Chapter 20
Fair Value

Introduction

20.01 The following section provides a discussion about fair value measurements and disclosures and the fair value option. FASB Accounting Standards Codification (ASC) 820, Fair Value Measurement, defines fair value, establishes a framework for measuring fair value, and requires certain disclosures about fair value measurements. FASB ASC 825, Financial Instruments, allows entities to choose, at specified election dates, to measure eligible items at fair value (the fair value option). The following paragraphs summarize FASB ASC 820 and FASB ASC 825 but are not intended as a substitute for reviewing this guidance in its entirety.

Accounting and Financial Reporting1

Definition of Fair Value

20.02 FASB ASC 820-10-20 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. The FASB ASC glossary defines an orderly transaction as a transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale).

Unit of Account

20.03 For recognition and disclosure purposes, the reporting entity must determine the appropriate unit of account to apply the provision of FASB ASC 820. FASB ASC 820-10-35-2E states that whether the asset or liability is a standalone asset or liability, a group of assets, a group of liabilities, or a group of assets and liabilities depends on its unit of account. The unit of account is generally based on the applicable guidance that requires or permits fair value measurement, except for instances explicitly discussed in FASB ASC 820.

The Principal (or Most Advantageous) Market

20.04 FASB ASC 820-10-35-5 states that a fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place either in the principal market for the asset or liability or, in the absence of a principal market, in the most advantageous market for the asset or liability. The FASB ASC glossary defines the principal market as the market with the greatest volume and level of activity for the asset or liability. The most advantageous market, as defined in the FASB ASC glossary, is the market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability, after taking into account transaction costs and transportation costs. Paragraphs 5A–6 of FASB ASC 820-10-35 state that a reporting entity need not undertake an exhaustive search of all possible markets to identify the principal market or, in the absence of a principal market, the most advantageous market, but it should take into account all information that is reasonably available. If there is a principal market for the asset or liability, the fair value measurement should represent the price in that market (whether that price is directly observable or estimated using another valuation technique), even if the price in a different market is potentially more advantageous at the measurement date.

20.05 The reporting entity must have access to the principal (or most advantageous) market at the measurement date. Because different entities (and businesses within those entities) with different activities may have access to different markets, the principal (or most advantageous) market for the same asset or liability might be different for different entities (and businesses within those entities). Therefore, paragraphs 6A–6B of FASB ASC 820-10-35 state that the principal (or most advantageous) market (and thus, market participants), should be considered from the perspective of the reporting entity, thereby allowing for differences between and among entities with different activities. Although a reporting entity must be able to access the market, the reporting entity does not need to be able to sell the particular asset or transfer the particular liability on the measurement date to be able to measure fair value on the basis of the price in that market.

20.06 Paragraphs 3–3A of FASB ASC 820-10-30 explain that, in many cases, the transaction price will equal the fair value (for example, that might be the case when, on the transaction date, the transaction to buy an asset takes place in the market in which the asset would be sold). When determining whether fair value at initial recognition equals the transaction price, a reporting entity should take into account factors specific to the transaction and to the asset or liability. Even when there is no observable market to provide pricing information about the sale of an asset or the transfer of a liability at the measurement date, FASB ASC 820-10-35-6C states that a fair value measurement should assume that a transaction takes place at that date, considered from the perspective of a market participant that holds the asset or owes the liability. That assumed transaction establishes a basis for estimating the price to sell the asset or to transfer the liability.

20.07 The transaction price might not represent the fair value of an asset or a liability at initial recognition under certain conditions. For example, if the transaction is conducted between related parties, the seller is under duress, the unit of account differs, the market in which the transaction was conducted differs from the principal (or most advantageous) market that would be used by the entity. Paragraphs 46–49 of FASB ASC 820-10-55 (example 5) illustrate when the price in a transaction involving a derivative instrument might (and might not) equal the fair value of the instrument at initial recognition.

Market Participants

20.08 Fair value measurement should be based on the assumptions of market participants, as stated in FASB ASC 820-10-35-9, where a reporting entity should measure the fair value of an asset or a liability using the assumptions that a market participant would use in pricing the asset or liability. The reporting entity is not required to identify specific market participants but rather identify characteristics that distinguish market participants generally considering factors specific to the asset or liability, the principal (or most advantageous) market for the asset or liability, and market participants with which the reporting entity would enter into a transaction in the market.

The Price

20.09 Paragraphs 9A–9C of FASB ASC 820-10-35 provide additional guidance on the price. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (that is, an exit price) regardless of whether that price is directly observable or estimated using another valuation technique. The price should not be adjusted for transaction costs because they are not a characteristic of an asset or a liability; rather, they are specific to the transaction and will differ depending on the transaction. Further, transaction costs do not include transportation costs. The price in the principal (or most advantageous) market should be adjusted for the costs, if any, that would be incurred to transport the asset from its current location to that market.

Application of Fair Value Measurement to Nonfinancial Assets

20.10 Highest and best use for nonfinancial assets. FASB ASC 820-10-35-10A states that a fair value measurement of a nonfinancial asset takes into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use. (Application of the highest and best use concept is limited to the fair value measurement of nonfinancial assets and cannot be used to measure the fair value of financial assets.)

20.11 FASB ASC 820-10-35-10B states that the highest and best use of a nonfinancial asset takes into account the use of the asset that is physically possible, legally permissible, and financial feasible, as follows:

  1. a.  A use that is physically possible takes into account the physical characteristics of the asset that market participants would take into account when pricing the asset (for example, the location or size of a property).
  2. b.  A use that is legally feasible takes into account any legal restrictions on the use of the asset that market participants would take into account when pricing the asset (for example, the zoning regulation application to a property).
  3. c.  A use that is financially feasible takes into account whether a use of the asset that is physically possible and legally permissible generates adequate income or cash flows (taking into account the costs of converting the asset to that use) to produce an investment return that market participants would require from an investment in that asset put to that use.

20.12 Even if the reporting entity intends a different use, paragraphs 10C–10D of FASB ASC 820-10-35 state that the highest and best use is determined from the perspective of market participants. However, a reporting entity’s current use of a nonfinancial asset is presumed to be its highest and best use unless market or other factors suggest that a different use by market participants would maximize the value of the asset. To protect its competitive position, or for other reasons, a reporting entity may intend not to use an acquired nonfinancial asset actively, or it may intend not to use the asset according to its highest and best use. For example, that might be the case for an acquired intangible asset that the reporting entity plans to use defensively by preventing others from using it. Nevertheless, the reporting entity should measure the fair value of a nonfinancial asset assuming its highest and best use by market participants.

20.13 Valuation premise for nonfinancial assets. FASB ASC 820-10-35-10E states that the highest and best use of a nonfinancial asset establishes the valuation premise used to measure the fair value of the asset, as follows:

  1. a.  The highest and best use of a nonfinancial asset might provide maximum value to market participants through its use in combination with other assets as a group (as installed or otherwise configured for use) or in combination with other assets and liabilities (for example, a business).

i.  If the highest and best use of the asset is to use the asset in combination with other assets or with other assets and liabilities, the fair value of the asset is the price that would be received in a current transaction to sell the asset assuming that the asset would be used with other assets or with other assets and liabilities and that those assets and liabilities (that is, its complementary assets and the associated liabilities) would be available to market participants.

ii.  Liabilities associated with the asset and with the complementary assets include liabilities that fund working capital, but do not include liabilities used to fund assets other than those within the group of assets.

iii.  Assumptions about the highest and best use of a nonfinancial asset should be consistent for all of the assets (for which highest and best use is relevant) of the group of assets or the group of assets and liabilities within which the asset would be used.

  1. b.  The highest and best use of a nonfinancial asset might provide maximum value to market participants on a standalone basis. If the highest and best use of the asset is to use it on a standalone basis, the fair value of the asset is the price that would be received in a current transaction to sell the asset to market participants that would use the asset on a standalone basis.

FASB ASC 820-10-55-25 (example 1) illustrates the application of the highest and best use and valuation premise concepts for nonfinancial assets.

Application of Fair Value Measurement to Liabilities and Instruments Classified in a Reporting Entity’s Shareholders’ Equity2

20.14 According to paragraphs 16–16AA of FASB ASC 820-10-35, a fair value measurement assumes that a financial or nonfinancial liability or an instrument classified in a reporting entity’s shareholders’ equity (for example, equity interests issued as consideration in a business combination) is transferred to a market participant at the measurement date. The transfer of such a liability or instrument assumes the following:

  1. a.  A liability would remain outstanding and the market participant transferee would be required to fulfill the obligation. The liability would not be settled with the counterparty or otherwise extinguished on the measurement date.
  2. b.  An instrument classified in a reporting entity’s shareholders’ equity would remain outstanding and the market participant transferee would take on the rights and responsibilities associated with the instrument. The instrument would not be canceled or otherwise extinguished on the measurement date.

Even when there is no observable market to provide pricing information about the transfer of such a liability or instrument (for example, because contractual or other legal restrictions prevent the transfer of such items), there might be an observable market for such items if they are held by other parties as assets (for example, a corporate bond or a call option on a reporting entity’s shares). In all cases, a reporting entity should maximize the use of relevant observable inputs and minimize the use of unobservable inputs to meet the objective of a fair value measurement, which is to estimate the price at which an orderly transaction to transfer the liability or instrument classified in shareholders’ equity would take place between market participants at the measurement date under current market conditions.

20.15 Liabilities and instruments classified in a reporting entity’s shareholders’ equity held by other parties as assets. Paragraphs 16B–16BB of FASB ASC 820-10-35 state that when a quoted price for the transfer of an identical liability or a similar liability or instrument classified in a reporting entity’s shareholders’ equity is not available and the identical item is held by another party as an asset, a reporting entity should measure the fair value of the liability or equity instrument from the perspective of a market participant that holds the identical items as an asset at the measurement date. In such cases, a reporting entity should measure the fair value of the liability or equity instrument as follows:

  1. a.  Using the quoted price in an active market (defined in the FASB ASC glossary as a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis) for the identical item held by another party as an asset, if that price is available.
  2. b.  If that price is not available, using other observable inputs, such as the quoted price in a market that is not active for the identical item held by another party as an asset.
  3. c.  If the observable prices discussed in item (a) or item (b) are not available, using another valuation technique, such as

i.  an income approach (for example, a present value technique that takes into account the future cash flows that a market participant would expect to receive from holding the liability or equity instrument as an asset; see FASB ASC 820-10-55-3F).

ii.  a market approach (for example, using quoted prices for similar liabilities or instruments classified as shareholders’ equity held by other parties as assets; see FASB ASC 820-10-55-3A).

20.16 According to FASB ASC 820-10-35-16D, a reporting entity should adjust the quoted price only if there are factors specific to the asset that are not applicable to the fair value measurement of the liability or equity instrument. A reporting entity should ensure that the price of the asset does not reflect the effect of a restriction preventing the sale of that asset. Some factors that may indicate that the quoted price of the asset should be adjusted include the following:

  • The quoted price for the asset relates to a similar (but not identical) liability or equity instrument held by another party as an asset. For example, the liability or equity instrument may have a particular characteristic (for example, the credit quality of the issuer) that is different from that reflected in the fair value of the similar liability or equity instrument held as an asset.
  • The unit of account for the asset is not the same as for the liability or equity instrument. For example, for liabilities, in some cases the price for an asset reflects a combined price for a package comprising both the amounts due from the issuer and a third-party credit enhancement. If the unit of account for the liability is not for the combined package, the objective is to measure the fair value of the issuer’s liability, not the fair value of the combined package. Thus, in such cases, the reporting entity would adjust the observed price for the asset to exclude the effect of the third-party credit enhancement. See FASB ASC 820-10-35-18A for further guidance.

20.17 Liabilities and instruments classified in a reporting entity’s shareholders’ equity not held by other parties as assets. Paragraphs 16H–16I of FASB ASC 820-10-35 explain that when a quoted price for the transfer of an identical or a similar liability or instrument classified in a reporting entity’s shareholders’ equity is not available and the identical item is not held by another party as an asset, a reporting entity should measure the fair value of the liability or equity instrument using a valuation technique from the perspective of a market participant that owes the liability or has issued the claim on equity. For example, when applying a present value technique, a reporting entity might take into account either of the following:

  • The future cash outflows that a market participant would expect to incur in fulfilling the obligation, including the compensation that a market participant would require for taking on the obligation (see paragraphs 16J–16K of FASB ASC 820-10-35).
  • The amount that a market participant would receive to enter into or issue an identical liability or equity instrument, using the assumptions that market participants would use when pricing, the identical item (for example, having the same credit characteristics) in the principal (or most advantageous) market for issuing a liability or an equity instrument with the same contractual terms.

20.18 Nonperformance risk. Paragraphs 17–18 of FASB ASC 820-10-35 state that the fair value of a liability reflects the effect of nonperformance risk. Nonperformance risk includes, but may not be limited to, a reporting entity’s own credit risk and is assumed to be the same before and after the transfer of the liability. When measuring the fair value of a liability, a reporting entity should take into account the effect of its credit risk (credit standing) and any other factors that might influence the likelihood that the obligation will or will not be fulfilled. That effect may differ depending on the liability. For example, whether the liability is an obligation to deliver cash (a financial liability) or an obligation to deliver goods or services (a nonfinancial liability), or the terms of credit enhancements related to the liability, if any.

FASB ASC 820-10-55-56 illustrates the effect of credit risk on the fair value measurement of a liability.

20.19 Third-party credit enhancements. As stated in paragraph 18A of FASB ASC 820-10-35, the issuer of a liability issued with an inseparable third-party credit enhancement that is accounted for separately from the liability should not include the effect of the credit enhancement in the fair value measurement of the liability. Instead, the issuer would take into account its own credit standing and not that of the third-party guarantor when measuring the fair value of the liability.

20.20 Restriction preventing the transfer of a liability or an instrument classified in a reporting entity’s shareholders’ equity. When measuring the fair value, FASB ASC 820-10-35-18B states that a reporting entity should not include a separate input or an adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the item. The effect of that restriction is either implicitly or explicitly included in the other inputs to the fair value measurement.

Application of Fair Value Measurement to Financial Assets and Financial Liabilities with Offsetting Positions in Market Risks or Counterparty Credit Risk

20.21 Paragraphs 18D–18L of FASB ASC 820-10-35 provide fair value guidance to reporting entities that hold a group of financial assets and financial liabilities with offsetting positions in market risks or counterparty credit risks. The guidance permits a reporting entity that manages a group of financial assets and financial liabilities on the basis of its net exposure to either market risks or credit risk to apply an exception to FASB ASC 820 for measuring fair value. That exception permits a reporting entity to measure the fair value of a group of financial assets and financial liabilities on the basis of the price that would be received to sell a net long position (that is, an asset) for a particular risk exposure or paid to transfer a net short position (that is, a liability) for a particular risk exposure in an orderly transaction between market participants at the measurement date under current market conditions. Accordingly, a reporting entity should measure the fair value of the group of financial assets and financial liabilities consistently with how market participants would price the net risk exposure at the measurement date.

20.22 A reporting entity is permitted to use the exception in the preceding paragraph only if the reporting entity does all of the following:

  1. a.  Manages the group of financial assets and financial liabilities on the basis of the reporting entity’s net exposure to a particular market risk (or risks) or to the credit risk of a particular counterparty in accordance with the reporting entity’s documented risk management or investment strategy
  2. b.  Provides information on that basis about the group of financial assets and financial liabilities to the reporting entity’s management
  3. c.  Is required or has elected to measure those financial assets and financial liabilities at fair value in the statement of financial position at the end of each reporting period

The exception does not pertain to financial statement presentation. In some cases, the basis for the presentation of financial instruments in the statement of financial position differs from the basis for the measurement of financial instruments (for example, if a FASB ASC topic does not require or permit financial instruments to be presented on a net basis). In such cases, a reporting entity may need to allocate the portfolio-level adjustments (see subsequent discussion of exposure to market risks and credit risk of a particular counterparty) to the individual assets or liabilities that make up the group of financial assets and financial liabilities managed on the basis of the reporting entity’s net risk exposure. A reporting entity should perform such allocations on a reasonable and consistent basis using a methodology appropriate in the circumstances.

20.23 A reporting entity should make an accounting policy decision to use the portfolio measurement exception described in paragraph 20.21. A reporting entity that uses the exception should apply that accounting policy, including its policy for allocating bid-ask adjustments (see subsequent discussion of exposure to market risks in paragraph 20.24) and credit adjustments (see subsequent discussion of exposure to the credit risk of a particular counterparty in paragraph 20.27), if applicable, consistently from period to period for a particular portfolio. The exception applies only to financial assets and financial liabilities within the scope of FASB ASC 815, Derivatives and Hedging, or FASB ASC 825.

20.24 Exposure to market risks. When using the exception to measure the fair value of a group of financial assets and financial liabilities managed on the basis of the reporting entity’s net exposure to a particular market risk (or risks), the reporting entity should apply the price within the bid-ask spread that is most representative of fair value in the circumstances to the reporting entity’s net exposure to those market risks (see paragraphs 36C–36D of FASB ASC 820-10-35).

20.25 In regard to applying the portfolio measurement exception, a reporting entity should also ensure that the market risk (or risks) to which the reporting entity is exposed within that group of financial assets and financial liabilities is substantially the same. For example, a reporting entity would not combine the interest rate risk associated with a financial asset with the commodity price risk associated with a financial liability, because doing so would not mitigate the reporting entity’s exposure to interest rate risk or commodity price risk. When using the exception, any basis risk resulting from the market risk parameters not being identical should be taken into account in the fair value measurement of the financial assets and financial liabilities within the group.

20.26 Similarly, the duration of the reporting entity’s exposure to a particular market risk (or risks) arising from the financial assets and financial liabilities should be substantially the same. For example, a reporting entity that uses a 12-month futures contract against the cash flows associated with 12 months’ worth of interest rate risk exposure on a 5-year financial instrument within a group made up of only those financial assets and financial liabilities measures the fair value of the exposure to 12-month interest rate risk on a net basis and the remaining interest rate risk exposure (that is, years 2–5) on a gross basis.

20.27 Exposure to the credit risk of a particular counterparty. When using the exception to measure the fair value of a group of financial assets and financial liabilities entered into with a particular counterparty, the reporting entity should include the effect of the reporting entity’s net exposure to the credit risk of that counterparty or the counterparty’s net exposure to the credit risk of the reporting entity in the fair value measurement when market participants would take into account any existing arrangements that mitigate credit risk exposure in the event of default (for example, a master netting agreement with the counterparty or an agreement that requires the exchange of collateral on the basis of each party’s net exposure to the credit risk of the other party). The fair value measurement should reflect market participants’ expectations about the likelihood that such an arrangement would be legally enforceable in the event of default.

Valuation Techniques

20.28 Paragraphs 24–24A of FASB ASC 820-10-35 explain that a reporting entity should use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value. Three widely used valuation techniques are the market approach, cost approach, and income approach. The main aspects of those approaches are summarized in paragraphs 3A–3G of FASB ASC 820-10-55. An entity should use valuation techniques consistent with one or more of these approaches to measure fair value:

  1. a.  Market approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities (for example, a business). Valuation techniques consistent with the market approach include matrix pricing and those that use market multiples derived from a set of comparables.
  2. b.  Cost approach. The cost approach reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost). Fair value is determined based on the cost to a market participant buyer to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence. That is because a market participant buyer would not pay more for an asset than the amount for which it could replace the service capacity of that asset.
  3. c.  Income approach. The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted). The measurement is based on the value indicated by current market expectations about those future amounts. Valuation techniques consistent with the income approach include present value techniques, option-pricing models, and the multiperiod excess earnings method. See discussion beginning in paragraph 20.31 regarding guidance for using the present value technique.

20.29 FASB ASC 820-10-35-24B states that, in some cases, a single valuation technique will be appropriate (for example, when valuing an asset or liability using quoted prices in an active market for identical assets or liabilities). In other cases, multiple valuation techniques will be appropriate (for example, that might be the case when valuing a reporting unit). If multiple valuation techniques are used to measure fair value, the results (that is, respective indications of fair value) should be evaluated considering the reasonableness of the range of values indicated by those results. A fair value measurement is the point within that range that is most representative of fair value in the circumstances. Example 3 beginning in FASB ASC 820-10-55-35 illustrates the use of multiple valuation techniques.

20.30 As explained in paragraphs 25–26 of FASB ASC 820-10-35, valuation techniques used to measure fair value should be applied consistently. However, a change in a valuation technique or its application is appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances. Such a change would be accounted for as a change in accounting estimate in accordance with the provisions of FASB ASC 250, Accounting Changes and Error Corrections. However, FASB ASC 250-10-50-5 explains that the disclosures in FASB ASC 250 for a change in accounting estimate are not required for revisions resulting from a change in a valuation technique or its application. See discussion of FASB ASC 820-10-50-2bbb for disclosure requirements when there has been a change in valuation techniques.

Present Value Techniques

20.31 The components of a present value measurement. Paragraphs 4–19 of FASB ASC 820-10-55 and 820-10-55-20 describe the use of present value techniques to measure fair value. Those paragraphs neither prescribe the use of a single specific present value technique nor limit the use of present value techniques to measure fair value to the techniques discussed. Present value (that is, the application of the income approach) is a tool used to link future amounts (for example, cash flows or values) to a present amount using a discount rate. A fair value measurement of an asset or a liability using a present value technique captures all of the following elements from the perspective of market participants at the measurement date: (a) an estimate of future cash flows for the asset or liability being measured; (b) expectations about possible variations in the amount and timing of the cash flows representing the uncertainty inherent in the cash flows; (c) the time value of money, represented by the rate on risk-free monetary assets that have maturity dates or durations that coincide with the period covered by the cash flows and pose neither uncertainty in timing nor risk of default to the holder (that is, a risk-free interest rate); (d) the price for bearing the uncertainty inherent in the cash flows (that is, a risk premium); (e) other factors that market participants would take into account in the circumstances; and (f) for a liability, the nonperformance risk relating to that liability, including the reporting entity’s (that is, the obligor’s) own credit risk.

20.32 General principles. Present value techniques differ in how they capture the elements discussed in the preceding paragraph. FASB ASC 820-10-55-6 provides the general principles that govern the application of any present value technique used to measure fair value, as follows:

  • Cash flows and discount rates should reflect assumptions that market participants would use when pricing the asset or liability.
  • Cash flows and discount rates should take into account only factors attributable to the asset (or liability) being measured.
  • To avoid double counting or omitting the effects of risk factors, discount rates should reflect assumptions that are consistent with those inherent in the cash flows. For example, a discount rate that reflects the uncertainty in expectations about future defaults is appropriate if using the contractual cash flows of a loan (that is, a discount rate adjustment technique), but is not appropriate if using expected (that is, probability-weighted) cash flows (that is, an expected present value technique) because the expected cash flows already reflect assumptions about the uncertainty in future defaults; instead, a discount rate that is commensurate with the risk inherent in the expected cash flows should be used.
  • Assumptions about cash flows and discount rates should be internally consistent. For example, nominal cash flows, which include the effects of inflation, should be discounted at a rate that includes the effects of inflation.
  • Discount rates should be consistent with the underlying economic factors of the currency in which the cash flows are denominated.

20.33 Risks and uncertainty. FASB ASC 820-10-55-9 describes how present value techniques differ in how they adjust for risk and in the type of cash flows they use. For example, the discount rate adjustment technique uses a risk-adjusted discount rate and contractual, promised, or most likely cash flows. In contrast, method 1 of the expected present value technique uses risk-adjusted expected cash flows and a risk-free rate. Expected cash flow, as defined in the FASB ASC glossary, is the probability-weighted average (that is, the mean of the distribution) of possible future cash flows. Method 2 of the expected present value technique uses expected cash flows that are not risk adjusted and a discount rate (this rate is different from the rate used in the discount rate adjustment technique) adjusted to include the risk premium that market participants require. The discount rate adjustment technique and two methods of expected present value techniques are discussed more fully in paragraphs 10–16 of FASB ASC 820-10-55.

The Fair Value Hierarchy

20.34 Because fair value is a market-based measurement, FASB ASC 820-10-35-9 states that fair value should be measured using the assumptions that market participants would use in pricing the asset or liability (referred to as inputs), assuming that market participants act in their economic best interest. The FASB ASC glossary defines inputs as assumptions that market participants would use when pricing the asset or liability, including assumptions about risk, such as the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) or the risk inherent in the inputs to the valuation technique. Inputs may be observable or unobservable (both as defined in the FASB ASC glossary):

  • Observable inputs are developed using market data, such as publicly available information about actual events or transactions, and that reflect the assumptions that market participants would use when pricing the asset or liability.
  • Unobservable inputs are inputs for which market data are not available and that are developed using the best information available about the assumptions that market participants would use when pricing the asset or liability.

Paragraphs 37–54B of FASB ASC 820-10-35 establish a fair value hierarchy that distinguishes between observable and unobservable inputs. FASB ASC 820-10-35-36 states that valuation techniques used to measure fair value should maximize the use of relevant observable inputs and minimize the use of unobservable inputs.

20.35 The fair value hierarchy in FASB ASC 820 categorizes the inputs to valuation techniques used to measure fair value into three broad levels. The three levels are discussed as follows:

  • Level 1. FASB ASC 820-10-35-40 defines Level 1 inputs as quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date. The FASB ASC glossary defines active market as a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis. Paragraphs 41–41C and 44 of FASB ASC 820-10-35 go on to explain that a quoted price in an active market provides the most reliable evidence of fair value and should be used without adjustment to measure fair value whenever available, except as specified in FASB ASC 820-10-35-41C. A Level 1 input will be available for many financial assets and financial liabilities, some of which might be exchanged in multiple active markets (for example, on different exchanges). Therefore, the emphasis within Level 1 is on determining both the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability and whether the reporting entity can enter into a transaction for the asset or liability at the price in the market for the asset or liability at the measurement date. If a reporting entity holds a position in a single asset or liability (including a position comprising a large number of identical assets or liabilities, such as a holding of financial instruments) and the asset or liability is traded in an active market, the fair value of the asset or liability should be measured within Level 1 as the product of the quoted price for the individual asset or liability and the quantity held by the reporting entity. That is the case, even if a market’s normal daily trading volume is not sufficient to absorb the quantity held and placing orders to sell the position in a single transaction might affect the quoted price. FASB ASC 820-10-55-42 (example 4) illustrates the use of Level 1 inputs to measure the fair value of a financial asset that trades in multiple active markets with different prices.
  • Level 2. FASB ASC 820-10-35-47 defines Level 2 inputs as inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Paragraphs 48–51 of FASB ASC 820-10-35 go on to explain that if the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability. Adjustments to Level 2 inputs will vary depending on factors specific to the asset or liability. Those factors include the condition and location of the asset, the extent to which inputs relate to items that are comparable to the asset or liability (including those factors described in FASB ASC 820-10-35-16D [see paragraph 20.16]), and the volume or level of activity in the markets within which the inputs are observed. An adjustment to a Level 2 input that is significant to the entire measurement might result in a fair value measurement categorized within Level 3 of the fair value hierarchy if the adjustment uses significant unobservable inputs. Level 2 inputs include the following:

—  Quoted prices for similar assets or liabilities in active markets

—  Quoted prices for identical or similar assets or liabilities in markets that are not active

—  Inputs other than quoted prices that are observable for the asset or liability (for example, interest rates and yield curves observable at commonly quoted intervals, implied volatilities, or credit spreads)

—  Market-corroborated inputs (defined in the FASB ASC glossary as inputs that are derived principally from or corroborated by observable market data by correlation or other means).

  • Level 3. Level 3 inputs, as defined in the FASB ASC glossary, are unobservable inputs for the asset or liability. Paragraphs 53–54A of FASB ASC 820-10-35 state that unobservable inputs should be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. Unobservable inputs should reflect the assumptions that market participants would use when pricing the asset or liability (including assumptions about risk). Assumptions about risk include the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and the risk inherent in the inputs to the valuation technique. A measurement that does not include an adjustment for risk would not represent a fair value measurement if market participants would include one when pricing the asset or liability. A reporting entity should develop unobservable inputs using the best information available in the circumstances, which might include the reporting entity’s own data. In developing unobservable inputs, a reporting entity may begin with its own data, but it should adjust those data if reasonably available information indicates that other market participants would use different data or there is something particular to the reporting entity that is not available to other market participants (for example, an energy-specific synergy). A reporting entity need not undertake exhaustive efforts to obtain information about market participant assumptions. However, a reporting entity should take into account all information about market participant assumptions that is reasonably available. Unobservable inputs developed in the manner described previously are considered market participant assumptions and meet the objectives of a fair value measurement.

As explained in FASB ASC 820-10-35-37A, in some cases, the inputs used to measure fair value of an asset or liability might be categorized within different levels of the fair value hierarchy. In those cases, the fair value measurement is categorized in its entirety in the same level of the fair value hierarchy as the lowest level input that is significant to the entire measurement. Assessing the significance of a particular input to the entire measurement requires judgment, taking into account factors specific to the asset or liability. Adjustments to arrive at measurements based on fair value, such as costs to sell when measuring fair value less costs to sell, should not be taken into account when determining the level of the fair value hierarchy within which a fair value measurement is categorized.

20.36 As discussed in paragraphs 38 and 38A of FASB ASC 820-10-35, the availability of relevant inputs and their relative subjectivity might affect the selection of appropriate valuation techniques (see FASB ASC 820-10-35-24 discussed in paragraph 20.28). However, the fair value hierarchy prioritizes the inputs to valuation techniques, not the valuation techniques used to measure fair value. For example, a fair value measurement developed using a present value technique might be categorized within Level 2 or Level 3, depending on the inputs that are significant to the entire measurement and the level of the fair value hierarchy within which those inputs are categorized. If an observable input requires an adjustment using an unobservable input and that adjustment results in a significantly higher or lower fair value measurement, the resulting measurement would be categorized within Level 3 of the fair value hierarchy. For example, if a market participant would take into account the effect of a restriction on the sale of an asset when estimating the price for the asset, a reporting entity would adjust the quoted price to reflect the effect of that restriction. If that quoted price is a Level 2 input and the adjustment is an unobservable input that is significant to the entire measurement, the measurement would be categorized within Level 3 of the fair value hierarchy.

Categorizing Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent) Within the Fair Value Hierarchy

20.37 According to FASB ASC 820-10-35-54B, categorization within the fair value hierarchy of a fair value measurement of an investment within the scope of paragraphs 4–5 of FASB ASC 820-10-15 that is measured at net asset value per share (or its equivalent, for example member units or an ownership interest in partners’ capital to which a proportionate share of net assets is attributed) requires judgment, considering the following:

  • If a reporting entity has the ability to redeem its investment with the investee at net asset value per share (or its equivalent) at the measurement date, the fair value measurement of the investment should be categorized within Level 2 of the fair value hierarchy.
  • If a reporting entity would never have the ability to redeem its investment with the investee at net asset value per share (or its equivalent), the fair value measurement of the investment should be categorized within Level 3 of the fair value hierarchy.
  • If a reporting entity cannot redeem its investment with the investee at net asset value per share (or its equivalent) at the measurement date but the investment may be redeemable with the investee at a future date (for example, investments subject to a lockup or gate or investments whose redemption period does not coincide with the measurement date), the reporting entity should take into account the length of time until the investment will become redeemable in determining whether the fair value measurement of the investment should be categorized within Level 2 or Level 3 of the fair value hierarchy. For example, if the reporting entity does not know when it will have the ability to redeem the investment or it does not have the ability to redeem the investment in the near term at net asset value per share (or its equivalent), the fair value measurement of the investment should be categorized within Level 3 of the fair value hierarchy.

Measuring the Fair Value of Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent)6

20.38 Paragraphs 59–62 of FASB ASC 820-10-35 contain guidance intended to improve financial reporting by permitting the use of a practical expedient, with appropriate disclosures, when measuring the fair value of an alternative investment that does not have a readily determinable fair value. This practical expedient permits a reporting entity to estimate the fair value of an investment within the scope of paragraphs 4–5 of FASB ASC 820-10-15 using the net asset value per share (or its equivalent) of the investment, if the net asset value per share of the investment is calculated in a manner consistent with the measurement principles of FASB ASC 946, Financial Services—Investment Companies, as of the reporting entity’s measurement date.

20.39 According to FASB ASC 820-10-15-4, the guidance contained in paragraphs 59–62 of FASB ASC 820-10-35 and FASB ASC 820-10-50-6A should apply only to an investment that meets both of the following criteria as of the entity’s measurement date:

  1. a.  The investment does not have a readily determinable fair value.7
  2. b.  The investment is an investment company within the scope of FASB ASC 946 or is an investment in a real estate fund for which it is industry practice to measure investment assets at fair value on a recurring basis and to issue financial statements that are consistent with the measurement principles in FASB ASC 946.

20.40 FASB ASC 820-10-35-60 explains that if the net asset value per share of the investment obtained from the investee is not as of the reporting entity’s measurement date or is not calculated in a manner consistent with the measurement principles of FASB ASC 946, the reporting entity should consider whether an adjustment to the most recent net asset value per share is necessary.

20.41 FASB ASC 820-10-35-61 states that a reporting entity should decide on an investment-by-investment basis whether to apply the practical expedient in FASB ASC 820-10-35-59 and should apply the practical expedient consistently to the fair value measurement of the reporting entity’s entire position in a particular investment, unless it is probable at the measurement date that the reporting entity will sell a portion of an investment at an amount different from net asset value per share (or its equivalent) as described in FASB ASC 820-10-35-62. In those situations, the reporting entity should account for the portion of the investment that is being sold in accordance with FASB ASC 820 (that is, the reporting entity should not apply the guidance discussed in FASB ASC 820-10-35-59).

Measuring Fair Value When the Volume or Level of Activity for an Asset or a Liability Has Significantly Decreased

20.42 Paragraphs 54C–54J of FASB ASC 820-10-35 clarify the application of FASB ASC 820 in measuring fair value when the volume and level of activity for an asset or liability has significantly decreased. Guidance is also included in identifying transactions that are not orderly. In addition, paragraphs 90–98 of FASB ASC 820-10-55 include illustrations on the application of this guidance.

20.43 The fair value of an asset or liability might be affected when there has been a significant decrease in the volume or level of activity for the asset or liability in relation to normal market activity for the asset or liability (or similar assets or liabilities). To determine whether there has been a significant decrease, FASB ASC 820-10-35-54C provides a number of factors a reporting entity should evaluate for significance and relevance. According to FASB ASC 820-10-35-54D, if, after evaluating the factors, the reporting entity concludes that there has been a significant decrease, further analysis of the transactions or quoted prices is needed. A decrease in the volume or level of activity on its own may not indicate that a transaction price or quoted price does not represent fair value or that a transaction in that market is not orderly. However, if a reporting entity determines that a transaction or quoted price does not represent fair value (for example, there may be transactions that are not orderly), an adjustment to the transaction or quoted price will be necessary if the reporting entity uses that price as a basis for measuring fair value and that adjustment may be significant to the fair value measurement in its entirety.

20.44 If determined there has been a significant decrease, FASB ASC 820-10-35-54F states that a change in valuation technique or the use of multiple valuation techniques may be appropriate (for example, the use of a market approach and a present value technique). When weighing indications of fair value resulting from the use of multiple valuation techniques, a reporting entity should consider the reasonableness of the range of fair value measurements. The objective is to determine the point within the range that is most representative of fair value under current market conditions. A wide range of fair value estimates may be an indication that further analysis is needed.

20.45 Even when there has been such a significant decrease, paragraphs 54G–54H of FASB ASC 820-10-35 state that the objective of a fair value measurement remains the same. Estimating the price at which market participants would be willing to enter into a transaction at the measurement date under current market conditions if there has been a significant decrease in the volume and level of activity for the asset or liability depends on the facts and circumstances at the measurement date and requires judgment. A reporting entity’s intention to hold the asset or to settle or otherwise fulfill the liability is not relevant when measuring fair value because fair value is a market-based measurement, not an entity-specific measurement.

20.46 Identifying transactions that are not orderly. According to FASB ASC 820-10-35-54I, the determination of whether a transaction is orderly (or is not orderly) is more difficult if there has been a significant decrease in the volume or level of activity for the asset or liability in relation to normal market activity for the asset or liability (or similar assets or liabilities). In such circumstances, it is not appropriate to conclude that all transactions in that market are not orderly (that is, forced liquidations or distressed sales). Circumstances that may indicate that a transaction is not orderly include the following:

  • There was not adequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities under current market conditions.
  • There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant.
  • The seller is in or near bankruptcy or receivership (that is, the seller is distressed).
  • The seller was required to sell to meet regulatory or legal requirements (that is, the seller was forced).
  • The transaction price is an outlier when compared with other recent transactions for the same or a similar asset or liability.

A reporting entity should evaluate the circumstances to determine whether the transaction is orderly based on the weight of the evidence available.

20.47 FASB ASC 820-10-35-54J states that a reporting entity should consider all the following when measuring fair value or estimating market risk premiums:

  • If the evidence indicates the transaction is not orderly, a reporting entity should place little, if any, weight (compared with other indications of fair value) on that transaction price.
  • If the evidence indicates that a transaction is orderly, a reporting entity should take into account that transaction price. The amount of weight placed on the transaction price when compared with other indications of fair value will depend on the facts and circumstances, such as the following:

—  The volume of the transaction.

—  The comparability of the transaction to the asset or liability being measured.

—  The proximity of the transaction to the measurement date.

  • If a reporting entity does not have sufficient information to conclude whether a transaction is orderly, it should take into account the transaction price. However, the transaction price may not represent fair value (that is, the transaction price is not necessarily the sole or primary basis for measuring fair value or estimating market risk premiums). When a reporting entity does not have sufficient information to conclude whether particular transactions are orderly, the reporting entity should place less weight on those transactions when compared with other transactions that are known to be orderly.

A reporting entity need not undertake exhaustive efforts to determine whether a transaction is orderly, but it should not ignore information that is reasonably available. When a reporting entity is a party to a transaction, it is presumed to have sufficient information to conclude whether a transaction is orderly.

Using Quoted Prices Provided by Third Parties

20.48 Paragraphs 54K–54M of FASB ASC 820-10-35 address using quoted prices provided by third parties. Specifically, FASB ASC 820 does not preclude the use of quoted priced provided by third parties, such as pricing services or brokers, if a reporting entity has determined that the quoted prices provided by those parties are developed in accordance with FASB ASC 820. If there has been a significant decrease in the volume or level of activity for the asset or liability, a reporting entity should evaluate whether the quoted prices provided by third parties are developed using current information that reflects orderly transactions or a valuation technique that reflects market participation assumptions (including assumptions about risk). In weighing a quoted price as an input to a fair value measurement, a reporting entity places less weight (when compared with other indications of fair value that reflect the results of transactions) on quotes that do not reflect the result of transactions. Furthermore, the nature of a quote (for example, whether the quote is an indicative price or a binding offer) should be taken into account when weighing the available evidence, with more weight given to quotes provided by third parties that represent binding offers. Management is ultimately responsible for the estimates recorded on its financial statements and accordingly should establish processes and procedures for persons with an appropriate level of expertise to review prices provided by third parties for reasonableness.

Disclosures8

20.49 FASB ASC 820-10-50 discusses the disclosures required for assets and liabilities measured at fair value. FASB ASC 820-10-50-1 explains that the reporting entity should disclose information that helps users of its financial statements assess both (a) for assets and liabilities that are measured at fair value on a recurring or nonrecurring basis in the statement of financial position after initial recognition, the valuation techniques and the inputs used to develop those measurements and (b) for recurring fair value measurements using significant unobservable inputs (Level 3), the effect of the measurements on earnings (or changes in net assets) or other comprehensive income for the period.

20.50 To meet the objectives described in FASB ASC 820-10-50-1 (see paragraph 20.49), FASB ASC 820-10-50-2 requires a reporting entity to disclose, at a minimum, the following information for each of assets and liabilities measured at fair value in the statement of financial position after initial recognition:

  1. a.  For recurring fair value measurements, the fair value measurement at the end of the reporting period, and for nonrecurring fair value measurements, the fair value measurement at the relevant measurement date and the reasons for the measurement.
  2. b.  For recurring and nonrecurring fair value measurements, the level of the fair value hierarchy within which the fair value measurements are categorized in their entirety (Level 1, 2, or 3).
  3. c.  For assets and liabilities held at the end of the reporting period that are measured at fair value on a recurring basis, the amounts of any transfers between Level 1 and Level 2 of the fair value hierarchy, the reasons for the transfers, and the reporting entity’s policy for determining when transfers between levels are deemed to have occurred (see FASB ASC 820-10-50-2C discussed in paragraph 20.52). Transfers into each level should be disclosed and discussed separately from transfers out of each level.
  4. d.  For recurring and nonrecurring fair value measurements categorized within Level 2 and Level 3 of the fair value hierarchy, a description of the valuation technique(s) and the inputs used in the fair value measurement. If there has been a change in valuation technique, the reporting entity should disclose that change and the reason(s) for making it. For fair value measurements categorized within Level 3 of the fair value hierarchy, a reporting entity should provide quantitative information about the significant unobservable inputs used in the fair value measurement. A reporting entity is not required to create quantitative information to comply with this disclosure requirement if quantitative unobservable inputs are not developed by the reporting entity when measuring fair value (for example, when a reporting entity uses prices from prior transactions or third-party pricing information without adjustment). However, when providing this disclosure, a reporting entity cannot ignore quantitative unobservable inputs that are significant to the fair value measurement and are reasonably available to the reporting entity.
  5. e.  For recurring fair value measurements categorized within Level 3 of the fair value hierarchy, a reconciliation from the opening balances to the closing balances, disclosing separately changes during the period attributable to the following:

i.  Total gains or losses for the period recognized in earnings (or changes in net assets), and the line item(s) in the statement of income (or activities) in which those gains or losses are recognized.

ii.  Total gains or losses for the period recognized in other comprehensive income, and the line item(s) in other comprehensive income in which those gains or losses are recognized.

iii.  Purchases, sales, issuances, and settlements (each of those types of changes disclosed separately).

iv.  The amounts of any transfers into or out of Level 3 of the fair value hierarchy, the reasons for those transfers, and the reporting entity’s policy for determining when transfers between levels are deemed to have occurred (see FASB ASC 820-10-50-2C discussed in paragraph 20.52). Transfers into Level 3 should be disclosed and discussed separately from transfers out of Level 3.

  1. f.  For recurring fair value measurements categorized within Level 3 of the fair value hierarchy, the amount of the total gains or losses for the period in item (e)(i) included in earnings (or changes in net assets) that is attributable to the change in unrealized gains or losses relating to those assets and liabilities held at the end of the reporting period, and the line item(s) in the statement of income (or activities) in which those unrealized gains or losses are recognized.
  2. g.  For recurring and nonrecurring fair value measurements categorized within Level 3 of the fair value hierarchy, a description of the valuation processes used by the reporting entity (including, for example, how an entity decides its valuation policies and procedures and analyzes changes in fair value measurements from period to period).
  3. h.  For recurring fair value measurements categorized within Level 3 of the fair value hierarchy, a narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs if a change in those inputs to a different amount might result in a significantly higher or lower fair value measurement. If there are interrelationships between those inputs and other unobservable inputs used in the fair value measurement, a reporting entity should also provide a description of those interrelationships and how they magnify or mitigate the effect of changes in the unobservable inputs on the fair value measurement. To comply with that disclosure requirement, the narrative description of the sensitivity to changes in unobservable inputs should include, at a minimum, the unobservable inputs disclosed when complying with item (d).
  4. i.  For recurring and nonrecurring fair value measurements, if the highest and best use of a nonfinancial asset differs from its current use, a reporting entity should disclose that fact and why the nonfinancial asset is being used in a manner that differs from its highest and best use.

FASB ASC 820-10-50-2F states that a nonpublic entity is not required to disclose the information discussed in items (c) and (h) unless required by another FASB ASC topic.

20.51 FASB ASC 820-10-50-2B explains that a reporting entity should determine appropriate classes of assets and liabilities on the basis of (a) the nature, characteristics, and risks of the asset or liability; and (b) the level of the fair value hierarchy within which the fair value measurement is categorized. Further, the number of classes may need to be greater for fair value measurements within Level 3 of the fair value hierarchy because those measurements have a greater degree of uncertainty and subjectivity. A class of assets and liabilities will often require greater disaggregation than the line items presented in the statement of financial position.

20.52 FASB ASC 820-10-50-2C explains that a reporting entity should disclose and consistently follow its policy for determining when transfers between levels of the fair value hierarchy are deemed to have occurred in accordance with items (bb) and (c)(3) in FASB ASC 820-10-50-2 (see items (c) and (e)(iv) in paragraph 20.50). The policy about the timing of recognizing transfers should be the same for transfers into the levels as for transfers out of the levels. Examples of policies for determining the timing of transfers include the following:

  • The date of the event or change in circumstances that caused the transfer
  • The beginning of the reporting period
  • The end of the reporting period

20.53 If a reporting entity makes an accounting policy decision to use the exception in FASB ASC 820-10-35-18D (see paragraph 20.21), FASB ASC 820-10-50-2D requires disclosure of that fact.

20.54 For each class of assets and liabilities not measured at fair value in the statement of financial position but for which the fair value is disclosed, FASB ASC 820-10-50-2E requires a reporting entity to disclose the information required by items (b), (bbb)(1), and (h) in FASB ASC 820-10-50-2 (see items (b), (d), and (i) in paragraph 20.50). However, a reporting entity is not required to provide the quantitative disclosures about significant unobservable inputs used in fair value measurements categorized within Level 3 of the fair value hierarchy required by item (bbb)(2) in FASB ASC 820-10-50-2 (see item (d) in paragraph 20.50). For such assets and liabilities, a reporting entity does not need to provide the other disclosures required by FASB ASC 820.

20.55 FASB ASC 820-10-50-3 states that, for derivative assets and liabilities, the reporting entity should present both the fair value disclosures required by items (a)–(bb) in FASB ASC 820-10-50-2 (see items (a)–(c) in paragraph 20.50) on a gross basis and the reconciliation disclosures required by items (c)–(d) in FASB ASC 820-10-50-2 (see items (e)–(f) in paragraph 20.50) on either a gross or net basis.

20.56 For a liability measured at fair value and issued with an inseparable third-party credit enhancement, FASB ASC 820-10-50-4A requires an issuer to disclose the existence of that credit enhancement.

Additional Disclosures for Financial Instruments

20.57 Paragraphs 2A–7 of FASB ASC 825-10-50 provide guidance about which entities are required to apply the disclosure requirements for financial instruments. For annual reporting periods, the disclosure guidance related to fair value of financial instruments in paragraphs 10–19 of FASB ASC 825-10-50 applies to all entities but is optional for an entity that is a nonpublic entity, the entity’s total assets are less than $100 million on the date of the financial statements, and the entity has no instrument that, in whole or in part, is accounted for as a derivative instrument under FASB ASC 815 other than commitments related to origination of mortgage loans to be held for sale during the reporting period. For all interim periods, the disclosure guidance applies to all entities but is optional for those entities that do not meet the definition of a publicly traded company, as defined in U.S. generally accepted accounting principles (GAAP).

20.58 Concentrations of credit risk of all financial instruments. Except as indicated in FASB ASC 825-10-50-22, an entity should disclose all significant concentrations of credit risk arising from all financial instruments, whether from an individual counterparty or groups of counterparties. When applying this disclosure requirement, the term financial instrument includes derivative instruments accounted for under FASB ASC 815. Refer to FASB ASC 825-10-50-21 for specific information to be disclosed about each significant concentration. Entities are not required to disclose information about concentrations of credit risk for the financial instruments included in FASB ASC 825-10-50-22.

20.59 Market risk of all financial instruments. FASB ASC 825-10-50-23 states that an entity is encouraged, but not required, to disclose quantitative information about the market risks of financial instruments that is consistent with the way it manages or adjusts those risks. Appropriate ways of reporting that quantitative information will differ for different entities and will likely evolve over time as management approaches and measurement techniques evolve.

Fair Value Measurements of Investments in Certain Entities That Calculate Net Asset Value per Share (or its Equivalent)

20.60 For investments that are within the scope of paragraphs 4–5 of FASB ASC 820-10-15 and measured at fair value on a recurring or nonrecurring basis during the period, FASB ASC 820-10-50-6A requires disclosure of information that will help users of the financial statements to understand the nature and risks of the investments and whether the investments are probable of being sold at amounts different from net asset value per share (or its equivalent). These disclosures, to the extent applicable, are required for each class of investment. The required disclosures, at a minimum, are as follows:

  1. a.  The fair value measurement (as determined by applying paragraphs 59–62 of FASB ASC 820-10-35) of the investments in the class at the reporting date and a description of the significant investment strategies of the investee(s) in the class.
  2. b.  For each class of investment that includes investments that can never be redeemed with the investees, but the reporting entity receives distributions through the liquidation of the underlying assets of the investees, the reporting entity’s estimate of the period of time over which the underlying assets are expected to be liquidated by the investees.
  3. c.  The amount of the reporting entity’s unfunded commitments related to investments in the class.
  4. d.  A general description of the terms and conditions upon which the investor may redeem investments in the class (for example, quarterly redemption with 60 days’ notice).
  5. e.  The circumstances in which an otherwise redeemable investment in the class (or a portion thereof) might not be redeemable (for example, investments subject to a lockup or gate). Also, for those otherwise redeemable investments that are restricted from redemption as of the reporting entity’s measurement date, the reporting entity should disclose its estimate of when the restriction from redemption might lapse. If an estimate cannot be made, the reporting entity should disclose that fact and how long the restriction has been in effect.
  6. f.  Any other significant restriction on the ability to sell investments in the class at the measurement date.
  7. g.  If a reporting entity determines that it is probable that it will sell an investment(s) for an amount different from net asset value per share (or its equivalent), as described in FASB ASC 820-10-35-62, the reporting entity should disclose the total fair value of all investments that meet the criteria in FASB ASC 820-10-35-62 and any remaining actions required to complete the sale.
  8. h.  If a group of investments would otherwise meet the criteria in FASB ASC 820-10-35-62 but the individual investments to be sold have not been identified (for example, if a reporting entity decides to sell 20 percent of its investments in private equity funds, but the individual investments to be sold have not been identified), so the investments continue to qualify for the practical expedient in FASB ASC 820-10-35-59, the reporting entity should disclose its plans to sell and any remaining actions required to complete the sale(s).

Fair Value Option

20.61 FASB ASC 825 creates a fair value option under which an entity may irrevocably elect fair value as the initial and subsequent measure for many financial instruments and certain other items, with changes in fair value recognized in earnings as those changes occur. FASB ASC 825-10-35-4 explains that a business entity should report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. An election is made on an instrument-by-instrument basis (with certain exceptions as discussed in FASB ASC 825-10-25-7), generally when an instrument is initially recognized in the financial statements and certain other election dates as outlined in FASB ASC 825-10-25-4. The fair value option need not be applied to all identical items, except as required by FASB ASC 825-10-25-7. Most financial assets and financial liabilities are eligible to be recognized using the fair value option, as are firm commitments for financial instruments and certain nonfinancial contracts (described in FASB ASC 825-10-15-4).

20.62 As explained by FASB ASC 825-10-15-5, specifically excluded from eligibility is an investment in a subsidiary that the entity is required to consolidate, an interest in a variable interest entity that the entity is required to consolidate, employer’s and plan’s obligations for pension benefits, other postretirement benefits (including health care and life insurance benefits), postemployment benefits, employee stock option and stock purchase plans, and other forms of deferred compensation arrangements (or assets representing net overfunded positions in those plans), financial assets and liabilities recognized under leases (this does not apply to a guarantee of a third-party lease obligation or a contingent obligation arising from a cancelled lease), deposit liabilities of depository institutions, and financial instruments that are, in whole or in part, classified by the issuer as a component of shareholder’s equity (including temporary equity).

20.63 FASB ASC 825-10-45 and 825-10-5011 also include presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. Paragraphs 1–2 of FASB ASC 825-10-45 state that entities should report assets and liabilities that are measured using the fair value option in a manner that separates those reported fair values from the carrying amounts of similar assets and liabilities measured using another measurement attribute. To accomplish that, an entity should either (a) report the aggregate of both fair value and non-fair-value items on a single line, with the fair value amount parenthetically disclosed or (b) present separate lines for the fair value carrying amounts and the non-fair-value carrying amounts. As discussed in FASB ASC 825-10-25-3, upfront costs and fees, such as debt issue costs, may not be deferred for items that the fair value option has been elected.

Auditing Considerations12

20.64 AU-C section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures (AICPA, Professional Standards), addresses the auditor’s responsibilities relating to accounting estimates, including fair value accounting estimates and related disclosures, in an audit of financial statements. Specifically, it expands on how AU-C sections 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement; 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained (AICPA, Professional Standards); and other relevant AU-C sections are to be applied with regard to accounting estimates. It also includes requirements and guidance related to misstatements of individual accounting estimates and indicators of possible management bias.

20.65 If the preparation of the financial statements involves the use of expertise in a field other than accounting, paragraph .A7 of AU-C section 620, Using the Work of an Auditor’s Specialist (AICPA, Professional Standards), states that the auditor, who is skilled in accounting and auditing, may not possess the necessary expertise to audit those financial statements. The engagement partner is required by AU-C section 220, Quality Control for an Engagement Conducted in Accordance With Generally Accepted Auditing Standards (AICPA, Professional Standards), to be satisfied that the engagement team and any external auditor’s specialists (defined in the auditing standards as an individual or organization possessing expertise in a field other than accounting or auditing, whose work in that field is used by the auditor to assist the auditor in obtaining sufficient appropriate audit evidence) who are not part of the engagement team, collectively, have the appropriate competence and capabilities to perform the audit engagement.13 Further, the auditor is required by AU-C section 300, Planning an Audit (AICPA, Professional Standards), to ascertain the nature, timing, and extent of resources necessary to perform the engagement.14 The auditor’s determination of whether to use the work of an auditor’s specialist, and, if so, when and to what extent, assists the auditor in meeting these requirements. As the audit progresses or as circumstances change, the auditor may need to revise earlier decisions about using the work of an auditor’s specialist.

20.66 Auditing interests in trusts held by a third-party trustee and reported at fair value. In circumstances in which the auditor determines that the nature and extent of auditing procedures should include verifying the existence and testing the measurement of investments held by a trust simply receiving a confirmation from the trustee, either in aggregate or on an investment by investment basis, does not in and of itself constitute adequate audit evidence with respect to the requirements for auditing the fair value of the interest in trust under AU-C section 540. In addition, receiving conformation from the trustee for investments in aggregate does not constitute adequate audit evidence with respect to the existence assertion. Receiving confirmation from the trustee on an investment-by-investment basis, however, typically would constitute adequate audit evidence with respect to the existence assertion. Also, in discussing obtaining an understanding of how management identifies the need for accounting estimates, paragraph .A15 of AU-C section 540 states that the preparation and fair presentation of the financial statements requires management to determine whether a transaction, an event, or a condition gives rise to the need to make an accounting estimate and that all necessary accounting estimates have been recognized, measured, and disclosed in the financial statements in accordance with the applicable financial reporting framework.

20.67 In circumstances in which the auditor is unable to audit the existence or measurement of interests in trusts at the financial statement date, the auditor should consider whether that scope limitation requires the auditor to either qualify his or her opinion or to disclaim an opinion, as discussed in AU-C section 705, Modifications to the Opinion in the Independent Auditor’s Report (AICPA, Professional Standards).

20.68

Considerations for Audits Performed in Accordance With PCAOB Standards15

PCAOB Staff Audit Practice Alert No. 2, Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists (AICPA, PCAOB Standards and Related Rules, PCAOB Staff Guidance, sec. 400.02), provides guidance on auditors' responsibilities for auditing fair value measurements of financial instruments and when using the work of specialists under the existing standards of the PCAOB. This alert is focused on specific matters that are likely to increase audit risk related to the fair value of financial instruments in a rapidly changing economic environment. This practice alert highlights certain requirements in the auditing standards related to fair value measurements and disclosures in the financial statements and certain aspects of GAAP that are particularly relevant to the current economic environment.

PCAOB Staff Audit Practice Alert No. 4, Auditor Considerations Regarding Fair Value Measurements, Disclosures, and Other-Than-Temporary Impairments (AICPA, PCAOB Standards and Related Rules, PCAOB Staff Guidance, sec. 400.04), informs auditors about potential implications of recently issued FASB guidance on reviews of interim financial information and annual audits. This alert addresses the following topics: (a) reviews of interim financial information; (b) audits of financial statements, including integrated audits; (c) disclosures; and (d) auditor reporting considerations.

Notes

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