4.3 Fair value measurement and disclosures
5 min read•august 16, 2024
measurement is crucial in financial reporting, providing a standardized way to value assets and liabilities. It's based on market participant assumptions and uses various techniques to determine the price in an orderly transaction.
The fair value hierarchy categorizes inputs into three levels, prioritizing observable market data. This topic covers valuation approaches, input classification, and required disclosures, helping accountants accurately report financial instrument values in line with accounting standards.
Fair Value Measurement Concepts
Definition and Key Principles
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- Fair value refers to the price received to sell an asset or paid to transfer a liability in an orderly transaction between at the measurement date
- Assumes transaction occurs in principal market or most advantageous market for the asset or liability
- Considers characteristics market participants would factor into pricing (condition, location, restrictions)
- Applies concept of for non-financial assets
- Assumes market participants act independently, knowledgeably, and in their economic best interest
- Reflects non-performance risk in liability valuations, including entity's own credit risk
- Maximizes use of and minimizes
Market Participant Assumptions
- Independent parties able to transact for the asset or liability
- Knowledgeable about the item being measured
- Willing and able to enter into a transaction
- Acting in their own economic best interest
- Would consider asset characteristics like condition and location
- Would use the asset in its highest and best use (for non-financial assets)
Key Considerations in Fair Value Measurement
- Principal market takes precedence over most advantageous market
- Entry price may differ from exit price used for fair value
- Transaction costs excluded from fair value measurement
- Highest and best use determined from market participant perspective, even if different from current use
- Blockage factors not considered when valuing financial instruments traded in an active market
- Non-performance risk reflected in liability fair values (credit risk)
- Measurement considers characteristics specific to the asset or liability
Valuation Techniques for Financial Instruments
Market Approach
- Uses prices and information from market transactions of identical or comparable assets/liabilities
- Techniques include market multiples and matrix pricing
- Most directly fulfills the fair value definition
- Preferred when recent transactions of identical items are available
- Adjustments may be needed for differences between the measured item and market comparables
- Examples of market inputs (stock prices, commodity prices)
Income Approach
- Converts future cash flows or income/expenses to a single current discounted amount
- Reflects current market expectations about future amounts
- Techniques include present value methods, option pricing models, multi-period excess earnings
- Incorporates time value of money and risk premiums
- Discount rates should reflect assumptions consistent with inherent risks
- Examples of applications (bonds, derivatives, business valuations)
Cost Approach
- Reflects amount required to replace the service capacity of an asset (current replacement cost)
- Considers physical deterioration, functional obsolescence, and economic obsolescence
- Often used for tangible assets like property, plant and equipment
- May be combined with other approaches for more complex valuations
- Assumes market participant would not pay more than replacement cost
- Examples of use (real estate, equipment valuation)
Specialized Techniques
- Option pricing models (Black-Scholes-Merton formula, binomial model) for options and complex instruments
- Present value techniques for items without direct market prices
- Yield-to-maturity and discounted cash flow analysis for debt instruments
- Credit/debit valuation adjustments (CVA/DVA) to reflect counterparty and own credit risk
Fair Value Hierarchy and Inputs
Level 1 Inputs
- Quoted prices in active markets for identical assets or liabilities
- Most reliable evidence of fair value
- Used without adjustment when available
- Examples (stock prices on major exchanges, government bond prices)
- Preferred input when measuring fair value
- take precedence over other valuation inputs
Level 2 Inputs
- Observable inputs other than Level 1 quoted prices
- Include quoted prices for similar assets/liabilities in active markets
- Quoted prices for identical or similar items in non-active markets
- Observable inputs like interest rates, yield curves, volatilities
- Inputs corroborated by observable market data
- Examples (interest rate swaps, foreign currency forwards)
Level 3 Inputs
- Unobservable inputs used when relevant observable inputs unavailable
- Reflect reporting entity's own assumptions about market participant assumptions
- Developed using best information available in the circumstances
- Examples (long-dated option contracts, private equity investments)
- Require additional disclosures due to subjectivity
- Used as a last resort when observable inputs not available
Hierarchy Application
- Fair value hierarchy prioritizes inputs, not valuation techniques
- Categorization based on lowest level input significant to entire measurement
- Significance judged against entire fair value measurement
- Transfers between levels recognized at end of reporting period
- Disclosures required for transfers between Level 1 and Level 2
Fair Value Measurement Disclosures
Valuation Techniques and Inputs
- Disclose techniques and inputs for recurring and non-recurring fair value measurements
- Describe any changes in valuation techniques and reasons for the change
- Quantitative information on significant unobservable inputs for Level 3 measurements
- Narrative description of sensitivity to changes in unobservable inputs for Level 3
- Interrelationships between inputs and how they affect fair value measurement
Level 3 Reconciliations and Transfers
- Reconcile opening to closing balances for Level 3 measurements
- Separate disclosure of changes during period (gains/losses, purchases, sales, transfers)
- Disclose amount of total gains or losses attributable to unrealized changes
- Reasons for transfers into or out of Level 3
- Entity's policy for determining when transfers between levels occur
Additional Required Disclosures
- Fair value hierarchy level for items not measured at fair value but fair value disclosed
- For non-financial assets, highest and best use if different from current use
- Presence of third-party evidence in developing unobservable inputs
- Description of valuation processes for Level 3 measurements
- Sensitivity analysis for financial instruments using
- If highest and best use differs from current use, reason for difference
Disclosure Presentation
- Information provided by class of asset or liability
- Classes determined based on nature, characteristics, and risks
- More disaggregation for Level 3 measurements
- Both narrative and tabular formats used as appropriate
- Sufficient detail to allow reconciliation to line items in financial statements
Key Terms to Review (21)
ASC 820: ASC 820, also known as the Fair Value Measurement standard, defines how to measure fair value and establishes a framework for reporting fair value measurements in financial statements. This standard emphasizes the importance of market-based measurements, providing guidance on how to assess and disclose fair value for various assets and liabilities. Understanding ASC 820 is essential for ensuring transparency and consistency in financial reporting, particularly in how companies present their financial position and results of operations.
Cost Approach: The cost approach is a method used in fair value measurement that estimates the value of an asset by determining the cost to replace or reproduce it, minus any depreciation. This approach is often utilized for valuing specialized assets or properties where market data is scarce, allowing for a clear view of what it would cost to create the asset from scratch. Understanding this method is essential for accurate financial reporting and valuation in various accounting contexts.
Current cost: Current cost refers to the amount that would be paid to acquire an asset at present, or the amount that would be received to sell a liability at present. This concept emphasizes the importance of reflecting the current market value of assets and liabilities in financial statements, as it provides a more accurate view of a company's financial position. Understanding current cost is crucial for fair value measurement and disclosures, as it informs stakeholders about the real economic value of an entity’s resources and obligations.
Disclosure Requirements: Disclosure requirements are the rules and regulations that dictate the information companies must provide to stakeholders in their financial statements and accompanying notes. These requirements ensure transparency, allowing investors, regulators, and other interested parties to make informed decisions about a company's financial position and performance. Compliance with these requirements is crucial as it relates to various financial reporting topics, including regulatory oversight, consolidation practices, foreign currency dealings, fair value assessments, and the recognition of related party transactions.
Fair value: Fair value is the estimated price at which an asset or liability could be exchanged between knowledgeable, willing parties in an arm's length transaction. This concept is crucial for accurately reflecting the true value of financial instruments, assets, and liabilities in financial statements, impacting recognition, measurement, and disclosures across various scenarios.
Financial Accounting Standards Board (FASB): The Financial Accounting Standards Board (FASB) is an independent organization responsible for establishing and improving financial accounting and reporting standards in the United States. FASB's standards, known as Generally Accepted Accounting Principles (GAAP), play a crucial role in ensuring transparency, consistency, and comparability of financial statements. The board's work impacts various areas such as regulatory compliance, foreign currency translation, functional currency determination, and fair value measurement and disclosures.
Highest and Best Use: Highest and best use refers to the most profitable legal use of a property, taking into account its potential for generating income or value. This concept is crucial in fair value measurement, as it influences how properties are assessed and valued for financial reporting and disclosures. Determining the highest and best use involves analyzing market conditions, zoning laws, and the physical characteristics of the property.
Historical Cost: Historical cost is the original monetary value of an asset or liability at the time it was acquired, typically recorded in financial statements. This accounting method emphasizes the actual transaction price, rather than potential future value or market price, providing a stable and reliable foundation for financial reporting. It plays a crucial role in ensuring consistency and comparability in financial statements under various reporting standards.
IFRS 13: IFRS 13 is an International Financial Reporting Standard that provides guidance on how to measure fair value and requires enhanced disclosures about fair value measurements. This standard establishes a framework for measuring fair value and sets out the necessary disclosure requirements to ensure transparency in financial reporting.
Impairment testing: Impairment testing is the process of evaluating whether an asset's carrying amount exceeds its recoverable amount, determining if a write-down is necessary. This assessment is crucial for accurately reflecting an asset's value in financial statements, impacting both fair value measurement and the quality of reported earnings. By ensuring that assets are not overstated on the balance sheet, impairment testing helps maintain transparency and reliability in financial reporting.
Income approach: The income approach is a method used to estimate the value of an asset based on the income it generates. This approach considers the future income streams expected from the asset, discounted to their present value, reflecting the time value of money and associated risks. It is particularly relevant for fair value measurement and disclosures as it provides a systematic way to assess how much an investment is worth by focusing on its ability to produce economic benefits.
International Accounting Standards Board (IASB): The International Accounting Standards Board (IASB) is an independent organization that develops and establishes global accounting standards known as International Financial Reporting Standards (IFRS). The IASB plays a crucial role in the regulatory environment, ensuring that financial statements are comparable and transparent across different countries, thereby facilitating international trade and investment. Its standards also influence the translation of foreign currency financial statements and help determine functional currencies, as well as establish guidelines for fair value measurement and disclosures.
Level 1 Inputs: Level 1 inputs are the highest quality inputs used in fair value measurement, representing quoted prices for identical assets or liabilities in active markets. These inputs provide the most reliable measure of fair value, as they reflect actual transactions that occur in the marketplace. Because they are observable and readily available, Level 1 inputs are considered the most objective and transparent basis for valuing assets and liabilities.
Level 2 inputs: Level 2 inputs refer to the second tier of the fair value hierarchy, which includes inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly. These inputs might include market data from comparable transactions or inputs derived from pricing models that use observable market data, providing a more refined estimate of fair value than Level 1 inputs, which are based solely on quoted prices in active markets.
Level 3 inputs: Level 3 inputs are the most subjective type of inputs used in fair value measurement, relying on unobservable data to determine the value of an asset or liability. These inputs are utilized when observable market data is not available, making them crucial for valuing unique or illiquid assets. Due to their subjective nature, level 3 inputs require significant judgment and estimation, often leading to a higher degree of uncertainty in the resulting fair value measurements.
Mark-to-market accounting: Mark-to-market accounting is an accounting practice that involves valuing assets and liabilities at their current market prices rather than historical costs. This method provides a more accurate reflection of the financial position of a company, as it accounts for fluctuations in the value of assets and liabilities based on market conditions.
Market approach: The market approach is a valuation method that estimates the fair value of an asset by comparing it to similar assets that have been sold in the marketplace. This technique focuses on current market conditions and utilizes prices from transactions involving comparable assets to derive an estimated value, making it particularly relevant in situations where market activity is robust.
Market participants: Market participants are individuals or entities that engage in buying and selling securities in financial markets, influencing prices through their actions. They include investors, traders, brokers, and institutions who contribute to market liquidity and efficiency. Understanding the behavior and motivations of market participants is crucial for fair value measurement and accurate financial disclosures.
Observable inputs: Observable inputs are data points that are publicly available and can be verified through external sources, which are used in fair value measurements. They play a crucial role in determining the value of an asset or liability by providing objective evidence based on market activity. This is essential for ensuring transparency and consistency in financial reporting, especially when it comes to evaluating multiple-element arrangements.
Reconciliation of Level 3 Inputs: Reconciliation of level 3 inputs refers to the process of verifying and validating the values used in fair value measurements that rely on unobservable inputs, which are typically based on the entity's own assumptions and data. This reconciliation is essential in ensuring transparency and accuracy in financial reporting, as level 3 inputs can be highly subjective and less reliable compared to observable market data. The reconciliation process helps to identify changes in valuation techniques, assumptions, or inputs over time, providing a clearer picture of how these factors affect the fair value estimates reported in financial statements.
Unobservable inputs: Unobservable inputs are inputs used in a fair value measurement that are not based on observable market data and therefore require significant judgment or estimation. These inputs typically arise in situations where market prices are not available for an asset or liability, and they are essential for valuing items where less transparency exists. Their use indicates the level of estimation and discretion involved in the valuation process, often reflecting the unique characteristics of the asset or liability being measured.