ASC 820 Portfolio Valuations
July 29, 2016
What Business Leaders Need to know about ASC 820 Portfolio Valuations
Why A Portfolio Valuation?
Complex valuation topics can come into play while trying to value portfolios containing assets or liabilities that are “illiquid” (i.e. have no “active market” currently in place). These issues can be particularly relevant to entities such as hedge funds, private equity firms, and insurance companies, that are required under US GAAP to value such assets and liabilities at fair value for financial reporting. Such portfolios can have holdings such as illiquid equity or debt, real estate investments, privately held businesses, derivatives, etc. Fair market valuations are essential to determining fair value on such holdings in order to provide accurate information to entities such as investors, creditors, and the firm itself. While the broad ASC 820 doesn’t only apply to assets or liabilities with no active market, the difficulties in doing a portfolio valuation arise when there is no clear observable inputs (quoted market prices of identical assets or liabilities).
What is ASC 820?
Section 820 of the Accounting Standards Codification (ASC 820) lays the foundation for how portfolio valuations are to be performed. The FASB defines fair value as “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 focuses on a price where a hypothetical transaction could occur from the perspective of the participant who holds the asset or liability. Thus, the definition focuses on the exit price, not the price paid to acquire the asset (the entry price).
ASC 820 requires that reporting of assets at fair value considers factors such as risk, market participants, the asset or liability itself, and whether the transaction took place in a primary or other market. All these contributing factors need to be meticulously considered when determining fair value.
Can I perform my own Portfolio Valuation?
While no law prohibits a firm or investment manager from performing a valuation on their own portfolio, doing carries some risk. Given that there is no given formula in place to calculate fair value, much of the valuation is driven by assumptions and the judgement of the individuals performing the valuation. With this being the case, there may be significant risk in the potential for conflict of interest inherent in valuing one’s own portfolio – especially if changes in methodology can be observed over time. In the event of an audit or lawsuit, if the valuation is found to be misleading or inaccurate, the company can be subject to restatement requirements as well as legal ramifications if investors have been misled. Having a third-party firm perform the valuation will mitigate risk of a conflict of interest and can provide much greater support in the event the valuation is questioned or audited.
In addition to mitigating risk, many third-party firms are well qualified technically to meet the requirements of ASC 820, which focuses on a market-based measurement as opposed to an entity-specific measurement. Thus, the valuation should place more weight on market data from sources independent of the entity receiving the portfolio valuation. In the event there is scarce market data available, a firm can include their own assumptions based upon the best information available. Even when an entity is forced to only provide its own assumptions, it would be advantageous to have a valuation firm review those assumptions and ensure they are congruent with what the third party firm observes independently in the marketplace.
With a third-party firm performing the valuation, the reporting entity will still need to be forthright in providing information to the valuation firm. Clear information will need to be given on the condition of the portfolio assets or liabilities, and any restrictions on any items in the portfolio. The information provided by the reporting entity will be key in the assumptions used in calculating fair value.
How to select a Valuation Firm?
With the many different types of assets and liabilities that can exist within a portfolio, one key is to ensure the firm chosen to perform a portfolio valuation has experience in valuing holdings similar to the holdings in the portfolio needing a valuation. Asking for examples of valuations of similar portfolio holdings, as well as clarification on the methodologies that will be used to conclude on value are helpful in assessing a valuation firm. In receiving an example report a portfolio manager can have a clear vision of the information that will be conveyed in a finalized report. When viewing a sample report, the valuation firm must clearly present the inputs used to develop fair value as per ASC 820.
While getting a portfolio valuation can be a daunting task, a valuation firm can help to alleviate risk from a conflict of interest and an appropriate value can be placed on any portfolio.