5 Things to Know about Fair Value and Equity Investments

The rules are changing for how companies report their investments in other businesses. As highlighted in a recent article in the New York Times, new rules from the FASB regarding how entities will have to measure certain equity investments (for example, Google’s equity holdings in Uber) may lead to increased earnings volatility and additional fair value complexities. Here are five things to know about the “new” rules and a few questions to consider as the implementation dates approach.

1. The rules are not actually new, but were part of the FASB’s Accounting Standards Update No. 2016-01, issued in January 2016. That said, the guidance will be effective for public companies beginning in fiscal 2018 (for calendar year-end filers) and for all other entities beginning in fiscal 2019.

2. The new rules will require entities to measure equity investments at fair value (other than those accounted for under the equity method or those that result in consolidation), with changes in fair value recognized in net income. In other words, many minority-position equity investments that are currently carried at cost may now have to be carried at fair value at the end of each reporting period.

3. What about securities without a readily determinable fair value, like private company shares? The new rules allow for a “measurement alternative” whereby an entity may elect to measure an equity security that does not qualify for the ASC 820 NAV practical expedient at: a) cost, minus b) impairment (if any), plus or minus c) changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.

4. The portion of the “measurement alternative” referencing orderly transactions for identical/similar investments raises a number of interesting valuation and accounting questions. Suppose Company A invests $10 million in a Series A financing round for Company B and initially carries its investment at $10 million cost. Six months later, Company B completes a Series B round at a higher “headline” valuation. How will this transaction be reflected in the fair value of Company A’s equity investment at quarter-end? What about the potential for different rights and preferences between the Series A and B classes of stock? What about Company C – who might also have bought Series A shares – will the reported fair value of its equity holdings be different or similar to that reported by Company A? These are all questions that will undoubtedly challenge registrants, auditors, and valuation specialists.

5. Entities that use the new “measurement alternative” will also be required to make a qualitative assessment at each reporting period as to whether the investment is impaired. If an equity security without a readily determinable fair value is impaired, an entity shall include an impairment loss in net income equal to the difference between the fair value of the investment and its carrying amount.

Admittedly, this summary only scratches the surface of the potential implications and practical implementation of the new rules. The NYT article also suggests that the rules could have the potential to confuse investors about the value of these types of investments and may have the unintended consequence of muddling the presentation of financial statements rather than clarifying them.  With rising levels of corporate venture capital investment, the number of companies with equity investments in early-stage or closely-held businesses on their balance sheets is only increasing. We will continue to monitor the development and commentary on these changes and will explore some additional angles on the subject in future posts.

Related Links:

• Corporate Venture Capital Trends
• How to Value Venture Capital Portfolio Investments
• In the Eye of the Beholder: Increasing SEC Scrutiny of Public Company Fair Value Marks
• Marking Illiquid Investments in Liquid Funds