements of instruments classified in stockholders’ equity.
The fair value of a liability takes into account the impact of nonperformance risk, including, but not limited to, credit risk. Nonperformance risk could also be relevant to fair value measurements of instruments classified in stockholders’ equity if those equity instruments are redeemable.
In determining fair value, an entity should not make an adjustment for the nontransferability of a liability instrument or instrument classified in stockholders’ equity (see further clarification in Section 10.2.7.4.4).

While the above guidance from ASC 820 addresses fair value measurements performed on the basis of a present value technique used to measure the fair value of a liability instrument or instrument classified in stockholders’ equity when such an instrument is not held by another entity as an asset, the same concepts apply when the liability instrument or instrument classified in stockholders’ equity is measured on the basis of the identical item held by another entity as an asset. However, in the latter case, the relevant adjustments for nonperformance risk, risk premiums, and transferability restrictions will be reflected explicitly or implicitly in the fair value measurement of the related asset.

10.2.7.4.2 Risk Premiums

The cash flows associated with certain liability instruments and instruments classified in stockholders’ equity (and the corresponding items held as an asset by another entity, if applicable) are uncertain (i.e., there are risks related to either the amount or timing of cash flows). In these situations, the fair value measurement of the liability must incorporate an adjustment that reflects a risk premium on the basis of market-participant assumptions (i.e., the compensation market participants would demand for bearing such risks). Note that risk premiums are intended to reflect premiums for compensation related to bearing the risk of the instrument’s uncertain cash flows that arise because the cash flows are indexed to an underlying other than nonperformance risk (e.g., a liability whose principal and interest are indexed to the price of gold). The premium demanded by a market participant to bear nonperformance risk is reflected by adjusting a fair value measurement to take such risk into account. To reflect that premium as both a risk premium and a premium for nonperformance risk would be inappropriate since it would double-count the risk’s impact.

ASC 820-10-35-16L indicates that a risk premium may be incorporated into a discounted cash flow technique by (1) adjusting the cash flows (i.e., the use of probability-weighted cash flows), (2) adjusting the rate used to discount cash flows, or (3) aspects of both. However, an entity is not permitted to double-count or omit such risk adjustments. Such risk adjustments would be incorporated, as necessary, regardless of whether the fair value of a liability or instrument classified in stockholders’ equity is measured by using a present value technique under ASC 820-10-35-16BB(c) (i.e., to measure the fair value of the corresponding identical item held by another party as an asset) or ASC 820-10-35-16H through 35-16L (i.e., to measure the fair value of the liability because it is not held as an asset by another party). A separate adjustment for a risk premium is unnecessary when the fair value of a liability or instrument classified in stockholders’ equity is measured on the basis of a quoted price for the identical item held by another party as an asset, since the quoted price will already reflect compensation for such risk. If the fair value of a liability or instrument classified in stockholders’ equity is measured on the basis of a quoted price for a similar, but not identical, item held by another party as an asset, an adjustment for a risk premium would also be unnecessary unless the difference arises because of uncertain cash flows.

Case C of Example 7 in ASC 820 illustrates the impact that a market risk premium may have on the fair value of an ARO liability (see Section 10.2.7.5).

10.2.7.4.3 Nonperformance Risk

The ASC master glossary defines nonperformance risk as “[t]he risk that an entity will not fulfill an obligation.” Nonperformance risk includes, but is a broader concept than, credit risk, which is the risk that an entity will not make payments of cash or other financial instruments in accordance with the terms of an obligation.

Nonperformance risk is associated with all liabilities. For some liabilities (i.e., financial liabilities), nonperformance risk consists entirely of the credit risk of the obligor (e.g., a financial liability that requires the obligor to make contractual principal and interest payments). Other liabilities (i.e., nonfinancial liabilities) pose nonperformance risks for reasons other than credit risk. In addition to an entity’s own credit risk, nonperformance risk might include the risk associated with the entity’s ability to deliver a good or perform a service. Consider a derivative liability associated with a contract for the delivery of a commodity (e.g., oil, natural gas, electricity) that is carried at fair value. Nonperformance risk would include the risk that the entity will not be able to obtain and deliver the commodity to the counterparty.

ASC 820-10-35-17 and 35-18 and ASC 820-10-55-56 indicate that the fair value of a liability must reflect the nonperformance risk of the instrument. For example, an entity must take into account the effect of credit risk (credit standing) on the fair value of a financial liability in all periods in which the liability is measured at fair value because other entities would take into account the effect of the entity’s credit risk when estimating the price they would be willing to pay to own the instrument as an asset. Entities should consider nonperformance risk when measuring both financial and nonfinancial liabilities at fair value. ASC 820-10-35-16 states, in part, that “[a] fair value measurement assumes that a financial or nonfinancial liability . . . is transferred to a market participant [that assumes the obligation] at the measurement date.” ASC 820-10-35-17 adds that “[n]onperformance risk is assumed to be the same before and after the transfer of the liability.” Thus, under ASC 820, it is assumed that the transferor’s credit risk is similar to that of the transferee. Accordingly, to the extent that the fair value of a liability is not determined on the basis of the fair value of the identical item owned as an asset by another party, the entity must ensure that adjustments for nonperformance risk do not result in a change in the nonperformance risk for the liability.

The extent to which nonperformance risk affects the fair value of a liability depends on various factors, including the unit of account for the liability, credit spreads, entity-specific credit standing, and credit enhancements. Collateral is a form of credit enhancement that is contractually linked to an obligation (i.e., the provisions of the obligation require a lien on the collateral until the obligation is settled). It typically affects the stated terms of liabilities (e.g., the interest rate charged to a borrower). Thus, in estimating the fair value of a collateralized liability, an entity should assume that the lender would require the borrower, to whom the obligation would be transferred, to post the amount of collateral that is stipulated in that particular arrangement. However, the unit of account for a liability excludes an inseparable third-party credit enhancement that is accounted for separately from the liability. Therefore, the fair value of such liabilities should not take into account the third-party credit enhancement. Rather, an entity measures the fair value of such liabilities under the assumption that the third-party credit enhancement did not exist (i.e., the issuer would take into account its own credit standing and not that of the third-party guarantor when measuring the fair value of the liability). See Section 12.3.1.1.1.1 for further discussion of when third-party credit enhancements are treated as a separate unit of account. See Section 10.2.7.2 for discussion of the need to make adjustments to the quoted price of an asset that includes the impact of a third-party credit enhancement when the fair value of a liability is measured on the basis of the identical item held by another party as an asset.

Nonperformance risks related to nonfinancial liabilities, such as commodity delivery contracts or service contracts may be mitigated by “make-whole” or other default provisions that require an entity to make cash payments for damages incurred if it fails to meet its delivery or service obligation. However, the entity must still consider credit risk since it may be unable to meet such cash payment obligations.

Connecting the Dots

As discussed in Section 10.1, the best practices and guidance in the IASB’s Expert Advisory Panel report are useful to entities that measure and disclose the fair values of financial instruments in accordance with ASC 820. Paragraph 35 of the report addresses factors an entity may consider in evaluating the credit risk of a debt instrument and states the following:

Understanding the credit risk of a debt instrument involves evaluating the credit quality and financial strength of both the issuer and the credit support providers. There are many factors an entity might consider and some of the more common factors are as follows:

(a) collateral asset quality: the assets to which the holder of an instrument has recourse in the event of non-payment or default could be either all of the assets of the issuing entity or specified assets that are legally separated from the issuer (ring-fenced). The greater the value and quality of the assets to which an entity has recourse in the event of default, the lower the credit risk of the instrument. Measuring the fair value of a debt instrument therefore involves assessing the quality of the assets that support the instrument (the collateral) and the level of the collateralisation, and evaluating the likelihood that the assigned collateral will generate adequate cash flows to make the contractual payments on the instrument.

(b) subordination: the level of subordination of an instrument is critical to assessing the risk of non-payment of an instrument. If other more senior instruments have higher claims over the cash flows and assets that support the instrument, this increases the risk of the instrument. The lower the claim on the cash flows and assets, the more risky an instrument is and the higher the return the market will demand on the instrument.

(c) non-payment protection: many instruments contain some form of protection to reduce the risk of non-payment to the holder. In measuring fair value, both the issuer and the holder of the instrument consider the effect of the protection on the fair value of the instrument, unless the entity accounts for the protection as a separate instrument. Protection might take the form of a guarantee or a similar undertaking (eg when a parent guarantees the debt of a subsidiary), an insurance contract, a credit default swap or simply the fact that more assets support the instrument than are needed to make the payments (this is commonly referred to as over-collateralisation). The risk of nonpayment is also reduced by the existence of more subordinated tranches of instruments that take the first losses on the underlying assets and therefore reduce the risk of more senior tranches absorbing losses. When protection is in the form of a guarantee, an insurance contract or a credit default swap [and that protection is not accounted for as a separate instrument], it is necessary to identify the party providing the protection and assess that party’s creditworthiness (to the extent that the protection is not accounted for separately). The protection will be more valuable if the credit risk of the protection provider is low. This analysis involves considering not only the current position of the protection provider but also the effect of other guarantees or insurance contracts that it might have written. For example, if the provider has guaranteed many correlated debt securities, the risk of its non-performance might increase significantly with increases in defaults on those securities. In addition, the credit risk of some protection providers moves as market conditions change. Thus, an entity evaluates the credit risk of each protection provider at each measurement date.

Although the above guidance is relevant to evaluating the nonperformance risk associated with an asset or liability, this evaluation is complex. Accordingly, an entity should consider engaging those with specialized knowledge (e.g., valuation experts, credit risk management specialists) to perform this analysis.

Cases A, B, C, and E of Example 7 in ASC 820 and Examples 10-10 through 10-12 in Section 10.2.7.5 illustrate the impact that nonperformance risk may have on the fair value measurement of liabilities.

10.2.7.4.3.1 Debt Assumed in a Business Combination

ASC 805-20-30-1 requires an acquirer to initially measure an acquiree’s debt that is assumed in a business combination at fair value. If the acquirer guarantees the acquiree’s debt, the credit characteristics of the combined entity should be considered when the fair value of the assumed debt obligation is initially measured. (This guidance is consistent with the discussion in EITF Issue 98-1.11) However, if the debt remains solely the acquiree’s obligation (i.e., the acquirer does not guarantee or collateralize the debt), only the acquiree’s credit risk should be considered as of the measurement date used to measure the fair value of the assumed debt.

10.2.7.4.4 Transferability Restrictions

Under ASC 820-10-35-18B, the fair value measurement of a liability instrument or instrument classified in stockholders’ equity should not include a separate input or adjustment related to a contractual restriction that prevents the entity from transferring the item. ASC 820-10-35-18B states, in part, that “[t]he effect of a restriction that prevents the transfer of a liability or an instrument classified in a reporting entity’s shareholders’ equity is either implicitly or explicitly included in the other inputs to the fair value measurement.”

The fair value measurement of a liability instrument or instrument classified in stockholders’ equity will often be determined on the basis of the fair value of the identical item held as an asset by another entity. In these circumstances, if there is a restriction on the transferability of the asset that is instrument-specific (as opposed to entity-specific), the fair value measurement of the asset will be affected by the restriction. In this circumstance, the fair value measurement of a liability instrument or instrument classified in stockholders’ equity would similarly be affected by the restriction (i.e., the fair value measurement of the liability or equity instrument would not be adjusted to remove the impact of the restriction on the fair value of the identical item held by another party as an asset because the restriction does not represent a factor specific to the asset in accordance with ASC 820-10-35-16D). In summary, a restriction that prevents the holder of an asset from transferring, or affects its ability to transfer, this asset — when this restriction is appropriately incorporated into the fair value measurement of the asset — will also be incorporated into the fair value measurement of the liability or equity instrument from the perspective of the entity that has issued the liability or equity instrument. However, neither of the following transferability restrictions should have any impact on the fair value of a liability or equity instrument:

A restriction on the transferability of an asset that is entity-specific.
A restriction only on the issuer’s ability to transfer its liability or own equity instruments.

See Section 10.2.2.2 for further discussion of how transfer restrictions affect fair value measurements of assets.

10.2.7.5 Examples

Example 7 in ASC 820 consists of several cases illustrating the fair value measurement of liabilities.

ASC 820-10

Example 7: Measuring Liabilities

55-55A A fair value measurement of a liability assumes that the liability, whether it is a financial liability or a nonfinancial liability, is transferred to a market participant at the measurement date (that is, the liability would remain outstanding and the market participant transferee would be required to fulfill the obligation; it would not be settled with the counterparty or otherwise extinguished on the measurement date).

55-56 The fair value of a liability reflects the effect of nonperformance risk. Nonperformance risk relating to a liability includes, but may not be limited to, the reporting entity’s own credit risk. A reporting entity takes into account the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value because those that hold the reporting entity’s obligations as assets would take into account the effect of the reporting entity’s credit standing when estimating the prices they would be willing to pay. Cases A–E illustrate the measurement of liabilities and the effect of nonperformance risk (including a reporting entity’s own credit risk) on a fair value measurement. . . .

Case A: Liabilities and Credit Risk — General

55-57 This Case has the following assumptions:

Entity X and Entity Y each enter into a contractual obligation to pay cash ($500) to Entity Z in 5 years.
Entity X has a AA credit rating and can borrow at 6 percent, and Entity Y has a BBB credit rating and can borrow at 12 percent. . . .

55-57A Entity X will receive about $374 in exchange for its promise (the present value of $500 in 5 years at 6 percent). Entity Y will receive about $284 in exchange for its promise (the present value of $500 in 5 years at 12 percent). The fair value of the liability to each entity (that is, the proceeds) incorporates that reporting entity’s credit standing.

Case B: Structured Note

55-59 On January 1, 20X7, Entity A, an investment bank with a AA credit rating, issues a five-year fixed rate note to Entity B. The contractual principal amount to be paid by Entity A at maturity is linked to the Standard and Poor’s S&P 500 index. No credit enhancements are issued in conjunction with or otherwise related to the contract (that is, no collateral is posted and there is no third-party guarantee). Entity A elects to account for the entire note at fair value in accordance with paragraph 815-15-25-4. The fair value of the note (that is, the obligation of Entity A) during 20X7 is measured using an expected present value technique. Changes in fair value are as follows:

Fair value at January 1, 20X7. The expected cash flows used in the expected present value technique are discounted at the risk-free rate using the treasury yield curve at January 1, 20X7, plus the current market observable AA corporate bond spread to treasuries, if nonperformance risk is not already reflected in the cash flows, adjusted (either up or down) for Entity A’s specific credit risk (that is, resulting in a credit-adjusted risk-free rate). Therefore, the fair value of Entity A’s obligation at initial recognition takes into account nonperformance risk, including that reporting entity’s credit risk, which presumably is reflected in the proceeds.
Fair value at March 31, 20X7. During March 20X7, the credit spread for AA corporate bonds widens, with no changes to the specific credit risk of Entity A. The expected cash flows used in the expected present value technique are discounted at the risk-free rate using the treasury yield curve at March 31, 20X7, plus the current market observable AA corporate bond spread to treasuries if nonperformance risk is not already reflected in the cash flows, adjusted for Entity A’s specific credit risk (that is, resulting in a credit-adjusted risk-free rate). Entity A’s specific credit risk is unchanged from initial recognition. Therefore, the fair value of Entity A’s obligation changes as a result of changes in credit spreads generally. Changes in credit spreads reflect current market participant assumptions about changes in nonperformance risk generally, changes in liquidity risk, and the compensation required for assuming those risks.
Fair value at June 30, 20X7. As of June 30, 20X7, there have been no changes to the AA corporate bond spreads. However, on the basis of structured note issues corroborated with other qualitative information, Entity A determines that its own specific creditworthiness has strengthened within the AA credit spread. The expected cash flows used in the expected present value technique are discounted at the risk-free rate using the treasury yield curve at June 30, 20X7, plus the current market observable AA corporate bond spread to treasuries (unchanged from March 31, 20X7), if nonperformance risk is not already reflected in the cash flows, adjusted for Entity A’s specific credit risk (that is, resulting in a credit-adjusted risk-free rate). Therefore, the fair value of the obligation of Entity A changes as a result of the change in its own specific credit risk within the AA corporate bond spread.

Case C: Asset Retirement Obligation

55-77 On January 1, 20X1, Entity A assumes an asset retirement obligation in a business combination. The reporting entity is legally required to dismantle and remove an offshore oil platform at the end of its useful life, which is estimated to be 10 years.

55-78 On the basis of paragraph 410-20-30-1, Entity A uses the expected present value technique to measure the fair value of the asset retirement obligation.

55-79 If Entity A was contractually allowed to transfer its asset retirement obligation to a market participant, Entity A concludes that a market participant would use all of the following inputs, probability-weighted as appropriate, when estimating the price it would expect to receive:

Labor costs
Allocation of overhead costs
The compensation that a market participant would require for undertaking the activity and for assuming the risk associated with the obligation to dismantle and remove the asset. Such compensation includes both of the following:
1. Profit on labor and overhead costs
2. The risk that the actual cash outflows might differ from those expected, excluding inflation.
Effect of inflation on estimated costs and profits
Time value of money, represented by the risk-free rate
Nonperformance risk relating to the risk that Entity A will not fulfill the obligation, including Entity A’s own credit risk.

55-80 The significant assumptions used by Entity A to measure fair value are as follows:

Labor costs are developed on the basis of current marketplace wages, adjusted for expectations of future wage increases, required to hire contractors to dismantle and remove offshore oil platforms. Entity A assigns probability assessments to a range of cash flow estimates as follows.

The probability assessments are developed on the basis of Entity A’s experience with fulfilling obligations of this type and its knowledge of the market.
Entity A estimates allocated overhead and equipment operating costs using the rate it applies to labor costs (80 percent of expected labor costs). This is consistent with the cost structure of market participants.
Entity A estimates the compensation that a market participant would require for undertaking the activity and for assuming the risk associated with the obligation to dismantle and remove the asset as follows:
1. A third-party contractor typically adds a markup on labor and allocated internal costs to provide a profit margin on the job. The profit margin used (20 percent) represents Entity A’s understanding of the operating profit that contractors in the industry generally earn to dismantle and remove offshore oil platforms. Entity A concludes that this rate is consistent with the rate that a market participant would require as compensation for undertaking the activity.
2. A contractor would typically require compensation for the risk that the actual cash outflows might differ from those expected because of the uncertainty inherent in locking in today’s price for a project that will not occur for 10 years. Entity A estimates the amount of that premium to be 5 percent of the expected cash flows, including the effect of inflation.
Entity A assumes a rate of inflation of 4 percent over the 10-year period on the basis of available market data.
The risk-free rate of interest for a 10-year maturity on January 1, 20X1, is 5 percent. Entity A adjusts that rate by 3.5 percent to reflect its risk of nonperformance (that is, the risk that it will not fulfill the obligation), including its credit risk. Therefore, the discount rate used to compute the present value of the cash flows is 8.5 percent.

55-81 Entity A concludes that its assumptions would be used by market participants. In addition, Entity A does not adjust its fair value measurement for the existence of a restriction preventing it from transferring the liability. As illustrated in the following table, Entity A measures the fair value of its liability for the asset retirement obligation as $194,879.

Case D: Debt Obligation — Quoted Price

55-82 On January 1, 20X1, Entity B issues at par a $2 million BBB-rated exchange-traded 5-year fixed-rate debt instrument with an annual 10 percent coupon. Entity B has elected to account for this instrument using the fair value option.

55-83 On December 31, 20X1, the instrument is trading as an asset in an active market at $929 per $1,000 of par value after payment of accrued interest. Entity B uses the quoted price of the asset in an active market as its initial input into the fair value measurement of its liability ($929 × [$2 million ÷ $1,000] = $1,858,000).

55-84 In determining whether the quoted price of the asset in an active market represents the fair value of the liability, Entity B evaluates whether the quoted price of the asset includes the effect of factors not applicable to the fair value measurement of a liability, for example, whether the quoted price of the asset includes the effect of a third-party credit enhancement that would be separately accounted for from the perspective of the issuer. Entity B determines that no adjustments are required to the quoted price of the asset. Accordingly, Entity B concludes that the fair value of its debt instrument at December 31, 20X1, is $1,858,000. Entity B categorizes and discloses the fair value measurement of its debt instrument within Level 1 of the fair value hierarchy.

Case E: Debt Obligation — Present Value Technique

55-85 On January 1, 20X1, Entity C issues at par in a private placement a $2 million BBB-rated 5-year fixed-rate debt instrument with an annual 10 percent coupon. Entity C has elected to account for this instrument using the fair value option.

55-86 At December 31, 20X1, Entity C still carries a BBB credit rating. Market conditions, including available interest rates, credit spreads for a BBB-quality credit rating and liquidity, remain unchanged from the date the debt instrument was issued. However, Entity C’s credit spread has deteriorated by 50 basis points because of a change in its risk of nonperformance. After taking into account all market conditions, Entity C concludes that if it was to issue the instrument at the measurement date, the instrument would bear a rate of interest of 10.5 percent or Entity C would receive less than par in proceeds from the issue of the instrument.

55-87 For the purpose of this example, the fair value of Entity C’s liability is calculated using a present value technique. Entity C concludes that a market participant would use all of the following inputs (consistent with paragraph 820-10-55-5) when estimating the price the market participant would expect to receive to assume Entity C’s obligation:

The terms of the debt instrument, including all of the following:
1. Coupon rate of 10 percent
2. Principal amount of $2 million
3. Term of 4 years.
The market rate of interest of 10.5 percent (which includes a change of 50 basis points in the risk of nonperformance from the date of issue).

55-88 On the basis of its present value technique, Entity C concludes that the fair value of its liability at December 31, 20X1, is $1,968,641.

55-89 Entity C does not include any additional input into its present value technique for risk or profit that a market participant might require for compensation for assuming the liability. Because Entity C’s obligation is a financial liability, Entity C concludes that the interest rate already captures the risk or profit that a market participant would require as compensation for assuming the liability. Furthermore, Entity C does not adjust its present value technique for the existence of a restriction preventing it from transferring the liability.

Below are some additional examples illustrating the impact of collateral on the fair value measurements of liabilities.

Example 10-10

How Collateral Affects Fair Value of Liabilities

Entity J has unsecured obligations. If these obligations were rated by a nationally recognized credit agency, a below-investment-grade rating (e.g., BB) would be warranted. On January 1, 20X3, J borrows $10 million in exchange for a fixed-rate, five-year bullet maturity debt at a 125-basis-point spread over the prevailing interest rate on five-year U.S. Treasury bonds (for simplicity, transaction costs are ignored). The lender requires J to collateralize its obligation by granting a security interest in designated machinery and equipment. Management estimates that J could have arranged a similar loan with no collateral at a 200-basis-point spread to five-year U.S. Treasury bonds. On January 1, 20X3, five-year U.S. Treasury bonds yielded 7 percent.

As of January 1, 20X3, the fair value of the loan (including any impact from the collateral) is $10 million. The present value of the loan’s contractual cash flows, discounted at J’s unsecured borrowing rate of 9 percent (7 percent plus 200 basis points), is $9.7 million. This example illustrates that both an issuer’s credit standing and the effect of credit enhancements must be considered in the determination of the fair value of the liability. If J ignored the reduction in the interest rate attributable to the effect of collateral, it would have mistakenly concluded that the fair value of its debt was $9.7 million rather than $10 million.

Impact of Collateral and Other Factors on the Fair Value of a Liability

In subsequent periods, J should consider factors that affect the fair value of the obligation, including the following:

Current levels of the benchmark interest rate.
Credit spreads on comparable, collateralized obligations.
Other terms of the obligation (e.g., put or call rights).
Other current, relevant market information (e.g., regulatory considerations).
The collateral’s current fair value.

Note that, in this example, the liability would be held as an identical asset by another party. The fair value measurement of such an asset would not differ from that in the discussion above.

Example 10-11

Effect of a Decline in Collateral’s Fair Value on a Collateralized Debt Instrument

On January 1, 20X3, Entity K issues $100 million of notes collateralized by a portion of its aircraft fleet. As of September 30, 20X3, there has been a substantial decline in the fair value of the aircraft that serves as collateral for the notes. Assume that K’s credit standing remains unchanged and that all other stated terms of the notes represent current market conditions for the remaining term of the obligation (e.g., benchmark rate or spread over benchmark rates).

In determining the fair value of the obligation, K will have to consider the decline in the fair value of the collateral. While considering this effect, K determines that the fair value of the identical item held as an asset by another party would only represent a payment of $80 million for the asset and therefore that no adjustments are necessary under ASC 820-10-35-16D. Thus, the fair value of the notes has decreased by $20 million even though K’s credit standing remains unchanged.

Example 10-12

Effect of a Decline in the Borrower’s Credit Standing on a Collateralized Obligation

Assume the same facts as in the previous example except that the fair value of the aircraft has not changed; instead, the credit standing of K has declined. In determining the fair value of the obligation, K will have to consider the effect of the decline in its credit standing. Entity K will also need to consider the fact that the fair value of the collateral has not changed.

10.2.8 Application to Financial Assets and Financial Liabilities With Offsetting Risk Positions

10.2.8.1 General

ASC 820-10

Application to Financial Assets and Financial Liabilities With Offsetting Positions in Market Risks or Counterparty Credit Risk

35-18D A reporting entity that holds a group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items is exposed to market risks (that is, interest rate risk, currency risk, or other price risk) and to the credit risk of each of the counterparties. If the reporting entity manages that group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items on the basis of its net exposure to either market risks or credit risk, the reporting entity is permitted to apply an exception to this Topic for measuring fair value. That exception permits a reporting entity to measure the fair value of a group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items on the basis of the price that would be received to sell a net long position (that is, an asset) for a particular risk exposure or paid to transfer a net short position (that is, a liability) for a particular risk exposure in an orderly transaction between market participants at the measurement date under current market conditions. Accordingly, a reporting entity shall measure the fair value of the group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items consistently with how market participants would price the net risk exposure at the measurement date.

35-18E A reporting entity is permitted to use the exception in paragraph 820-10-35-18D only if the reporting entity does all of the following:

Manages the group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items on the basis of the reporting entity’s net exposure to a particular market risk (or risks) or to the credit risk of a particular counterparty in accordance with the reporting entity’s documented risk management or investment strategy
Provides information on that basis about the group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items to the reporting entity’s management
Is required or has elected to measure those financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items at fair value in the statement of financial position at the end of each reporting period.

35-18F The exception in paragraph 820-10-35-18D does not pertain to financial statement presentation. In some cases, the basis for the presentation of financial instruments in the statement of financial position differs from the basis for the measurement of financial instruments, for example, if a Topic does not require or permit financial instruments to be presented on a net basis. In such cases, a reporting entity may need to allocate the portfolio-level adjustments (see paragraphs 820-10-35-18I through 35-18L) to the individual assets or liabilities that make up the group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items managed on the basis of the reporting entity’s net risk exposure. A reporting entity shall perform such allocations on a reasonable and consistent basis using a methodology appropriate in the circumstances.

35-18G A reporting entity shall make an accounting policy decision to use the exception in paragraph 820-10-35-18D. A reporting entity that uses the exception shall apply that accounting policy, including its policy for allocating bid-ask adjustments (see paragraphs 820-10-35-18I through 35-18K) and credit adjustments (see paragraph 820-10-35-18L), if applicable, consistently from period to period for a particular portfolio.

35-18H The exception in paragraph 820-10-35-18D applies only to financial assets and financial liabilities within the scope of Topic 815 or Topic 825 and nonfinancial items accounted for as derivatives in accordance with Topic 815.

As discussed in Section 4.3.2, the unit of valuation for financial assets, nonfinancial derivative assets, all liabilities, and equity instruments is generally the individual instrument, which is generally also its unit of account under other GAAP. An exception to this general principle is available for groups of financial assets, financial liabilities, and nonfinancial items accounted for as derivatives under ASC 815, if an entity (1) manages the group of assets and liabilities on the basis of net exposure to a market risk (or risks) or counterparty credit risk, (2) provides information on that basis to management, and (3) measures those assets and liabilities at fair value in the statement of financial position. One of the requirements for using this exception is that there must be a “group” of eligible assets and liabilities (i.e., a number of such assets and liabilities, and always more than two). ASC 820-10-35-18D indicates that an entity that uses this exception is permitted “to measure the fair value of a group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items on the basis of the price that would be received to sell a net long position (that is, an asset) for a particular risk exposure or paid to transfer a net short position (that is, a liability) for a particular risk exposure in an orderly transaction between market participants at the measurement date under current market conditions.” Accordingly, an entity that elects this exception should “measure the fair value of the group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items consistently with how market participants would price the net risk exposure at the measurement date.” This valuation exception may only be applied to a portfolio that includes eligible assets and eligible liabilities.

This exception applies only to valuation. It does not apply to financial statement presentation or disclosures required under other GAAP; thus, entities that apply this exception will be required to allocate the portfolio-level adjustments to the individual assets and liabilities that make up the portfolio managed on the basis of a net risk exposure. ASC 820 does not prescribe how an entity should allocate such portfolio adjustments but requires that any allocation approach be reasonable and consistently applied. See Section 11.2.3.5.5 for further discussion.

An entity must make an accounting policy decision to use the portfolio valuation exception. Once the policy is established for a particular portfolio, the entity must consistently apply that policy to the portfolio and must consistently apply its policy for allocating bid-ask adjustments and credit adjustments to the individual eligible items within the portfolio. Note, however, that although the portfolio valuation exception must be applied consistently, it may be appropriate for an entity to change its policy decision if its risk preferences change. Paragraph BC59 of ASU 2011-04 addresses this issue:

The Boards decided to require a reporting entity to provide evidence that it manages its net risk exposure consistently from period to period. The Boards decided this because a reporting entity that can provide evidence that it manages its financial instruments on the basis of its net risk exposure would do so consistently for a particular portfolio from period to period, and not on a net basis for that portfolio in some periods and on a gross basis in other periods. Some respondents found that requirement limiting because they noted that the composition of a portfolio changes continually as the reporting entity rebalances the portfolio and changes its risk exposure preferences over time. Although the reporting entity does not need to maintain a static portfolio, the Boards decided to clarify that the reporting entity must make an accounting policy decision to use the exception described in paragraphs BC56 and BC57. The Boards also decided that the accounting policy decision could be changed if the reporting entity’s risk exposure preferences change. In that case, the reporting entity can decide not to use the exception but instead to measure the fair value of its financial instruments on an individual instrument basis. However, if the reporting entity continues to value a portfolio using the exception, it must do so consistently from period to period. [Emphasis added]

If an entity’s risk exposure preferences change and the entity no longer applies the portfolio valuation exception as an accounting policy, the change does not represent a change in accounting principle under ASC 250; rather, it would generally reflect the application of U.S. GAAP to different facts and circumstances. Nevertheless, we believe that once the policy election is made, changes would be infrequent and would be necessitated by either significant changes in facts and circumstances or a conclusion that the conditions for applying the portfolio valuation exception are no longer met.

See Sections 10.2.8.2 and 10.2.8.3 for discussion of the nature of the risks that qualify for the portfolio valuation exception and the price within a bid-ask spread that is used to value a portfolio under this exception. See Example 10-16 for an illustration of the application of the portfolio valuation exception.

10.2.8.1.1 Disclosure

ASC 820-10-50-2D requires entities that make an accounting policy decision to use the portfolio valuation exception in ASC 820-10-35-18D to disclose that fact. See further discussion in Section 11.2.2.1. Section 11.2.3.5.5 discusses the allocation of portfolio-level adjustments to the individual items within a portfolio.

10.2.8.2 Exposure to Market Risks

ASC 820-10

Exposure to Market Risks

35-18I When using the exception in paragraph 820-10-35-18D to measure the fair value of a group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items managed on the basis of the reporting entity’s net exposure to a particular market risk (or risks), the reporting entity shall apply the price within the bid-ask spread that is most representative of fair value in the circumstances to the reporting entity’s net exposure to those market risks (see paragraphs 820-10-35-36C through 35-36D).

35-18J When using the exception in paragraph 820-10-35-18D, a reporting entity shall ensure that the market risk (or risks) to which the reporting entity is exposed within that group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items is substantially the same. For example, a reporting entity would not combine the interest rate risk associated with a financial asset with the commodity price risk associated with a financial liability, because doing so would not mitigate the reporting entity’s exposure to interest rate risk or commodity price risk. When using the exception in paragraph 820-10-35-18D, any basis risk resulting from the market risk parameters not being identical shall be taken into account in the fair value measurement of the financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items within the group.

35-18K Similarly, the duration of the reporting entity’s exposure to a particular market risk (or risks) arising from the financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items shall be substantially the same. For example, a reporting entity that uses a 12-month futures contract against the cash flows associated with 12 months’ worth of interest rate risk exposure on a 5-year financial instrument within a group made up of only those financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items measures the fair value of the exposure to 12-month interest rate risk on a net basis and the remaining interest rate risk exposure (that is, years 2 through 5) on a gross basis.

The ASC master glossary defines “market risk” as comprising interest rate risk, currency risk, and other price risk. To apply the portfolio valuation exception in ASC 820-10-35-18D, an entity must ensure that the particular market risk of the eligible items for which the exception is being applied are substantially the same. In doing so, the entity must consider both the nature and duration of the relevant market risk. Thus, the portfolio valuation exception should only be applied to a portfolio that includes eligible assets and liabilities for which the type of market risk is the same and that share that market risk for a similar period. It would be inappropriate to establish a portfolio that contains assets and liabilities subject to different market risks (i.e., different types of market risks or different durations of the same type of market risk) because of the lack of risk exposure mitigation. However, as indicated in ASC 820-10-35-18K, an entity could potentially measure an exposure to a particular type of market risk on a partial-net, partial-gross basis so that duration risk is appropriately taken into account.

When the portfolio valuation exception is applied to a portfolio of eligible items with offsetting market risks, an entity applies the guidance in ASC 820-10-35-36C and 35-36D to determine the price within the bid-ask spread that is most representative of the fair value of the portfolio (i.e., the net price to sell or transfer the portfolio). See Section 10.4.4 for discussion of the use of mid-market pricing as a practical expedient. See also Section 10.4.3.3 for discussion of the use of blockage factors when the portfolio valuation exception is applied.

10.2.8.3 Exposure to the Credit Risk of a Particular Counterparty

ASC 820-10

35-18L When using the exception in paragraph 820-10-35-18D to measure the fair value of a group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items entered into with a particular counterparty, the reporting entity shall include the effect of the reporting entity’s net exposure to the credit risk of that counterparty or the counterparty’s net exposure to the credit risk of the reporting entity in the fair value measurement when market participants would take into account any existing arrangements that mitigate credit risk exposure in the event of default (for example, a master netting agreement with the counterparty or an agreement that requires the exchange of collateral on the basis of each party’s net exposure to the credit risk of the other party). The fair value measurement shall reflect market participants’ expectations about the likelihood that such an arrangement would be legally enforceable in the event of default.

In addition to being applicable to offsetting positions in market risk, the portfolio valuation exception in ASC 820-10-35-18D can be used for a portfolio of eligible assets and liabilities entered into with a single counterparty so that this portfolio can be valued on the basis of the entity’s net exposure to the counterparty’s credit risk or the net exposure of the counterparty’s credit risk to the entity provided that market participants would take into account existing arrangements between the parties that mitigate credit risk exposure (e.g., collateral posting or master netting arrangements). In this circumstance, the individual eligible assets and liabilities must be with the same counterparty but do not need to share the same exposures to market risk. Those assets and liabilities are first measured at fair value, with the exception of consideration of credit risk. The portfolio valuation exception is then applied to measure the net credit risk of the portfolio. The determination of the net credit risk valuation adjustment should take into account the relevant arrangements between the parties that result in a mitigation of credit risk. Such portfolio-level credit risk valuation adjustments must be allocated to the individual assets and liabilities within the portfolio (see Section 11.2.3.5.5 for more information about such allocations).

Footnotes

ASU 2022-03 (issued in June 2022) clarified this concept and added an example illustrating it (see ASC 820-10-55-22A). This clarification is consistent with our historical guidance.

The definition of a market participant in ASC 820-10-20 refers to parties that have a “reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary.” ASC 820-10-35-54A notes that “[a] reporting entity need not undertake exhaustive efforts to obtain information about market participant assumptions. However, a reporting entity shall take into account all information about market participant assumptions that is reasonably available.”

Quoted from the Background Information and Basis for Conclusions of ASU 2012-07. While this ASU specifically applies to impairment assessments of unamortized film costs, the requirement to consider all relevant information that is obtained after the measurement date but before the financial statements are issued (or available to be issued) is broadly applicable to all fair value measurements.

See ASC 820-10-35-54 in Section 10.4.2.

See ASC 820-10-35-54E in Section 10.6.1.

Note that this framework for evaluating subsequent information and events would not apply to (1) investments that are measured at NAV per share in accordance with the practical expedient in ASC 820-10-35-59 through 35-62 or (2) Level 1 inputs.

See Section 12.3.1.2 for discussion of the accounting for up-front costs when the FVO is elected for an eligible item.

For example, ASC 820-10-55-3(b) indicates that if an entity determines a fair value measurement for a machine that is installed and ready for use by using an observed price for a similar machine that is not installed or ready for use, the observed price should be “adjusted for transportation and installation costs so that the fair value measurement reflects the current condition and location of the machine (installed and configured for use).” Similarly, if an entity is estimating the fair value of a machine that is not installed and ready to use by using an observed price for a similar machine that is installed and ready for use, the observed price may need to be adjusted to reflect the fair value of the uninstalled machine. Thus, like the adjustments for transportation costs illustrated in Examples 10-7 and 10-8, adjustments for installation costs could be additive or subtractive.

As discussed in Section 4.3.2.2, the unit of account for a liability instrument that is measured at fair value excludes inseparable third-party credit enhancements in accordance with ASC 825-10-25-13. See also Section 10.2.7.3.

Although this EITF Issue was not codified, the concepts in it are consistent with the market-participant approach in ASC 820.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.