ASC 718 guidelines may result in overestimating liability for ASC 820

As part of financial reporting requirements in accordance with the Accounting Standards Codification (ASC) No. 820, “Fair Value Measurement,” companies are required to record the fair value of certain financial instruments, such as warrants, convertible debt and embedded derivatives. Volatility is one of the primary assumptions used in the valuation of these instruments. However, ASC 820 guidelines related to volatility1 do not prescribe a specific methodology or provide guidance for the calculation or measurement of historical or implied2 volatility. Instead, more broadly, ASC 820 states that the reporting entity should use “…the valuation technique(s) appropriate for the measurement, considering the availability of data with which to develop inputs that represent the assumptions that market participants would use when pricing the asset or liability…”3

Given the lack of specific guidance in ASC 820, management and valuation professionals often rely on the  ASC No. 718, “Compensation – Stock Compensation” and Staff Accounting Bulletin (SAB) Topic 14, “Share-Based Payment” guidance for deriving the expected volatility assumption.4 However, ASC 718 refers to the required measurement basis as the fair value-based method because the measurement method used in the valuation of employee awards described in ASC 718 is not fair value. Subsequently, the guidance related to the volatility provided in these two accounting standards is designed specifically for the valuation of employee awards and may not account for all the facts that market participants may consider in the development of the expected volatility assumption in accordance with ASC 820. Without careful consideration of the specific use of ASC 718/SAB Topic 14 guidelines and the differences embedded between these guidelines and ASC 820, there is a potential risk of overestimating the expected volatility assumption and, thereby, the associated liability.

Beware the differences
ASC 718 and SAB Topic 14 guidance related to volatility outlines a distinct set of principles. Under ASC 718 and SAB Topic 14 guidelines, historical realized volatility should be measured over the term corresponding to the expected life of the options.5 In addition, the guidelines specifically prohibit exclusion of periods of high volatility due to market factors, such as market bubbles and/or market crashes. Furthermore, ASC 718 and SAB Topic 14 indicate that the methodology for weighting historical and implied volatility should be used consistently from one reporting period to another to avoid manipulation of the stock compensation expense due to selection of the lower of two volatilities. ASC 718 and SAB Topic 14 guidelines do not allow for subjective adjustments to deviations from the principles outlined in the guidance.

Furthermore, contrary to the principles outlined in ASC 718 and SAB Topic 14, ASC 820 permits the application of adjustments (discounts) when those adjustments are warranted. Specifically, Accounting Standards Update 2011-04, “Fair Value Measurement (Topic 820) — Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs” (ASU 2011-04) indicates that “in the absence of a Level 1 input, a reporting entity should apply premiums or discounts when market participants would do so when pricing the asset or liability.”  

There is market evidence that suggests that investors do not price warrants using full observed historical or implied volatility. A sample of 76 transactions in nontraded warrants exercisable for shares of publicly traded companies from the LiquiStat™ database of private sales transactions on the Restricted Securities Trading Network indicated average and median discounts to Black-Scholes model values6 of 41.5% and 44.0%, respectively, and the overall range of discounts of 1.8% to 71.4%.7 The discounts to Black-Scholes model value were directly correlated with the moneyness8 of the warrants and the volatility. In general, the more warrants were out-of-the-money and the higher the volatility was, the larger the difference was between the Black-Scholes model value and the transaction value.

Given that a market participant applies a discount to a Black-Scholes model when estimating a fair value of the warrants, under ASU 2011-04 guidance, in the absence of a Level 1 input, we believe it would be appropriate to apply a similar discount to the Black-Scholes fair value of warrants calculated for financial reporting purposes under ASC 820. Ideally, that discount should take into consideration the moneyness factor and the unadjusted volatility of the underlying stock.

In addition to the market evidence for the warrant transactions, there is ample anecdotal evidence that convertible debt is not priced using full historical realized or implied volatility. Instead, convertible debt is priced, on average, at a discount, as compared to the company’s own nonconvertible debt with similar maturity or publicly traded comparable debt issuances.9 For example, using historical realized and/or implied volatility without any downward adjustments to value, newly issued convertible debt would result in the value of the debt exceeding the price paid or would cause the value of the conversion option to constitute an unreasonably high percentage of the hybrid instrument, indicating that the volatility input is too high.
“Volatility haircut” concept
Both the warrant transactions and the convertible debt issuances imply that a downward adjustment to volatility, known as a “volatility haircut,” is one appropriate methodology to incorporate market participant discounts when estimating the fair value of these instruments for ASC 820 purposes. This volatility haircut may be interpreted as an adjustment to the option pricing model to account for certain risks that are not incorporated into the model, such as lack of marketability of the underlying instrument.

Many professional valuation firms have developed qualitative and quantitative methodologies to determine the volatility haircut adjustment for warrants and convertible debt instruments valued under ASC 820 guidelines.

Overestimation of liability

The financial impact related to the fair value measurement of liabilities associated with warrant or debt issuances can be significant. It is management’s responsibility to accurately estimate the fair value associated with these instruments, without overburdening the company’s financial statements with the liability and the corresponding expense, which are too high.

When faced with applying ASC 820 guidance in estimating the fair value of the warrants and convertible debt, give careful consideration to the expected volatility assumption. Although ASC 718 and SAB Topic 14 guidelines can serve as a starting basis for estimating the expected volatility, consider the implied volatility and any additional discounts to volatility that a market participant would apply in estimating the fair value of these instruments. Talk to your auditors to understand their position on the historical volatility look-back period and “volatility haircut” topics.

Staying informed when preparing your valuation and considering guidance outside of ASC 718 and SAB Topic 14 to capture market participants’ point of view may result in a more accurate measure of the fair value.

1 ASC 820-10, 55-21 and 55-22.
2  Volatility derived from at-the-money or close to at-the-money exchange traded options on the subject company’s stock.
3  ASC 820-10-55-1.
4  AICPA Accounting and Valuation Guide, “Valuation of Privately-Held-Company Equity Securities Issued as Compensation,” provides additional comprehensive guidance for estimating the expected volatility for private companies.
5  718-10-55-37 provides for allowance of consideration of mean reversion of volatility (e.g., lower weighting on short-term high volatility and weighting more toward a longer term); however, it is not commonly used in the valuation practice.
6  For a nondividend-paying stock, the Black-Scholes model would result in the same value as a binomial lattice model. For a dividend-paying stock, application of the binomial lattice model would result in a higher value than a Black-Scholes model, all else being equal, thereby increasing the discount compared to the “model price.”
7  Source: Discounts for Illiquid Shares and Warrants: The LiquiStatTM Database of Transactions on the Restricted Securities Trading Network, Espen Robak, Pluris Valuation Advisors white paper.
8  Moneyness is the ratio or stock price to strike price. At-the-money warrants will exhibit the ratio of 1.0, while in-the-money and out-of-the-money warrants will exhibit a ratio of greater or less than 1.0, respectively.
9  Based on internal analysis conducted by Grant Thornton LLP. Since neither the market yield on convertible debt nor the expected volatility used by investors to price the security are observable, it is hard to determine whether debt is priced using the higher yield or lower volatility, as both figures have a negative impact on the fair value of a convertible debt. However, given the LiquiStatTM Database warrant discount observations, we believe that the conversion option in convertible debt is priced using a lower volatility.
10  Long-term Equity AnticiPation Securities (LEAPS), are American-style, long-term put and call contracts on common stock. LEAPs provide the holder the right to purchase, in the case of a call, or sell, in the case of a put, a specified number of stock shares at a predetermined price up to the expiration date of the option, which can be up to three years in the future.
11  SAB Topic 14, Section D, Question 3, Response Section 4.
12  SAB Topic 14, Section D, Question 1