1.3 Fair value measurements
8 min read•august 19, 2024
measurements are crucial in accounting for mergers and acquisitions. They provide a standardized way to value assets and liabilities, ensuring accurate financial reporting and informed decision-making during complex transactions.
Understanding , , and disclosures is essential for accountants and financial professionals. These concepts help in assessing the reliability of fair value measurements and their impact on financial statements, particularly in M&A scenarios.
Fair value definition
- Fair value 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
- Represents an from the perspective of a market participant holding the asset or owing the liability
- Determined based on assumptions market participants would use in pricing the asset or liability, including risk assumptions
Quoted prices in active markets
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- The most reliable evidence of fair value comes from for identical assets or liabilities
- An active market has sufficient frequency and volume of transactions to provide pricing information on an ongoing basis
- Examples include major stock exchanges (NYSE, NASDAQ) for publicly traded securities
Valuation techniques
- Used to estimate fair value when quoted prices in active markets are not available
- Techniques should maximize the use of relevant observable inputs and minimize the use of unobservable inputs
- Common valuation techniques include the , , and
Inputs to valuation techniques
- Inputs are assumptions market participants would use in pricing the asset or liability
- Inputs can be observable (based on market data) or unobservable (company's own data)
- Observable inputs include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar items in markets that are not active
- Unobservable inputs reflect the reporting entity's own assumptions about the assumptions market participants would use
Fair value hierarchy
- Categorizes fair value measurements into three levels based on the observability and significance of the inputs used
- Helps users assess the relative reliability of the fair value measurements
- are the most reliable, while are the least reliable
Level 1 inputs
- Unadjusted quoted prices in active markets for identical assets or liabilities accessible to the entity at the measurement date
- Provides the most reliable evidence of fair value and should be used without adjustment whenever available
- Example: Quoted stock prices on major exchanges for actively traded securities
Level 2 inputs
- Inputs other than Level 1 quoted prices that are observable for the asset or liability, either directly or indirectly
- Includes quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar items in markets that are not active
- Also includes inputs derived principally from or corroborated by observable market data through correlation or other means
- Example: Interest rate swaps valued using observable yield curves
Level 3 inputs
- Unobservable inputs for the asset or liability
- Used when observable inputs are not available
- Reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing the asset or liability
- Example: Private equity investments valued using discounted cash flow analysis with company-specific growth and discount rate assumptions
Present value techniques
- Used to estimate fair value by discounting future cash flows or costs
- Capture all the elements that market participants would consider in setting a price
- Can be applied to both assets and liabilities
Elements of present value measurement
- Estimate of future cash flows for the asset or liability being measured
- Expectations about possible variations in the amount and timing of the cash flows
- Time value of money, represented by the risk-free rate
- Price for bearing the uncertainty inherent in the cash flows (risk premium)
- Other factors market participants would consider (liquidity, credit risk)
Application to assets vs liabilities
- For assets, consider the cash inflows expected to be generated by the asset over its life and the proceeds from its ultimate disposal
- For liabilities, present value techniques consider the cash outflows expected to be required to settle the liability in the normal course of business
Discount rate adjustment technique
- Uses a single set of cash flows and a discount rate that incorporates all the expectations about future cash flows and risk premiums
- Discount rate is derived from observed rates of return for comparable assets or liabilities traded in the market
- Most commonly used for debt securities with contractual cash flows
Expected cash flow technique
- Uses multiple cash flow scenarios to capture the range of possible outcomes and assigns probability weights to each scenario
- Resulting probability-weighted cash flows are then discounted at a risk-free rate
- More complex but provides a better representation of uncertainty when cash flows are not contractual
Highest and best use
- Considers the use of a non-financial asset by market participants that would maximize its value
- May be different from the asset's current use by the reporting entity
- Provides a basis for measuring fair value even if the entity intends a different use
Valuation premise for non-financial assets
- assumes the asset is used in combination with other assets as a group (as installed or configured for use)
- assumes the asset is used on a standalone basis
In-use vs in-exchange valuation
- If an asset's is in-use, fair value considers the asset's use in combination with other assets (even if the entity intends to use it on a standalone basis)
- If an asset's highest and best use is in-exchange, fair value considers the asset's use on a standalone basis (even if the entity intends to use it in combination with other assets)
- Highest and best use is determined from the perspective of market participants, even if the entity intends a different use
Liabilities and credit risk
- Fair value of a liability reflects the effect of (the risk the entity will not fulfill the obligation)
- Nonperformance risk includes the reporting entity's own credit risk
- Fair value of a liability is not adjusted for restrictions preventing its transfer
Nonperformance risk
- Encompasses both the entity's own credit risk and any other risks that might affect the likelihood the obligation will not be fulfilled (asset-specific risk)
- Should be the same before and after the transfer of the liability
- Can be measured using the credit spreads of the entity's own traded debt or credit default swap prices
Restrictions preventing transfer
- The fair value of a liability is not adjusted to reflect restrictions that prevent its transfer
- Transfer restrictions are specific to the liability and would not transfer to the market participant
- Example: Debt covenants that restrict transfer to another party do not affect the fair value of the debt
Measuring fair value of investments
- Applies to investments in subsidiaries, associates, and joint ventures as well as debt and equity securities
- Specific considerations for investment companies and entities that qualify for the
In investment companies
- Investment companies measure their investments at fair value, including controlling interests in investees
- Fair value provides the most relevant information to investors in an investment company
- Investments are measured at fair value even if the investment company has the ability to exercise significant influence or control over the investee
Practical expedient
- Entities are permitted to measure fair value of certain investments using net asset value per share (or its equivalent) as a practical expedient
- Applies to investments that do not have readily determinable fair values and are in entities that calculate net asset value per share
- Examples include certain hedge funds, private equity funds, and real estate funds
- Disclosures are required about the nature and risks of investments measured using the practical expedient
Fair value at initial recognition
- Generally, the transaction price (the price paid or received) represents the fair value of an asset or liability at initial recognition
- In some cases, the transaction price may not represent fair value (e.g., related party transactions, transactions under duress)
Transaction price vs fair value
- If the transaction price differs from , the resulting gain or loss is recognized in profit or loss unless otherwise specified by the applicable accounting standard
- Gains or losses may be deferred if the fair value measurement uses significant unobservable inputs (Level 3)
Day 1 gains or losses
- Arise when the transaction price differs from the fair value measured using a valuation technique with unobservable inputs
- Recognized in profit or loss only to the extent they relate to a change in a factor market participants would consider in setting a price
- Unrecognized gains or losses are deferred and amortized over the life of the asset or liability
Disclosures about fair value
- Entities are required to provide disclosures about their fair value measurements to help users assess the used
- Disclosures vary based on the level of the fair value hierarchy and the significance of the measurements to the entity's financial position and performance
Valuation techniques and inputs
- Entities must disclose the valuation techniques and inputs used for each class of assets and liabilities measured at fair value
- Changes in valuation techniques and the reasons for those changes must also be disclosed
- Quantitative information about significant unobservable inputs used in Level 3 measurements is required
Transfers between hierarchy levels
- Entities must disclose the amounts of any transfers between levels of the fair value hierarchy and the reasons for those transfers
- Transfers are recognized as of the beginning of the reporting period
- Separate disclosures are required for transfers into and out of each level
Level 3 fair value measurements
- Entities must provide a reconciliation of the opening and closing balances for Level 3 measurements, showing total gains or losses, purchases, sales, issues, settlements, and transfers
- Unrealized gains or losses recognized in profit or loss for assets and liabilities still held at the end of the period must be separately disclosed
- Narrative description of the sensitivity of Level 3 measurements to changes in unobservable inputs is required if those changes would result in a significantly different fair value
Key Terms to Review (30)
Cost approach: The cost approach is a method used to estimate the value of an asset based on the cost of replacing or reproducing it, minus any depreciation. This approach focuses on determining what it would cost to replace an asset with a new one, taking into account factors like wear and tear, functional obsolescence, and economic obsolescence. It is often utilized in fair value measurements, especially for tangible assets, as well as for assessing identifiable intangible assets and their worth during auditing processes.
Day 1 gains or losses: Day 1 gains or losses refer to the immediate changes in the fair value of an acquired asset or liability recognized on the date of a business combination. This concept is crucial because it reflects how the market perceives the value of the assets and liabilities at the point of acquisition, highlighting discrepancies between their book values and their fair values as determined by market conditions. Understanding these gains or losses helps in evaluating the success of the acquisition and its impact on financial statements.
Disclosures about fair value: Disclosures about fair value refer to the necessary information that companies must provide regarding the fair value of their assets and liabilities in financial statements. This information helps users understand how fair values are determined and the potential impact on financial performance, providing transparency and aiding in decision-making. These disclosures are essential for assessing the risks and rewards associated with financial instruments, as they offer insight into how market conditions can affect valuations.
Discount rate adjustment technique: The discount rate adjustment technique is a method used to modify the discount rate applied in the valuation of an asset or liability to reflect changes in risk or market conditions. This technique helps to derive a more accurate fair value measurement by adjusting for factors such as credit risk, market volatility, and liquidity concerns that can affect future cash flows. Understanding how to apply this technique is essential for making informed investment decisions and ensuring compliance with accounting standards.
Elements of Present Value Measurement: Elements of present value measurement refer to the key components that are used to determine the present value of future cash flows. This involves understanding the timing of cash flows, the risk-free rate, and the risk premium, which collectively help in assessing the value of an investment today based on expected returns over time. These elements are crucial for fair value measurements, as they provide a systematic approach to evaluating the current worth of future benefits.
Exit Price: Exit price is 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. This concept is crucial as it reflects the current market conditions and provides insight into the value of assets and liabilities, allowing stakeholders to make informed decisions regarding financial reporting and valuation.
Expected cash flow technique: The expected cash flow technique is a method used to estimate the future cash flows of an investment or project by considering various scenarios and their probabilities. This approach allows decision-makers to assess the potential financial outcomes based on different assumptions, providing a more nuanced understanding of risks and returns associated with an investment. It plays a crucial role in fair value measurements by helping determine the current worth of future cash flows.
Fair Value: Fair value is the estimated price at which an asset could be bought or sold in a current transaction between willing parties, reflecting both the market conditions and the specific attributes of the asset. It is crucial for various financial reporting requirements and helps ensure that financial statements provide a true representation of a company's financial position.
Fair value at initial recognition: Fair value at initial recognition refers to the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction at the time the asset or liability is recognized. This concept is crucial as it sets the baseline measurement for subsequent accounting and valuation of the asset or liability, impacting financial statements and stakeholder decisions.
Fair Value Hierarchy: The fair value hierarchy is a system that categorizes the inputs used to measure fair value into three distinct levels. This hierarchy prioritizes the types of inputs based on their observability, allowing users to assess the reliability of the fair value measurements. Levels 1, 2, and 3 reflect varying degrees of market observability, with Level 1 being the most reliable due to quoted prices in active markets for identical assets or liabilities.
Highest and best use: Highest and best use is a concept in real estate appraisal that identifies the most profitable and legally permissible use of a property, maximizing its value. This determination considers factors like zoning laws, market demand, and physical characteristics of the property, ensuring that the chosen use is both feasible and financially advantageous.
In-exchange valuation: In-exchange valuation refers to the process of determining the fair value of assets or liabilities exchanged in a transaction. This method is crucial in mergers and acquisitions as it provides a reliable basis for assessing the worth of what is being exchanged, ensuring that both parties have a clear understanding of the economic implications of the deal.
In-use valuation: In-use valuation is a method for determining the fair value of an asset by considering its current use within a business rather than its potential sale value. This approach assesses the asset's contribution to the business operations, including any synergistic benefits that may arise from using the asset alongside other assets. It emphasizes understanding how the asset operates in its existing context, providing insights into its value based on operational effectiveness and expected cash flows.
Income Approach: The income approach is a valuation method that estimates the value of an asset based on its expected future income streams, discounted back to their present value. This method is especially relevant in contexts where cash flows generated by the asset can be reliably projected, providing insights into the asset's fair value in various financial scenarios, including mergers, acquisitions, and the valuation of intangible assets.
Inputs to Valuation Techniques: Inputs to valuation techniques are the various data points and assumptions used to determine the fair value of an asset or liability. These inputs are crucial as they help in building a model that reflects the current market conditions, economic factors, and specific characteristics of the asset or liability being valued. The inputs can vary widely, including observable market data, transaction prices, and unobservable inputs based on the company's own assumptions about future cash flows.
Level 1 inputs: Level 1 inputs are the most reliable and observable inputs used in fair value measurements, consisting of quoted prices in active markets for identical assets or liabilities. These inputs provide the highest quality evidence of fair value because they reflect actual market transactions, ensuring that the measurements are accurate and relevant. Level 1 inputs form the foundation for establishing fair values in various financial reporting contexts, making them crucial for transparency and consistency.
Level 2 Inputs: Level 2 inputs are inputs used in fair value measurements that are derived from observable market data for similar assets or liabilities, rather than being directly quoted from active markets. These inputs can include prices from similar transactions or market quotes, which help in estimating the fair value of an asset or liability when market prices are not readily available. This level of input provides a more reliable basis for valuation compared to unobservable inputs, thus enhancing the accuracy of financial reporting.
Level 3 Fair Value Measurements: Level 3 fair value measurements refer to the valuation of assets and liabilities based on unobservable inputs, relying on the entity's own assumptions about the factors that market participants would use in pricing the asset or liability. This level of measurement is significant because it is used when there is little to no market activity for the asset or liability being measured, making it more subjective than Levels 1 and 2, which utilize observable market data.
Level 3 Inputs: Level 3 inputs are unobservable inputs used in fair value measurements that rely on an entity's own assumptions about what market participants would use to price an asset or liability. These inputs are crucial when there is no active market for the asset or liability and therefore rely heavily on subjective judgment. They reflect the least reliable data compared to Level 1 and Level 2 inputs, making them a significant focus in the assessment of fair value measurements and auditing practices.
Market approach: The market approach is a valuation method that estimates the fair value of an asset based on the prices of similar assets in the marketplace. This approach relies on the principle of substitution, which suggests that a knowledgeable buyer would not pay more for an asset than the price of a comparable asset in a similar condition and location. It is particularly useful for assessing the value of identifiable intangible assets and plays a critical role in fair value measurements, bargain purchase gains, hedges, and corporate reorganizations.
Measuring Fair Value of Investments: Measuring fair value of investments refers to the process of determining the current market value of an investment asset, based on the price that would be received to sell that asset in an orderly transaction between market participants at the measurement date. This concept is essential in providing a clear and consistent approach to financial reporting, ensuring that investments are valued appropriately and transparently within financial statements.
Nonperformance risk: Nonperformance risk refers to the possibility that a party involved in a financial transaction will fail to meet their contractual obligations. This risk can arise from various factors, such as financial distress, changes in market conditions, or operational failures. Understanding nonperformance risk is crucial as it directly impacts the fair value measurements of assets and liabilities, influencing how they are assessed and reported in financial statements.
Practical Expedient: A practical expedient is a simplification or shortcut that entities can use when measuring fair value in financial reporting. It helps entities to reduce complexity and cost by allowing them to bypass certain detailed requirements while still maintaining the integrity of the fair value measurements. This approach is particularly useful in situations where market data is not readily available or where the costs of obtaining such data outweigh the benefits.
Present Value Techniques: Present value techniques are financial methods used to determine the current worth of a cash flow or series of cash flows that will occur in the future, discounted at a specific interest rate. These techniques are vital for assessing investments, pricing financial instruments, and evaluating fair value measurements by considering the time value of money, which recognizes that a dollar today is worth more than a dollar in the future due to its potential earning capacity.
Quoted prices in active markets: Quoted prices in active markets refer to the prices that are readily available for identical assets or liabilities in a market where transactions occur with sufficient frequency and volume. These prices reflect current market conditions and are considered the most reliable indicators of fair value. When valuing assets, these quoted prices are typically used in the valuation process due to their transparency and the level of market activity.
Restrictions Preventing Transfer: Restrictions preventing transfer refer to limitations imposed on the ability to sell or transfer an asset, often impacting its liquidity and overall value. These restrictions can stem from legal, regulatory, or contractual obligations, which may affect how fair value measurements are determined. Understanding these restrictions is crucial for assessing the true market value of assets and ensuring compliance with relevant accounting standards.
Transaction Price vs Fair Value: Transaction price refers to the amount agreed upon by both buyer and seller in an exchange, while fair value is an estimate of the asset's worth based on market conditions, reflecting what it could sell for in an active market. Understanding this distinction is crucial because transaction price may not always align with fair value due to factors like negotiation, market inefficiencies, or unique circumstances surrounding a transaction.
Transfers between hierarchy levels: Transfers between hierarchy levels refer to the movement of assets or liabilities from one level of the fair value hierarchy to another based on changes in the observability of inputs used in the measurement process. This concept is crucial as it indicates how market conditions and available information can affect the valuation of an asset or liability. When an asset's inputs shift from observable to unobservable, or vice versa, it alters the classification of its fair value measurement, which has implications for financial reporting and transparency.
Valuation Techniques: Valuation techniques are methods used to determine the fair value of an asset or liability. These techniques are essential for accurately assessing the worth of financial instruments, real estate, and businesses, which is crucial in various financial transactions and reporting scenarios. Understanding different valuation techniques helps in making informed investment decisions and ensures compliance with financial reporting standards.
Valuation techniques and inputs: Valuation techniques and inputs refer to the methods and assumptions used to estimate the fair value of an asset or liability. These techniques include approaches like market, income, and cost methods, which help in determining the monetary value based on relevant data, market conditions, and specific characteristics of the asset or liability being assessed. Understanding these techniques is essential for ensuring accurate financial reporting and compliance with standards that require fair value measurements.