Understanding The Importance Of ASC 820 In Compliant Valuations
Posted by Valentiam Group on March 30, 2020
Accounting Standards Codification 820 (ASC 820) is the Financial Standards Accounting Board (FASB) standard for defining fair market value. Adopted by FASB in 2018, the standard applies to all entities for fiscal years beginning after December 15, 2019. It represents a significant departure from FASB’s former standard for establishing fair market value, which was more prone to overstating asset value and understating liabilities.
Under the previous guidelines, fair market value was defined by the purchase price of the asset. ASC 820 instead defines fair market value as the price the asset would command in a transaction between participants in the open market. The logic for the change is apparent; the value of any type of asset is the price it would bring in the market, rather than the price for which it was purchased. This shift in focus requires that assets and liabilities be valued at their current fair market value. In this article, we’ll outline ASC 820 valuation methods and examine the implications of ASC 820.
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ASC 820 Valuation Methods
Under ASC 820, valuation techniques for assets and liabilities use the observable data that a market participant would use in pricing the asset (or calculating a liability), based on market data from independent sources. ASC 820 requires that companies use actual market data when available, whether they are using the income, market, or cost approach for valuation. Where data is not available, models based on market data are to be used.
Furthermore, Section 820-10-35-6 states that “if there is a principal market for the asset or liability, the fair value shall represent the price in that market, even if the price in a different market is potentially more advantageous at the measurement date.” The guideline specifies that quoted prices in the principal active market provide the most reliable measure of fair value; they should be used to establish fair value measurement levels.
The financial statements for any entity, prepared in compliance with generally accepted accounting principles (GAAP), must follow ASC 820.
Impact Of ASC 820
In addition to bringing valuations of all assets and liabilities more into line with fair market values, ASC 820 has particular relevance to the valuation of employee benefit plans. (Tweet this!) Employee benefit plans subject to Title 1 of the Employee Retirement Income Security Act (ERISA) are required to have financial statements for employee benefit plans prepared in conformity with GAAP. Non-ERISA plan assets reported on financial statements of the plan sponsor may also be subject to ASC 820; specifically, all employee benefit plans that are audited must comply with ASC 820 requirements. Investments in those plans must generally be reported at fair value in financial statements, and ASC 820 establishes a fair value framework for their valuation.
Moreover, in certain cases where model risk is particularly significant, it might be prudent to shift valuations of derivatives and other instruments from models not materially reliant on actual market prices to simulation-based methods derived from the historical distribution of instrument prices.
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Topics: Business valuation