Picture this: your venture-backed startup just closed its Series C. The CFO emails the auditor the year-end financials, expecting a quick sign-off on a warrant the company issued to a strategic partner. Three weeks later, the audit team comes back with eighteen questions about the volatility assumption, the risk-free rate, and why the discount for lack of marketability is "only" 18%. Welcome to ASC 820.
Fair value sounds intuitive—what would a willing buyer pay a willing seller—but the accounting standard behind it is one of the most disclosure-heavy, judgment-driven rules in U.S. GAAP. For private companies, funds, and the auditors who scrutinize them, getting it wrong can mean restatements, qualified opinions, or angry LPs. This guide walks through how the standard works, what regulators expect for Level 1, 2, and 3 inputs, and how to defend the hard-to-value positions that dominate most private portfolios.
What ASC 820 Actually Requires
ASC 820 (formerly FAS 157) is the FASB standard that defines fair value and prescribes a single framework for measuring it across U.S. GAAP. It does not tell you when to measure something at fair value—that's left to other standards like ASC 805 (Business Combinations), ASC 825 (Financial Instruments), or ASC 326 (Credit Losses). Instead, ASC 820 says: whenever you measure fair value, do it like this.
The bedrock definition is the exit price: the price you would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date. Two ideas hide in that sentence:
- Market participants, not the holder. You don't get to assume your favorite buyer, your unique synergies, or your private knowledge. The buyer is a hypothetical, knowledgeable, willing third party.
- Orderly transaction. Forced sales, distress sales, and fire-sale prices do not count. The transaction is what would happen in a normal market over a typical exposure period.
That framing matters because it forces companies to step outside their own perspective. A founder who "knows" the company is worth $100 million cannot just write that down. The question is what a market participant would pay today, considering risk, liquidity, and the specific terms of the instrument.
The Three-Level Hierarchy in Plain English
ASC 820 sorts every fair value measurement into one of three levels, based on the inputs used—not the asset itself. The higher up the hierarchy, the more objective and the easier to audit.
Level 1: Quoted Prices in Active Markets
Level 1 means an unadjusted, quoted price in an active market for an identical asset on the measurement date. Think: shares of Apple at the NYSE closing bell, or a U.S. Treasury bond with daily quotes.
This is the gold standard. There is no model, no judgment, no discount. You take the screen price, multiply by units held, and you're done. If you start adjusting the price (for block size, for restrictions, for a future event), you've left Level 1 and dropped to Level 2 or Level 3.
Level 2: Observable but Not Quoted
Level 2 inputs are observable, just not direct quotes for the identical asset on the active market. They include:
- Quoted prices for similar assets in active markets
- Quoted prices for identical assets in inactive markets
- Observable inputs other than quoted prices (yield curves, credit spreads, default rates, implied volatilities for liquid options)
- Market-corroborated inputs derived from observable data
A typical Level 2 example is an interest-rate swap valued by discounting future cash flows using the swap curve and a credit spread—all of those numbers come from observable markets, but no single screen tells you the exact value of your specific swap.
Level 3: Unobservable Inputs
Level 3 is where the standard earns its reputation. These are inputs that reflect the entity's own assumptions about what market participants would use—because there simply isn't enough market data to do otherwise. Private company common stock, complex derivatives, illiquid debt, and contingent earn-outs almost always land here.
For most venture and private equity funds, 80–95% of portfolio holdings are Level 3. That means the financial statements are dominated by valuations built on internal models, with assumptions auditors will probe in detail.
The "Lowest-Level Input" Rule
A measurement is classified by the lowest level of input that is significant to the overall fair value. If your DCF uses a publicly traded comparable's revenue multiple (Level 2-ish) but the projected revenue itself is unobservable and material, the whole measurement is Level 3. Don't classify based on the asset type—classify based on what is actually driving the number.
Valuation Techniques: Market, Income, and Cost Approaches
ASC 820 doesn't require any specific technique. It lists three approaches and says: use one or more, consistently, in a way that maximizes observable inputs.
Market approach. Use prices from market transactions for identical or comparable assets. For a private company, this often means trading multiples of public peers (EV/Revenue, EV/EBITDA), recent transactions in the same vertical, or—most powerfully—a recent financing round in the same company. A backsolve from a fresh round is usually the strongest Level 3 data point an auditor will accept.
Income approach. Discount future cash flows or earnings to a present value. The classic execution is a discounted cash flow (DCF) model with a build-up of the discount rate (risk-free rate + equity risk premium + size premium + company-specific risk). For intangibles, the Multi-Period Excess Earnings Method (MPEEM) isolates cash flow attributable to a single asset.
Cost approach. Estimate what it would cost to replace the asset's service capacity today (replacement cost new, less depreciation and obsolescence). Most useful for specialized equipment or assembled workforces, rarely for financial instruments.
A defensible Level 3 measurement usually triangulates: market approach as a sanity check, income approach as the primary methodology, and a calibration back to the most recent observable transaction whenever one exists.
The Two Categories That Trip Up Private Companies
Equity Stakes in Other Private Companies
If your company holds preferred stock in another startup—because of a partnership, a corporate venture investment, or a SAFE that converted—you owe a fair value measurement every reporting date. Cost is not a free pass; ASC 321 (or 820 if elected) requires reassessment whenever there's an observable price change or an impairment indicator.
The two-step framework most funds use:
- Determine enterprise value. Use a market approach (multiples from comparables and recent rounds) or income approach (DCF).
- Allocate to the capital structure. A simple pro-rata "current value" allocation works for early-stage companies with little exit visibility, but later-stage companies typically require an Option Pricing Method (OPM) or a Probability-Weighted Expected Return Method (PWERM) to reflect the different payoff structures of preferred, common, and convertible securities.
Then apply a Discount for Lack of Marketability (DLOM)—usually 15–30% depending on stage and expected time to liquidity—and you have your fair value per share.
Contingent Consideration (Earn-Outs)
When a buyer agrees to pay extra based on the target hitting future milestones, ASC 805 requires the buyer to record that earn-out at fair value on the acquisition date and remeasure it every period until settlement. ASC 820 governs how.
A simple earn-out tied to a single revenue threshold can be valued with a probability-weighted scenario analysis. But the moment payouts have caps, floors, catch-ups, multi-year metrics, or correlation between underlying drivers, you need a Monte Carlo simulation that models thousands of possible paths and discounts each payoff back to today.
Key inputs auditors will challenge:
- Volatility of the underlying metric (often modeled from public comp revenue volatility or fitted to management forecasts)
- Discount rate, which has two components: the risk-free rate for the time value of money, and a credit spread reflecting the buyer's nonperformance risk (because the seller is essentially holding the buyer's IOU)
- Correlation assumptions when multiple metrics drive a single payout
Remember: the earn-out liability moves every period, and changes hit the income statement. A poorly built initial model creates volatility in earnings for the entire earn-out period.
What the Disclosures Actually Look Like
ASC 820 mandates a parallel set of disclosures designed to give financial-statement readers enough information to assess the quality of every fair value number.
For Level 1 and 2: disclose the fair value, the level, and a brief description of the valuation technique and inputs.
For Level 3, the requirements expand significantly:
- Quantitative information about unobservable inputs. Public entities must show the range and weighted average of each significant input (discount rates, growth rates, DLOMs, volatilities). Nonpublic entities can skip the range and weighted average but must still disclose the inputs themselves and how they were derived.
- Reconciliation roll-forward. Beginning balance + purchases + sales + issuances + settlements + transfers in/out + realized gains/losses + unrealized gains/losses = ending balance. Disclose each component separately.
- Narrative sensitivity analysis. Describe how the fair value would change if the key unobservable inputs had been reasonably different at the reporting date. Focus on current-period uncertainty, not hypothetical disasters.
- Interrelationships between inputs. When two inputs naturally move together (default probability and loss severity, growth and discount rate), explain how those linkages amplify or offset the effect on fair value.
- Valuation process. Describe who values the assets, how often, and what governance exists. Auditors increasingly want to see a documented committee with finance, valuation, and an external specialist.
A common disclosure failure is treating these as boilerplate. Auditors and the SEC have publicly pushed back on cookie-cutter language that does not actually describe the specific inputs and judgment used.
Surviving Auditor Pushback: A Practical Playbook
Audit firms now staff dedicated valuation specialists who arrive with sample models, peer benchmarks, and pointed questions. The companies that get through year-end cleanly have a few habits in common.
Document the model on the day you build it. Six months later, no one remembers why a 22% discount rate was right. A short memo per significant measurement—source of inputs, calibration to recent transactions, justification for each subjective judgment—saves hours during fieldwork.
Calibrate to observable events. If a recent funding round implied an enterprise value of $200 million, your year-end Level 3 valuation cannot ignore that. Either match it, or be ready to explain in writing what changed between the round and the reporting date.
Use range-based inputs, not point estimates. "We used a 25% DLOM" is harder to defend than "We considered a 15–30% range based on study X and selected 25% because of factors Y and Z." Ranges show that you considered alternatives.
Engage a third-party valuation specialist for hard cases. Auditors are not allowed to rely on management's word alone for Level 3 valuations they consider high-risk. An independent valuation report from a credentialed firm shifts the burden of proof.
Recalibrate every period, even when nothing seems to have changed. A measurement carried forward unchanged for four quarters is a red flag. Markets move, comparables shift, and the passage of time alone changes a DCF's value.
Track and disclose transfers between levels. If you reclassified an asset from Level 2 to Level 3 because the market dried up, that needs to be disclosed with the reason. Transfers in and out of Level 3 in particular get heavy scrutiny.
Common Mistakes That Cause Restatements
- Using historical cost as a placeholder. ASC 820 does not allow it. If the asset is required to be at fair value, you owe a measurement.
- Ignoring counterparty credit risk on liabilities. When you measure your own debt at fair value, you must include your own nonperformance risk—even when it's uncomfortable.
- Confusing 409A with ASC 820. A 409A valuation values common stock for tax purposes; an ASC 820 measurement values the entire instrument (often preferred) for GAAP. The discount rates, allocation methods, and timing differ.
- Boilerplate sensitivity disclosure. "A small change in inputs could cause a material change in fair value" tells the reader nothing. Quantify or describe specifically.
- Failing to remeasure earn-outs. The acquisition-date measurement is just the start. Every reporting period requires a fresh look, and the income-statement impact is real.
Tying It Back to Your Books
ASC 820 is ultimately a bookkeeping discipline. Every fair value adjustment hits a specific account, every quarter, often with both a balance sheet and income statement component. If your underlying ledger isn't structured to capture (a) the gross movement, (b) the realized vs. unrealized split, and (c) the reclassifications between hierarchy levels, the disclosures become a manual spreadsheet exercise that no one trusts.
Treat each fair-value position as its own subaccount, tag every entry with the level and the valuation technique, and run a roll-forward report every period. That hygiene turns the disclosure preparation from "rebuild from scratch" into "format and review."
Keep Your Fair Value Records Audit-Ready From Day One
ASC 820 compliance lives or dies in the supporting workpapers—the source of every input, the version history of every model, the reasoning behind every judgment. Beancount.io provides plain-text accounting that gives you complete transparency and version control over every transaction, every adjustment, and every reclassification, so your fair value workpapers tie back to a tamper-evident ledger your auditors can actually trust. Get started for free and see why founders, CFOs, and finance teams are switching to plain-text accounting for the disclosures that matter most.