A Look at Fair Value Measurement — ASC 820 Level 3

by Stephen McCarthy, CPA, The Presidents Forum, and Peter L. Lohrey, Phd., Paritz & Company, PA – September 13, 2017
A Look at Fair Value Measurement — ASC 820 Level 3

Amazon went public in May 1997, with an initial share price of $18 and a valuation of $440 million. Twenty years later, Amazon’s shares crossed the $1,000 mark, and the company has a valuation of $478 billion. This raises the question, “How is value determined?”

The Financial Accounting Standards Board’s (FASB) topic ASC 820-10-20 sets the standard for Fair Value Measurement and Disclosure: “Fair value is 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.” ASC 820 defines fair value, establishes a framework for measuring it and expands disclosures about fair value measure­ments. This ASC defines fair value as the price to sell an asset or liability (exit price) not the price to acquire an asset or liability (entry price).

ASC 820 Hierarchy

The ASC 820 fair value hierarchy is out­lined in Table 1. Its goal is twofold:

  1. Valuation, to ensure that specified assets and liabilities are recorded at fair value
  2. Disclosure, to increase consistency and comparability in reporting fair values

Obviously, level 3 transactions are the most complicated because the value of the asset or liability requires the professional judgment of unobservable inputs.

Illustration of an ASC 820 Level 3 Assertion

A U.S. publicly traded company (Company A) owns a 100-percent interest in a pharmaceutical company (subsidiary) located in China (Company B). In a negotiated, arms-length transaction, Company B acquires three patents from a Chinese competitor (Company C). In return, Company A pays to Company C, 3 percent of the stock of Company B. Hence, valuation experts, hired by Com­pany A, must determine two separate values: the value of the patents acquired and the value of the common stock of Company B.

This situation presents three challeng­es for the auditor who must validate the client’s assertions:

  1. What is the value of the com­mon stock of Company B?
  2. What is the value of the three patents?
  3. How should the U.S. publicly traded parent company report this transaction in its next SEC filing?

Approach and Techniques 

In an Accounting Standards Update in May 2011, the FASB issued clarification on the valuation approach and techniques to be used under ASC 820 as outlined in Table 2. The goal of Company A’s experts is to utilize a valuation approach that maximizes the value of observable and unobservable inputs. However, in this case, the use of Level 3 unobservable inputs is the only way to value the three patents, hence, the valuation professional must mark the value to a model and not to the market.

Fair Value Accounting Assertions 

The required disclosure of the valuation approach must reflect methods that are consistently applied. The disclosure also needs to explain a change in either the approach or technique if necessary. Level 3 assertions should be supportable especially if they are material.

What Should An Auditor Do?

The auditor should refer to newly issued guidance, utilized by the valuation pro­fession’s newest credential — Certified in Entity and Intangible Valuations (CEIV) given by the AICPA — along with two in­ternational valuation professional organiza­tions. This document, entitled “Application of the Mandatory Performance Framework, Version 1.0,” was issued in January 2017. Specifically, Section A3 of this document, “Valuation of Intangible Assets, Certain Li­abilities, and Inventory Guidance,” provides an auditor with guidance about the type of documentation that must be provided.

In short, the answer to this ASC 820 Level 3 example is:

  1. The common stock of the private, wholly-owned Chinese subsidiary should be valued using IFRS 3.
  2. The value of the three patents should be determined by their relative value to each other, with their total value being compared to 3 percent of the value of the wholly-owned Chi­nese subsidiary’s common stock.
  3. The U.S. publicly traded parent should report this transaction under ASC 805 and not IFRS 3.

Value is determined by quoted prices, com­parable prices or various financial models. U.S. publicly traded companies, like Amazon, have quoted prices which provide these companies value under level 1 assertion. Level 2 and 3 assertions are subjective which makes the valuation more complicated. Use of a valuation professional is required.

Peter Lohrey

Peter Lohrey, PhD, CVA, CDBV, is the director of the forensic and valuation services department at Paritz & Company, PA. He is also an assistant accounting professor at Montclair State University.
Stephen F. McCarthy

Stephen F. McCarthy

Stephen F. McCarthy, CPA, CGMA, M.B.A., is the owner of The Presidents Forum. He is a member of the NJCPA and can be reached at stevemccarthy@thepresidentsforum.com.

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This article appeared in the September/October 2017 issue of New Jersey CPA magazine. Read the full issue.