10.4 Inputs to Valuation Techniques
10.4.1 General
ASC 820-10
General Principles
35-36 Valuation techniques
used to measure fair value shall maximize the use of
relevant observable inputs and minimize the use of
unobservable inputs.
35-36A Examples of markets
in which inputs might be observable for some assets and
liabilities (for example, financial instruments) include
exchange markets, dealer markets, brokered markets, and
principal-to-principal markets.
35-36B A reporting entity
shall select inputs that are consistent with the
characteristics of the asset or liability that market
participants would take into account in a transaction
for the asset or liability (see paragraphs 820-10-35-2B
through 35-2C). In some cases, those characteristics
result in the application of an adjustment, such as a
premium or discount (for example, a control premium or
noncontrolling interest discount). However, a fair value
measurement shall not incorporate a premium or discount
that is inconsistent with the unit of account in the
Topic that requires or permits the fair value
measurement. Premiums or discounts that reflect size as
a characteristic of the reporting entity’s holding
(specifically, a blockage factor that adjusts the quoted
price of an asset or a liability because the market’s
normal daily trading volume is not sufficient to absorb
the quantity held by the entity, as described in
paragraph 820-10-35-44) rather than as a characteristic
of the asset or liability (for example, a control
premium when measuring the fair value of a controlling
interest) are not permitted in a fair value measurement.
In all cases, if there is a quoted price in an active
market (that is, a Level 1 input) for an asset or a
liability, a reporting entity shall use that quoted
price without adjustment when measuring fair value,
except as specified in paragraph 820-10-35-41C.
Pending Content (Transition
Guidance: ASC 820-10-65-13)
35-36B A reporting entity shall select
inputs that are consistent with the
characteristics of the asset or liability that
market participants would take into account in a
transaction for the asset or liability (see
paragraphs 820-10-35-2B through 35-2C). In some
cases, those characteristics result in the
application of an adjustment, such as a premium or
discount (for example, a control premium or
noncontrolling interest discount). However, a fair
value measurement shall not incorporate a premium
or discount that is inconsistent with the unit of
account in the Topic that requires or permits the
fair value measurement. Premiums or discounts that
reflect size as a characteristic of the reporting
entity’s holding (specifically, a blockage factor
that adjusts the quoted price of an asset or a
liability because the market’s normal daily
trading volume is not sufficient to absorb the
quantity held by the entity, as described in
paragraph 820-10-35-44) rather than as a
characteristic of the asset or liability (for
example, a control premium when measuring the fair
value of a controlling interest) are not permitted
in a fair value measurement. Similarly, a discount
applied to the price of an equity security because
of a contractual sale restriction is inconsistent
with the unit of account being the equity
security. A contractual sale restriction is a
characteristic of the reporting entity holding the
equity security rather than a characteristic of
the asset and, therefore, is not considered in
measuring the fair value of an equity security
(see paragraphs 820-10-55-52 through 55-52A). A
contractual sale restriction prohibiting the sale
of an equity security is a characteristic of the
reporting entity holding the equity security and
shall not be separately recognized as its own unit
of account. In all cases, if there is a quoted
price in an active market (that is, a Level 1
input) for an asset or a liability, a reporting
entity shall use that quoted price without
adjustment when measuring fair value, except as
specified in paragraph 820-10-35-41C.
Under ASC 820, a fair value measurement should maximize the use of observable
inputs and minimize the use of unobservable inputs. Furthermore, the inputs used
in a valuation technique must be selected on the basis of the inputs that market
participants in the principal (or most advantageous) market would select after
considering the characteristics of the asset, liability, or equity-classified
instrument that is being measured at fair value.
If an entity is using a valuation technique to determine fair value and has
information indicating that market participants would use different inputs or
assumptions, the entity cannot choose to rely on its own information in
determining what inputs or assumptions to use, because a fair value measurement
is market-based rather than entity-specific. These concepts are addressed in the
definition of fair value as well as in a number of paragraphs in ASC 820 (e.g.,
ASC 820-10-05-1C, ASC 820-10-35-53, ASC 820-10-35-54A, and ASC 820-10-35-54E).
For more information, see Section
8.4.2.2.
10.4.2 Risk Adjustments When Significant Unobservable Inputs Are Used in Valuation Techniques
In accordance with the prioritization of inputs required by the
fair value hierarchy, an entity’s valuation technique should incorporate
relevant observable inputs (i.e., Level 1 and Level 2 inputs) whenever they are
available; however, if relevant observable inputs are not available, the entity
uses unobservable inputs (i.e., Level 3 inputs). ASC 820-10-35-53 indicates that
unobservable inputs must “reflect the assumptions that market participants would
use when pricing” an asset, liability, or instrument classified in an entity’s
stockholders’ equity. When using unobservable inputs, entities should consider
whether risk adjustments are necessary on the basis of whether market
participants would require such adjustments. ASC 820-10-35-54 states:
Assumptions about risk include the risk inherent in a
particular valuation technique used to measure fair value (such as a
pricing model) and the risk inherent in the inputs to the valuation
technique. A measurement that does not include an adjustment for risk
would not represent a fair value measurement if market participants
would include one when pricing the asset or liability. For example, it
might be necessary to include a risk adjustment when there is
significant measurement uncertainty (for example, when there has been a
significant decrease in the volume or level of activity when compared
with normal market activity for the asset or liability, or similar
assets or liabilities, and the reporting entity has determined that the
transaction price or quoted price does not represent fair value, as
described in paragraphs 820-10-35-54C through 35-54J).
Nonperformance and liquidity are risks that market participants may consider
under ASC 820. For an example illustrating how these risks may affect the fair
value measurement, see ASC 820-10-55-90 through 55-98 (also see
Section 10.6.4). Market participants may also consider
other risks, including, but not limited to, model uncertainty risk and risks
arising from the inability to hedge an underlying risk in an asset, liability,
or instrument classified in an entity’s stockholders’ equity.
It may be difficult to determine a risk adjustment that a market participant
would demand in an assumed transaction because the inputs in such a transaction
might not be directly observable. In such situations, an entity should look
beyond its own policies and transactions and consider the risks from a market
participant’s point of view.
When using Level 3 inputs, an entity may need to consider the following items,
when applicable, to incorporate market participants’ assumptions:
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Recent transactions of a similar nature and duration.
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Common industry practices.
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Historical trends and settlements of past transactions.
An entity may be able to calibrate its valuation technique to observed
transaction prices to determine whether the risks that market participants would
demand to be compensated for have been appropriately incorporated into the
technique (see Section 10.3.3). See
Section 10.6 for further discussion of
adjustments that may be necessary when the volume or level of activity for an
asset or liability has significantly decreased.
10.4.3 Premiums or Discounts Based on Size of a Position
10.4.3.1 General
ASC 820-10-35-36B addresses when a fair value measurement should include a
premium or discount as a result of the size of an asset, liability, or
instrument classified in an entity’s stockholders’ equity. In a manner
consistent with the guidance on transfer restrictions (see Section 10.2.2.2), a fair value measurement
includes a premium or discount that reflects the size of the item only if
size is a characteristic of the asset, liability, or instrument classified
in stockholders’ equity. A fair value measurement cannot include “[p]remiums
or discounts that reflect size as a characteristic of the . . . entity’s
holding” (i.e., a blockage factor) rather than as a characteristic of the
asset, liability, or instrument classified in stockholders’ equity that is
determined on the basis of its unit of account under other Codification
topics (e.g., a control premium or minority interest discount that is
appropriate on the basis of its unit of account). ASC 820-10-35-36B
indicates that when “there is a quoted price in an active market . . . for
an asset or a liability” (i.e., a Level 1 input), an entity must “use that
quoted price without adjustment when measuring fair value, except as
specified in paragraph 820-10-35-41C.” However, even if a fair value
measurement is categorized within Level 2 or Level 3 of the fair value
hierarchy in its entirety, the fair value measurement cannot include a
premium or discount for size (e.g., a blockage factor) when this premium or
discount results from the size of an entity’s holding rather than from a
characteristic of the item being valued.
10.4.3.2 Unit of Account
The determination of whether size is a characteristic of an asset, liability,
or instrument classified within an entity’s stockholders’ equity (and thus
whether the fair value measurement should include a premium or discount for
size) must be made on the basis of the unit of account for the item subject
to the fair value measurement. The unit of account is generally determined
under other Codification topics. See Chapter
4 for discussion of the unit of account.
ASC 820-10-35-44 addresses the unit of account for an asset or liability that
is traded in an active market:
If a reporting entity holds a position in a single asset or liability
(including a position comprising a large number of identical assets
or liabilities, such as a holding of financial instruments) and the
asset or liability is traded in an active market, the fair value of
the asset or liability shall be measured within Level 1 as the
product of the quoted price for the individual asset or liability
and the quantity held by the reporting entity. That is the case,
even if a market’s normal daily trading volume is not sufficient to
absorb the quantity held and placing orders to sell the position in
a single transaction might affect the quoted price.
The same “price times quantity” (or “P × Q”) approach must
be applied in other situations for which the unit of account is an
individual asset or liability. Thus, as discussed in Section 10.4.3.3, blockage factors are
generally prohibited under ASC 820.
10.4.3.3 Blockage Factors
As described in ASC 820-10-35-36B, a blockage factor represents a discount
that “adjusts the quoted price of an asset or a liability because the
market’s normal daily trading volume is not sufficient to absorb the
quantity held by the entity.” The basic principle in ASC 820-10-35-36B is
that blockage factors are prohibited at all levels of the fair value
hierarchy. An adjustment to a quoted price of an individual asset or
liability to reflect a blockage factor is not permitted under ASC 820 when
the unit of account for the asset or liability is the individual instrument
(i.e., the unit of account for the holding under U.S. GAAP is aligned with
the unit of account related to the quoted price). For example, if an entity
holds a large position in a publicly traded common stock and would expect to
sell the position in a single transaction (i.e., a large block), the price
it would receive would reflect a discount to the product of the quoted
market price and the number of shares held; however, that discount should
not be reflected in a fair value measurement because it reflects the size of
the entity’s holding as opposed to a characteristic of the asset held.
However, if the unit of account for fair value measurement purposes is the
entire holding (i.e., entire position), an adjustment to reflect the size of
the holding may be appropriate. Furthermore, if the unit of valuation
reflects the entire holding, an adjustment to reflect the size of the
holding may be appropriate even if the unit of account differs from the unit
of valuation and application of a blockage factor at the unit-of-account
level would be inappropriate. Thus, a discount that adjusts a quoted price
of an asset or liability to reflect a blockage factor could, in certain
circumstances, be consistent with the definition of fair value in ASC
820.
An entity would use a blockage factor (if market participants would
incorporate one) when it applies the portfolio valuation exception in ASC
820-10-35-18D through 35-18L. ASC 820-10-35-18D permits an 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” (emphasis added). See Section 10.2.8.1 for more information about
the portfolio valuation exception.
The three examples below further illustrate the application
of blockage factors in fair value measurements.
Example 10-14
Bond Forward Contract — Blockage Factor Is
Appropriate
Entity M enters into a single-bond forward contract
for the purchase of $1 billion in U.S. Treasury
bonds. The contract is accounted for as a derivative
instrument under ASC 815 and cannot be separated
into denominations.
Quotes are available for futures contracts based on
U.S. Treasury bonds that have a face value or
notional amount of $100,000. Entity M might
determine the fair value of its investment by
multiplying the available quote by 10,000. However,
this approach would not accurately reflect the
characteristics of the contract, namely that the
notional amount of M’s contract is $1 billion.
According to ASC 820-10-35-36B, “[a] reporting
entity [should] select inputs that are consistent
with the characteristics of the asset or liability
that market participants would take into account in
a transaction for the asset or liability.” In this
case, market participants would consider that, given
the acquisition of the investment from M, a purchase
of the entire contract would be required, of which
the $1 billion notional amount is a
characteristic.
Thus, it would be appropriate for M to adjust the
observed $100,000 notional prices related to the
bond forward contract for the size of its holding
(i.e., one contract with a notional amount of $1
billion) because the size of the holding is a
characteristic of the investment and both the unit
of account and the unit of valuation are the $1
billion contract.
Example 10-15
Bond Futures Contract — Blockage Factor Is Not
Appropriate
Entity N enters into 10,000 bond futures contracts,
each with a notional amount of $100,000 (i.e., total
notional amount of all contracts is $1 billion). The
contracts are accounted for as derivative
instruments under ASC 815. Quotes are available for
futures contracts based on U.S. Treasury bonds that
have a face value or notional amount of
$100,000.
In this case, under ASC 820, N would not be permitted
to consider its entire holding of 10,000 bond
futures contracts as the unit of valuation in a fair
value measurement because ASC 815 establishes the
unit of account as each individual bond futures
contract. Aggregating the bond futures contracts
into a single unit of valuation would be
inconsistent with ASC 820-10-35-36B. As a result, a
blockage factor is not permitted. Rather, the fair
value of N’s aggregate holding is equal to the
quoted price of a single bond futures contract with
a $100,000 notional amount multiplied by the 10,000
bond futures contracts held.
Example 10-16
Application of the Portfolio Valuation
Exception
Entity O holds 15 long-term fixed-interest notes
receivable with various counterparties. To manage
its interest rate risk, O enters into 10 bond
futures contracts. Information about its risk
management strategies and related investments is
provided to management. The notes receivable and
futures contracts are both measured at fair value.
Further, quoted prices are available for the bond
futures contracts. However, O must use a combination
of observable and unobservable inputs to determine
the fair value for individual fixed-interest notes
receivable. Entity O must first determine the unit
of valuation to assess whether it may apply a
discount that reflects size as a characteristic of
its holding.
Generally, each individual note receivable, as well
as each individual bond futures contract, represents
a single unit of account and should be valued
separately (i.e., the unit of valuation would be
consistent with the unit of account). However, ASC
820-10-35-18D contains an exception to the ASC 820
measurement requirements regarding the unit of
valuation. As discussed in Section 10.2.8.1, O
must meet the following criteria in ASC
820-10-35-18E to apply this exception:
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It manages the group on the basis of the net exposure to interest rate risk in accordance with its documented risk management or investment strategy.
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It provides information on that basis about the group to the reporting entity’s management.
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It is required or has elected to measure the assets and liabilities in the group at fair value in the statement of financial position at the end of each reporting period.
In addition, O must consider whether the portfolio
that consists of 15 notes receivable and 10 bond
futures contracts achieves substantive offset. It
would not be appropriate for O to apply the
portfolio valuation exception in ASC 820-10-35-18D
if the portfolio is not substantive. For example, a
portfolio might not be substantive if it consisted
of 15 notes receivable and one bond futures
contract. In this example, without evidence to the
contrary, it would appear that the portfolio was
established to avoid the prohibition against
blockage factors.
Entity O meets these criteria with respect to the 15
notes receivable and 10 bond futures contracts and
measures the fair value of the portfolio on the
basis of its net exposure (i.e., net asset basis).
In this case, the net exposure is O’s unit of
valuation for this fair value measurement even if
prices are available for individual notes receivable
and bond futures contracts. Thus, it would be
appropriate for O to apply a discount that reflects
size as a characteristic of its holding because size
is a characteristic of the net exposure (the
portfolio) that is being measured at fair value.
Entity O should measure the fair value of the group
in a manner consistent with how market participants
would price the net risk exposure as of the
measurement date.
10.4.3.4 Control Premiums
A control premium represents the amount a buyer is willing to pay for the
synergies and other potential benefits that would be derived from
controlling another entity. For example, incremental value could be
associated with a controlling interest in a publicly traded company. The
incremental value, or control premium, would represent the amount a buyer
may be willing to pay in excess of the market capitalization of the publicly
traded company (i.e., the product of the number of outstanding shares and
the quoted price per share) to obtain a 100 percent ownership interest in
that public company.
ASC 820-10-35-36B indicates that control premiums are not
permitted as adjustments to Level 1 measurements. However, for other fair
value measurements (i.e., Level 2 and Level 3 measurements), a control
premium may be appropriate. For example, in fair value measurements of
reporting units, a control premium may be relevant (see further discussion
in Section
10.10.3.2). As another example, when the fair value of a
noncontrolling interest is measured, a control premium and corresponding
minority interest discount may be appropriate. Entities must evaluate
relevant factors to determine whether a control premium is appropriate and,
if so, must estimate the amount of the control premium.
See AICPA Technical Q&As Section 6910.35 for guidance on the inclusion of
control premiums by investment companies when measuring the fair value of an
investee.
10.4.4 Inputs Based on Bid and Ask Prices
ASC 820-10
Inputs Based on Bid and Ask Prices
35-36C If an asset or a
liability measured at fair value has a bid price and an
ask price (for example, an input from a dealer market),
the price within the bid-ask spread that is most
representative of fair value in the circumstances shall
be used to measure fair value regardless of where the
input is categorized within the fair value hierarchy
(that is, Level 1, 2, or 3). The use of bid prices for
asset positions and ask prices for liability positions
is permitted but is not required.
35-36D This Topic does not
preclude the use of mid-market pricing or other pricing
conventions that are used by market participants as a
practical expedient for fair value measurements within a
bid-ask spread. For example, paragraphs 820-10-35-25
through 35-26 apply to a change from the use of
mid-market pricing or other pricing conventions to
another valuation technique. In addition, the disclosure
requirements in paragraph 820-10-50-2(bbb) apply to such
changes.
Pricing conventions are commonly used in certain industries. ASC 820-10-35-36C
states that the “use of bid prices for asset positions and ask prices for
liability positions is permitted but is not required.” Further, ASC
820-10-35-36D allows an entity to use “mid-market pricing or other pricing
conventions that are used by market participants as a practical expedient for
fair value measurements within a bid-ask spread.” An entity does not need to
meet any qualifying criteria to use such conventions.
The decision to use such pricing as a practical expedient is an accounting policy
election that should be consistently applied. It is generally inappropriate for
an entity to change to using a practical expedient once it has established a
policy of using the price that is most representative of fair value in the
circumstances. For an entity to change its approach, the change must result in
“a measurement that is equally or more representative of fair value in the
circumstances” in accordance with ASC 820-10-35-25. Typically, such a change
would not result in an equally or more representative measure of fair value.
In addition to establishing and consistently applying a policy
for fair value measurements within a bid-ask spread, an entity should disclose
its policy, if material.
The bid-ask spread practical expedient in ASC 820 is intended to be consistent
with the SEC’s ASR 118, which states, in part:
Some companies as a matter of general policy use the bid
price, others use the mean of the bid and asked prices, and still others
use a valuation within the range considered best to represent the value
in the circumstances; each of these policies is acceptable if
consistently applied.
A fair value measurement that represents the midpoint between an unadjusted Level
1 bid price as of the measurement date and an unadjusted Level 1 ask price as of
the measurement date may be categorized as a Level 1 fair value measurement. In
addition, a price within a bid-ask spread that is most representative of fair
value may be categorized as a Level 1 fair value measurement provided that both
the bid price and ask price represent Level 1 inputs as of the measurement
date.
Example 10-17
Use of Pricing Convention Practical Expedient
Entity P and Broker-Dealer Y hold the same debt security.
Broker-Dealer Y is a market maker in the debt security.
Entity P is not a market maker in the debt security.
Broker-dealers, including Y, trade the debt security in
an active market by using the bid and ask prices. Entity
P and Broker-Dealer Y’s respective policies are as follows:
-
Although P would most likely sell the debt security at or close to the bid price, P may establish and consistently apply a policy of using the mid-market price as the fair value of the debt security (and other similar securities). However, in accordance with ASR 118, which states, “[n]ormally, it is not acceptable to use the asked price alone,” it would be inappropriate for P to use the ask price for its long position.
-
Although Y may be able to exit at a price greater than the bid price, Y may have a consistently applied policy of carrying the same debt security (and other similar securities) by using the bid price.
See Section 9.2.1 for discussion of
inception gains and losses.
10.4.5 Income Taxes
10.4.5.1 Income Tax Rate Used When an Income Approach Is Applied
When a fair value measurement is determined under an income approach on the
basis of the present value of expected future cash flows, an entity may need
to include an adjustment for income taxes. Such an adjustment would be most
common in the valuation of nonfinancial assets or asset groups, such as a
business, reporting unit, long-lived asset group, or intangible asset.
When income taxes are reflected in a fair value measurement by using an
income approach, an entity would generally use the statutory rate unless
there is substantial evidence that another tax rate should be used. Under
ASC 820, fair value is determined from a market participant’s perspective.
Therefore, entity-specific data, such as an entity’s own effective tax rate
or the fact that the entity is not taxable (i.e., a partnership), are
usually irrelevant. The above guidance is consistent with that in Chapter 6
of the AICPA Accounting and Valuation Guide Assets Acquired in a Business
Combination to Be Used in Research and Development Activities, which
states, in part:
When choosing the appropriate tax rate, it is important to ensure
that it does not reflect specific tax circumstances of the subject
company, reporting entity, or both, which may occur by consideration
of net operating loss carryforwards, tax penalties, special
payments, and so forth. Instead, industry data demonstrating the tax
rates experienced by market participants would need to be considered
and compared with company-specific data and statutory rates.
The “tax rate experienced by market participants” would typically be the
statutory income tax rate unless there is substantial evidence that another
tax rate should be used.
10.4.5.2 Income Tax Benefits From Amortization of Intangible Assets
When an entity uses an income approach to measure the fair value of an
intangible asset, the measurement should include tax benefits that a market
participant would expect to receive for amortization expense that will be
deducted on its tax return(s) in the future. That is, when using an income
approach on a post-tax basis to measure the fair value of an intangible
asset, an entity should include all incremental cash flows. These would
include positive cash flows resulting from future income tax deductions for
the asset’s amortization expense (commonly referred to as tax amortization
benefits or “TABs”) that a market participant would expect to receive. A
market participant would expect to receive the TABs if the jurisdiction in
which the transaction is consummated allows for a deduction for amortization
expense of intangible assets. An entity must use judgment in determining
which jurisdiction should be considered from a market-participant
perspective.
At the 2006 AICPA Conference on Current SEC and PCAOB
Developments, Cheryl Tjon-Hing, a valuation specialist in the SEC’s Office
of the Chief Accountant, discussed how an entity should treat TABs in measuring
an asset’s fair value. She stated, in part:
Tax amortization benefits (TAB) represents, as its
name implies, the cash flow generated to an owner of an asset as a
result of being able to write-off the full fair value of that asset
for tax purposes — generally, this benefit may impact a fair value
conclusion, derived using an income approach, by as much as 20% to
30%. Now, it seems logical that the fair value of an asset should
not change just because of the way a transaction is structured. So TABs should be taken into account, in
determining asset fair values, no matter what the tax attributes
of a transaction are. But for those requiring more specific
guidance, FAS 109, paragraph A129 [footnote omitted] implicitly
states that TABs should be factored into an asset’s fair value. To
the extent that a portion of the step-up value is not deductible for
tax purposes, that is what deferred tax liabilities are for. In
fact, preparers of fair value measurements should be aware that if a
TAB is not factored into the fair value of an asset, there may be a
mismatch if any associated deferred tax liability is recorded, for
accounting purposes, in an acquisition transaction. Now, despite the
aforementioned accounting guidance, we often see that TABs are
excluded from asset fair values measured for business combinations
effected through a purchase of shares — usually, this is because
preparers argue that any step-up in fair value over tax value is not
deductible for tax purposes. [Emphasis added]
The AICPA Accounting and Valuation Guide Assets Acquired in a Business
Combination to Be Used in Research and Development Activities
includes a discussion of TABs and is a valuable resource for understanding
and applying valuation techniques to intangible assets. See Section 10.1 for more information about the
use of this practice aid.
10.4.6 Measuring the Fair Value of an Option
The term of an option that is measured at fair value under ASC 820 is one of the
many inputs into a fair value measurement. Before determining whether it should
use the expected term or the contractual term, an entity first needs to identify
and select a valuation technique (or techniques) that is appropriate in the
circumstances and for which sufficient data are available (see Section 10.3.2 for discussion of the use of
multiple valuation techniques). The valuation technique should incorporate the
inputs that market participants would consider when setting a price for the
instrument.
If market participants would consider the contractual term in pricing the option,
the entity’s valuation technique also must incorporate the contractual term as
an input, as might be the case, for example, with an option that can only be
exercised at maturity and that is valued by using the Black-Scholes-Merton
closed-form option pricing formula.
For options that may be terminated early, either upon early exercise or upon the
occurrence of a contingent event (e.g., an IPO, a change in control, or a
situation in which the share price exceeds a certain level), the entity may need
to use a valuation technique that can incorporate dynamic assumptions about the
term of the option. The fact that the term of the option is not fixed but
depends on future conditions or events can be explicitly modeled. For example,
an entity may use a binomial (lattice) model or simulation model that has been
designed to reflect not only the option’s contractual term but also early
exercise behavior (e.g., as a function of the stock price level) or the
likelihood that a contingency provision will be met at different points in time.
Depending on the facts and circumstances, the Black-Scholes-Merton closed-form
formula may not be an appropriate valuation technique for such an option,
irrespective of whether the contractual term or the expected term is used as an
input.
Entities should consider using a valuation specialist, as appropriate, and should
document their process of selecting a valuation technique and its associated
inputs, including their assumptions about the term used.