9.2 Transaction Price Is Not Fair Value

ASC 820-10

30-3A When determining whether fair value at initial recognition equals the transaction price, a reporting entity shall take into account factors specific to the transaction and to the asset or liability. For example, the transaction price might not represent the fair value of an asset or a liability at initial recognition if any of the following conditions exist:

The transaction is between related parties, although the price in a related party transaction may be used as an input into a fair value measurement if the reporting entity has evidence that the transaction was entered into at market terms.
The transaction takes place under duress or the seller is forced to accept the price in the transaction. For example, that might be the case if the seller is experiencing financial difficulty.
The unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value. For example, that might be the case if the asset or liability measured at fair value is only one of the elements in the transaction (for example, in a business combination), the transaction includes unstated rights and privileges that are measured separately, in accordance with another Topic, or the transaction price includes transaction costs.
The market in which the transaction takes place is different from the principal market (or most advantageous market). For example, those markets might be different if the reporting entity is a dealer that enters into transactions with customers in the retail market, but the principal (or most advantageous) market for the exit transaction is with other dealers in the dealer market.

30-5 Paragraph 820-10-55-46 illustrates situations in which the price in a transaction involving a derivative instrument might (and might not) equal the fair value of the instrument.

As discussed above, transaction prices often will equal fair value on initial recognition. However, if a transaction is carried out under duress or is between related parties, or if other factors are present, the transaction price may not equal fair value on initial recognition.1 Therefore, an entity needs to take additional considerations into account in determining the fair value on initial recognition of an asset, liability, or equity instrument.

The table below gives examples of factors that may suggest that the transaction price does not represent the fair value of an asset, liability, or equity instrument on initial recognition.

Table 9-1

Factor	Example(s)
The transaction is between related parties, although the price in a related-party transaction may be used as an input into a fair value measurement if the entity has evidence that the transaction was entered into at market terms.	A parent company purchases a portfolio of troubled loans from its wholly owned subsidiary. The price exceeds the fair value because it incorporates a capital contribution from the parent to the subsidiary. ASC 850 contains guidance on determining whether a transaction is a related-party transaction.
The transaction takes place under duress or the seller is forced to accept the price in the transaction because of urgency (e.g., the seller is experiencing financial difficulty).	A hedge fund divests itself of nonmarketable assets to stave off a liquidity crisis. Thus, there was not adequate exposure to the market before the measurement date to allow for usual and customary marketing activities for transactions involving such assets or liabilities.
The unit of account represented by the transaction price differs from the unit of account for the asset or liability measured at fair value.	A multiple-element transaction in which the asset or liability measured at fair value is only one of the elements in the transaction (e.g., in a business combination). A transaction includes unstated rights and privileges that should be separately measured (e.g., the seller of real estate grants a non-interest-bearing loan to the buyer). A debt instrument is issued with an inseparable third-party credit enhancement (see Section 4.3.2.2). The transaction price includes transaction costs. See Section 10.2.5.3 for further discussion of transaction costs.
The market in which the transaction takes place differs from the principal or most advantageous market.	The transaction price of the interest rate swap (e.g., zero) does not necessarily represent fair value from the dealer’s perspective at initial recognition. The dealer has access to the dealer market (i.e., with dealer counterparties).

ASC 820-10-55-46 through 55-49 also include the following example illustrating a situation in which it would not be appropriate to presume that the transaction price represents fair value as of the date of initial recognition:

ASC 820-10

Example 5: Transaction Prices and Fair Value at Initial Recognition — Interest Rate Swap at Initial Recognition

55-46 This Topic (see paragraphs 820-10-30-3 through 30-3A) clarifies that in many cases the transaction price, that is, the price paid (received) for a particular asset (liability), will represent the fair value of that asset (liability) at initial recognition, but not presumptively. This Example illustrates when the price in a transaction involving a derivative instrument might (and might not) equal the fair value of the instrument at initial recognition.

55-47 Entity A (a retail counterparty) enters into an interest rate swap in a retail market with Entity B (a dealer) for no initial consideration (that is, the transaction price is zero). Entity A can access only the retail market. Entity B can access both the retail market (that is, with retail counterparties) and the dealer market (that is, with dealer counterparties).

55-48 From the perspective of Entity A, the retail market in which it initially entered into the swap is the principal market for the swap. If Entity A were to transfer its rights and obligations under the swap, it would do so with a dealer counterparty in that retail market. In that case, the transaction price (zero) would represent the fair value of the swap to Entity A at initial recognition, that is, the price that Entity A would receive to sell or pay to transfer the swap in a transaction with a dealer counterparty in the retail market (that is, an exit price). That price would not be adjusted for any incremental (transaction) costs that would be charged by that dealer counterparty.

55-49 From the perspective of Entity B, the dealer market (not the retail market) is the principal market for the swap. If Entity B were to transfer its rights and obligations under the swap, it would do so with a dealer in that market. Because the market in which Entity B initially entered into the swap is different from the principal market for the swap, the transaction price (zero) would not necessarily represent the fair value of the swap to Entity B at initial recognition.

An initial difference between the transaction price and fair value may also result from an entity’s election to use mid-market pricing or other pricing conventions as a practical expedient in accordance with ASC 820-10-35-36D. See Example 9-2 for an illustration of this concept.

Connecting the Dots

ASC 946 requires investment companies to report investments (including investments in securities, common stock, or partnership interests for which market quotations are not readily available, such as private equity investments) at fair value as of each reporting date. An entity may also measure equity investments at fair value through earnings under ASC 321.

At initial recognition, an entity may be able to conclude that the initial transaction price (excluding transaction costs) is fair value (or may conclude that the equity security should be initially recognized at the transaction price). For subsequent reporting periods, ASC 820 requires entities to (1) use an appropriate valuation technique or combination of techniques to measure fair value (see ASC 820-10-35-24B) and (2) apply the valuation technique(s) consistently unless a change results in a measurement that is equally or more representative of fair value (see ASC 820-10-35-25). For private equity investments, valuation techniques that may be appropriate include market approaches (such as multiples of earnings) and income approaches (such as free cash flows-to-equity discount). While an entity may use the initial transaction price (excluding transaction costs) as a starting point for valuations on subsequent reporting dates (e.g., by calibrating certain parameters of its valuation model), it cannot assume that the initial transaction price (excluding transaction costs) equals fair value for subsequent reporting periods.

In applying valuation techniques, an entity should consider whether any change has occurred in factors affecting the investment’s fair value and should update its fair value measurement accordingly. Such considerations include market conditions (such as equity market conditions, discount rates, or market risk premiums) and investment-specific factors (such as projected cash flows or entity-specific risk factors). The following nonexhaustive list of factors for entities to consider in estimating the fair value of securities for which market quotations are not available is based, in part, on ASC 940-820-30-1:

The issuer’s financial standing.
The issuer’s business and financial plan.
The cost as of the purchase date.
The liquidity of the market.
Contractual restrictions on salability.
Pending public offerings for the financial instrument.
Pending reorganization activity affecting the financial instrument (such as merger proposals, tender offers, debt restructurings, and conversions).
Reported prices and the extent of public trading in similar financial instruments of the issuer or comparable entities.
The issuer’s ability to obtain needed financing.
Changes in the economic conditions affecting the issuer.
A recent purchase or sale of the entity’s security.
Pricing by other dealers in similar securities.

9.2.1 Inception Gains and Losses

If fair value is the initial measurement attribute under other Codification topics, an entity needs to assess whether the transaction price represents fair value at inception by considering factors specific to the transaction, including whether one or more of the factors in ASC 820-10-30-3A are present. In many cases, it is inappropriate to record an inception gain or loss as of the date of initial recognition of an asset or liability.

At the 2006 AICPA Conference on Current SEC and PCAOB Developments, Joseph McGrath, then a professional accounting fellow in the SEC’s Office of the Chief Accountant, stated the following:

Given [ASC 820’s] exit price notion, fair value at initial recognition is [not] limited to transaction price. Rather, [ASC 820] states that the entity “shall consider factors specific to the transaction and the asset or liability.” [Footnote omitted] One such factor is whether the transaction occurs in a market other than the entity’s principal market. [Example 5 in ASC 820-10-55-46 through 55-49] illustrates this concept with the example of a securities dealer transacting with a customer in the retail market. In this example, the dealer’s fair value is not necessarily transaction price, since its principal market to exit the transaction may be different. . . .

[W]e have heard that some believe that it is “open season” on inception gains. I would caution those constituents that there continue to be many instances in which day one gains are not appropriate. [ASC 820] does not allow the practice of “marking to model” when the transaction occurs in the entity’s principal market. Rather, transaction prices would generally be used in such a circumstance, and the model would be calibrated to match transaction price. Continuing with the previous example, if the securities dealer transacts with another in the dealer market, absent satisfaction of any of the criteria in [ASC 820-10-30-3A], transaction price would likely be the best estimate of the fair value. As a result, there would not be any inception gain.

Some have asserted that the use of a pricing model would automatically lead to day two gains even in situations where there was not an inception gain. Again, a word of caution, assuming that an entity uses a pricing model to value its transaction in subsequent periods, [ASC 820] would indicate that the pricing model should be calibrated, so that the model value at initial recognition equals transaction price. As a result of calibrating the model, simply using a pricing model to determine fair value would not result in day two gains, unless there were changes in the underlying market conditions. [Footnote omitted]

Mr. McGrath’s remarks indicate that if none of the factors in ASC 820-10-30-3A are present, the transaction price is most likely the best estimate of fair value. However, if any of the criteria in ASC 820-10-30-3A are met, there may be a difference between the transaction price and fair value. For example, ASC 820-10-30-3A(c) indicates that the transaction price might not represent fair value at initial recognition if “the transaction price includes transaction costs.” That might be the case in a transaction that includes a structuring fee. In such a situation, entities should consider adjusting a model value for the profit margin that another market participant would demand in a transaction to transfer the instrument. This is consistent with the risk adjustment discussion in the ASC 820-10-20 definition of inputs.

The examples below illustrate the concepts discussed above related to the recognition of inception gains and losses.

Example 9-1

Interest Rate Swap Entered Into Between Retail Counterparty and Dealer

A retail counterparty enters into an interest rate swap with a dealer for no initial consideration (i.e., the transaction price is zero). Assume that the valuation model used to determine the fair value of the interest rate swap at inception is significantly influenced by unobservable inputs. The initial model value is a $1 million loss. The retail counterparty should not conclude that the transaction price represents fair value on initial recognition without further consideration. Instead, the retail counterparty needs to assess whether the transaction price represents fair value by considering factors specific to the transaction, including whether one or more of the following factors in ASC 820-10-30-3A are present:

The retail counterparty and the dealer are related parties.
The retail counterparty enters into the transaction under duress or is otherwise forced to accept the price in the transaction.
The transaction price is related to a unit of account that includes elements other than the asset or liability measured at fair value, such as an unstated right or privilege, another element, or transaction costs. For example, a retail counterparty may agree to a price that includes an embedded structuring fee (i.e., a transaction cost) for services that have already been rendered by a dealer. In this case, the retail counterparty would separately account for the structuring fee in accordance with another Codification topic. Depending on the nature of the structuring fee, the retail counterparty may recognize a separate expense (i.e., a loss) at inception.
The retail counterparty’s transaction does not occur in the principal or most advantageous market.

Notwithstanding the preceding discussion, inception gains for retail counterparties that are due to factors specific to the financial instrument with significant unobservable inputs are expected to be infrequent, and all entities should clearly document their ASC 820-10-30-3A analysis and assertions. Inception losses, however, are more common for retail counterparties as a result of bid-ask spread differences between the entry transaction and the hypothetical exit transaction. This is illustrated in the example below.

Example 9-2

Debt Security Purchased by Nondealer

Assume the following:

A nondealer purchases a debt security from a dealer at the ask price of $101.
The current market-observable bid price is $99.
The nondealer’s policy is to use a mid-level price ($100) for its fair value measurements.

By paying $101 (the ask price) and then immediately measuring the fair value at the mid-level price of $100, the nondealer will have incurred an inception loss of $1. This example illustrates how a nondealer might incur a loss at inception because of its policy for determining fair value within the bid-ask spread. That is, a nondealer may incur an inception loss depending on (1) where it has initially transacted within or outside the bid-ask spread and (2) its bid-ask pricing policy. An entity should apply the guidance in ASC 820-10-35-36C and 35-36D to determine its bid-ask pricing policy.

In some cases, an entity is prohibited from recognizing an inception gain or loss even if the transaction price is not fair value at inception of the contract. For example, ASC 815-15-30-2 provides guidance on determining the initial carrying amount of a host contract and an embedded derivative when separate accounting is required by ASC 815-15. ASC 815-15-30-2 requires that an entity use the “with-and-without” method to calculate the initial carrying amount of the host contract. Under the with-and-without method, the initial carrying amount of the embedded derivative component of a hybrid instrument is equal to its fair value at inception of the contract (as determined under ASC 820), and the initial carrying amount of the host contract equals the excess of the transaction price for the hybrid instrument over the initial fair value of the embedded derivative.

In a speech at the 2003 AICPA Conference on Current SEC Developments, John James, then a fellow in the SEC’s Office of the Chief Accountant, clarified that when using the with-and-without method, an entity is not permitted to recognize an “immediate gain or loss that would occur if the relative fair value method were used” (the relative fair value method is not permitted). Mr. James discussed a situation in which the SEC staff objected to an entity’s recognition of a day 1 gain on an embedded derivative when the entity believed that if that embedded derivative were issued on a freestanding basis, the entity would have met the conditions to recognize such a gain. The staff believed that ASC 815 was prescriptive regarding the initial measurement for both the host contract and bifurcated derivative (i.e., the with-and-without method).

On the basis of this speech, it would not be appropriate for an entity to record an inception gain or loss for a hybrid instrument with an embedded derivative that must be bifurcated and accounted for separately in accordance with ASC 815-15. Rather, the difference between the basis of the hybrid instrument and the inception-date fair value of the embedded derivative should be recorded as the initial carrying amount of the host contract. As a result, any day 1 gains and losses (observable or unobservable) related to separately measured embedded derivatives effectively would be applied to the basis of the host contract and recognized as the host contract affects earnings (e.g., amortized as a yield adjustment to a nonderivative host financial instrument). For hybrid instruments not carried at fair value in their entirety, entities should apply the guidance from ASC 815-15-30-2 and the related SEC speech. These requirements do not apply to hybrid instruments recognized at fair value in their entirety.

Footnotes

In the absence of such factors, the initial fair value of an asset, liability, or equity instrument would be its transaction price.

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