Chapter 6
Fair Value Accounting

Learning objectives

  • Identify key requirements of FASB ASC 820, Fair Value Measurement.
  • Distinguish the difference between an orderly transaction and a forced transaction.
  • Identify key characteristics of the fair value measurement hierarchy.

Overview

The guidance in FASB ASC 820 describes how to determine fair values when existing (or new) financial reporting requirements dictate that a fair value be determined for recognition or disclosure purposes, or both.

FASB ASC 820 defines fair value, establishes a framework for measuring fair value when required under GAAP, and provides required disclosures about fair value measurements. It applies to other FASB ASC topics that require or permit fair value measurements.

Fair value is a market-based measurement, not an entity-specific measurement. The definition of fair value focuses on assets and liabilities because they are a primary subject of accounting measurement. Fair value measurements are also applied to instruments that are classified in shareholders’ equity when their measurement dictates that their fair value be determined.

For some assets and liabilities, observable market transactions and market information might be available. For other assets and liabilities, observable market transactions and market information might not be available. However, the objective of a fair value measurement in both cases is the same — to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions (that is, an exit price). An exit price is the price that would be received to sell an asset or paid to transfer a liability at the measurement date from the perspective of a market participant that holds the asset or owes the liability.

When a price for an identical asset or liability is not observable, a reporting entity measures fair value using another valuation technique that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. Because fair value is a market-based measurement, it is measured using the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk. As a result, a reporting entity’s intention to hold an asset or to settle or otherwise fulfill a liability is not relevant when measuring fair value.

This chapter integrates the broad changes, where applicable, brought about by the issuance of ASU No. 2018-13 — Fair Value Measurement (Topic 820) — Disclosure Framework — Changes to the Disclosure Requirements for Fair Value Measurement. The amendments in this ASU add, modify, and remove disclosure requirements in FASB ASC 820 related to recurring and nonrecurring fair value measurements. The effective dates follow:

  • For all entities, the amendments are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019.
  • The amendments on changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop level 3 fair value measurements, and the narrative description of measurement uncertainty should be applied prospectively for only the most recent interim or annual period presented in the initial fiscal year of adoption.
  • All other amendments should be applied retrospectively to all periods presented upon their effective date.
  • Early adoption is permitted upon issuance of this Update. An entity is permitted to early adopt any of the removed or modified disclosures and delay adoption of the additional disclosures until their effective date.

Scope

FASB ASC 820 is applicable to FASB ASC topics that permit or require fair value measurements or disclosures about fair value measurements, except for the following which are outside its scope:

  • Share-based payment transactions
  • Topics that require or permit measurements that are similar to fair value but that are not intended to measure fair value, including both of the following:
    • FASB ASC topics that permit measurements that are determined on the basis of, or otherwise use, standalone selling price
    • Inventory (FASB ASC 330)
  • Lease classification and measurement principles in accordance with FASB ASC 840; this scope exception does not apply to leases accounted for in accordance with the new leases standard, FASB ASC 842, Leases.
  • Upon adoption of ASU No. 2014-09, Revenue from Contracts with Customers, recognition and measurement of the following:
    • Revenue from contracts with customers (FASB ASC 606, Revenue from Contracts with Customers)
    • Gains and losses upon the derecognition of nonfinancial assets in accordance FASB ASC 610.

Definition of fair value

Fair value 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.

A fair value measurement is specific to a particular asset or liability. Therefore, the measurement should consider attributes specific to the asset or liability; for example, the condition and location of the asset or liability and restrictions, if any, on the sale or use of the asset at the measurement date. The asset or liability might be a standalone asset or liability (for example, a financial instrument or an operating asset) or a group of assets, liabilities, or both (for example, an asset group, a reporting unit, or a business).

Whether the asset or liability is a standalone asset or liability or a group of assets, liabilities, or both depends on its unit of account. The unit of account determines what is being measured by reference to the level at which the asset or liability is aggregated (or disaggregated) for purposes of applying other FASB ASC topics.

Orderly transaction

A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for market activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction such as a forced liquidation or distress sale. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of the seller. Therefore, the objective of a fair value measurement is to determine the price that would be received to sell the asset or paid to transfer the liability at the measurement date (that is, an exit price).

A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in 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. The principal market is the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability.

The most advantageous market is the market in which the reporting entity would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability, after considering transaction costs in the respective market(s). In either case, 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.

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 otherwise determined using a valuation technique), even if the price in a different market is potentially more advantageous at the measurement date.

The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability should not be adjusted for transaction costs. Transaction costs represent the incremental direct costs to sell the asset or transfer the liability in the principal (or most advantageous) market for the asset or liability. Transaction costs are not an attribute of the asset or liability; rather, they are specific to the transaction and will differ depending on how the reporting entity transacts. However, transaction costs do not include the costs that would be incurred to transport the asset or liability to (or from) its principal (or most advantageous) market. If location is an attribute of the asset or liability (as might be the case for a commodity), the price in the principal (or most advantageous) market used to measure the fair value of the asset or liability should be adjusted for the costs, if any, that would be incurred to transport the asset or liability to (or from) its principal (or most advantageous) market.

Market participants

Market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability that are

  • independent of each other (not related parties);
  • knowledgeable, having a reasonable understanding about the asset or liability and the transaction based on all available information, including information that might be obtained through due diligence efforts that are usual and customary;
  • able to enter into a transaction for the asset or liability; and
  • willing to transact for the asset or liability; that is, they are motivated but not forced or otherwise compelled to do so.

A reporting entity shall measure the fair value of an asset or liability using the assumptions that market participants would use in pricing the asset or liability, assuming that market participants act in their economic best interest. In developing those assumptions, the reporting entity need not identify specific market participants. Rather, the reporting entity should 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 whom the reporting entity would transact in that market.

Knowledge check

  1. Which would be representative of an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date?
    1. Usual and customary transactions involving assets or liabilities.
    2. A forced liquidation involving assets or liabilities.
    3. A distressed sale involving assets or liabilities.
    4. A transaction considered from the perspective of the buyer.

Fair value measurement for nonfinancial assets

A fair value measurement of a nonfinancial asset considers a market participant’s ability to generate economic benefit through the highest and best use of the asset or sale to another market participant with the same considerations. The highest and best use of a nonfinancial asset considers the use of the asset that is physically possible, legally permissible, and financially feasible. Highest and best use is determined from the perspective of market participants, even if the reporting entity intends a different use. When measuring financial assets or liabilities, this alternative is not relevant because there are no alternative uses to their fair value because the financial asset is not dependent on its use within a group of other assets or liabilities.

The highest and best use of the asset establishes the valuation premise used to measure the fair value of a nonfinancial asset, as follows:

  • When the highest and best use of a nonfinancial asset is in-combination; that is, when the asset would provide maximum value to market participants principally through its use in-combination with other assets as a group. If the highest and best use of the nonfinancial asset is in-combination, the fair value of the asset would be measured using an in-combination valuation premise.
    • When using an in-combination valuation premise, the fair value of the nonfinancial asset is determined based on the price that would be received in a current transaction to sell the nonfinancial asset assuming that the nonfinancial asset would be used with other assets as a group and that those assets would be available to market participants. Generally, assumptions about the highest and best use of the nonfinancial asset should be consistent for all of the assets of the group within which it would be used.
  • When the highest and best use of the nonfinancial asset would provide maximum value to market participants principally on a standalone basis. If the highest and best use of the nonfinancial asset is on a standalone basis, the fair value of the nonfinancial asset is the price that would be received in a current transaction to sell the nonfinancial asset to market participants that would use the nonfinancial asset on a standalone basis. Because the highest and best use of the nonfinancial asset is determined based on its use by market participants, the fair value measurement considers the assumptions that market participants would use in pricing the nonfinancial asset, whether using an in-combination or a standalone valuation premise.

See the case study at the end of this chapter for an example of the highest and best use.

Fair value measurement for liabilities

A fair value measurement assumes that a financial or nonfinancial liability is transferred to a market participant at the measurement date. The fair value of a liability reflects the effect of nonperformance risk. Nonperformance risk includes, but may not be limited to, the reporting entity’s own credit risk. The reporting entity should consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value. 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) — and the terms of credit enhancements related to the liability, if any.

Entry versus exit prices

When an asset is acquired or a liability is assumed in an exchange transaction for that asset or liability, the transaction price represents the price paid to acquire the asset or received to assume the liability (an entry price). In contrast, the fair value of the asset or liability represents the price that would be received to sell the asset or paid to transfer the liability (an exit price). Conceptually, entry prices and exit prices are different. Entities do not necessarily sell assets at the prices paid to acquire them. Similarly, entities do not necessarily transfer liabilities at the prices received to assume them. In many cases, the transaction price will equal the fair value.

Valuation

Valuation techniques used to measure fair value should be appropriate in the circumstances and supported by data that is sufficient to measure fair value in a manner that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs.

Market approach

The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business). For example, valuation techniques consistent with the market approach often use market multiples derived from a set of comparables. Multiples might be in ranges with a different multiple for each comparable. The selection of where within the range the appropriate multiple falls requires judgment, considering factors specific to the measurement (qualitative and quantitative).

Valuation techniques consistent with the market approach include matrix pricing. Matrix pricing is a mathematical technique used principally to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the security’s relationship to other benchmark quoted securities.

Income approach

The income approach converts future amounts (for example, cash flows or earnings) to a single (discounted) present value amount. The measurement is based on the value indicated by current market expectations about those future amounts. Those valuation techniques include present value techniques; option-pricing models, such as the Black-Scholes model or a binomial model (a lattice model), which incorporate present value techniques; and the multi-period excess earnings method, which is used to estimate the fair value of certain intangible assets.

Cost approach

The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost). From the perspective of a market participant (seller), the price that would be received for the asset is determined based on the cost to a market participant (buyer) to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence. Obsolescence encompasses physical deterioration, functional (technological) obsolescence, and economic (external) obsolescence and is broader than depreciation for financial reporting purposes (an allocation of historical cost) or tax purposes (based on specified service lives).

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, as might be the case when valuing a business unit). If multiple valuation techniques are used to measure fair value, the results (respective indications of fair value) should be evaluated and weighted, as appropriate, considering the reasonableness of the range indicated by those results. A fair value measurement is the point within that range that is most representative of fair value in the circumstances.

Valuation techniques used to measure fair value should be consistently applied. However, a change in a valuation technique or its application (for example, a change in its weighting when multiple valuation techniques are used) is appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances. That might be the case if, for example, new markets develop, new information becomes available, information previously used is no longer available, valuation techniques improve or market conditions change. Revisions resulting from a change in the valuation technique or its application should be accounted for as a change in accounting estimate; however, FASB ASC 250-10-50-5 explains that the disclosure requirements for a change in accounting estimate are not required for revisions resulting from a change in a valuation technique or its application.

Valuation inputs

FASB ASC 820 refers to inputs as assumptions that market participants would use in pricing the asset or liability, including assumptions about risk; for example, 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 as follows:

  • Observable inputs. Inputs that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data, such as publicly-available information obtained from sources independent of the reporting entity.
  • Unobservable inputs. Inputs developed from the best information available about the assumptions market participants would use in pricing the asset or liability and for which market data are unavailable.

Valuation techniques used to measure fair value should maximize the use of observable inputs and minimize the use of unobservable inputs.

Hierarchy of fair value measurements

To increase consistency and comparability in fair value measurements and related disclosures, the fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (level 1) and the lowest priority to fair value estimates derived from unobservable inputs (level 3).

In some cases, the inputs used to measure fair value might fall in different levels of the fair value hierarchy. The level in the fair value hierarchy within which the fair value measurement in its entirety falls should be determined based on the lowest level input that is significant to the fair value measurement in its entirety. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment, considering factors specific to the asset or liability.

The availability of inputs relevant to the asset or liability and the relative reliability of the inputs might affect the selection of appropriate valuation techniques. However, the fair value hierarchy prioritizes the inputs to valuation techniques, not the valuation techniques. For example, a fair value measurement using a present value technique might fall within level 2 or level 3, depending on the inputs that are significant to the measurement in its entirety and the level in the fair value hierarchy within which those inputs fall.

Level 1 inputs

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

An active market for the asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. A quoted price in an active market provides the most reliable evidence of fair value and should be used to measure fair value whenever available.

A reporting entity should not make an adjustment to a level 1 input except in the following circumstances:

  • If the reporting entity holds a large number of similar assets or liabilities (for example, debt securities) that are required to be measured at fair value, a quoted price in an active market might be available but not readily accessible for each of those assets or liabilities individually. In that case, fair value may be measured using an alternative pricing method that does not rely exclusively on quoted prices (for example, matrix pricing) as a practical expedient. However, the use of an alternative pricing method renders the fair value measurement a lower level measurement (typically level 2 as opposed to level 1).
  • In some situations, a quoted price in an active market might not represent fair value at the measurement date. That might be the case if, for example, significant events (principal-to-principal transactions, brokered trades, or announcements) occur after the close of a market but before the measurement date. The reporting entity should establish and consistently apply a policy for identifying those events that might affect fair value measurements. However, if the quoted price is adjusted for new information, the adjustment renders the fair value measurement a lower level measurement.
  • If an entity is measuring the fair value of a liability or an instrument classified in shareholders’ equity using the quoted price for the identical item traded as an asset in an active market and that price needs to be adjusted for factors specific to the item or the asset. Any adjustment to the quoted price of the asset results in a fair value measurement categorized within a lower level of the fair value hierarchy.

If the reporting entity holds a position in a single asset or liability (including a block) and the instrument is traded in an active market, the fair value of the position should be measured within level 1 as the product of the quoted price for the individual instrument times the quantity held. The quoted price should not be adjusted because of the size of the position relative to trading volume (blockage factor). Premiums or discounts related to size as a characteristic of the reporting entity’s holding (specifically, a blockage factor) rather than as a characteristic of the asset or liability (for example, a control premium) are not permitted in a fair value measurement, 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.

Level 2 inputs

Level 2 inputs are inputs other than quoted prices included within level 1 that are observable for the asset or liability, either directly or indirectly. 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. 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, that is, markets in which there are few transactions for the asset or liability, the prices are not current, or price quotations vary substantially either over time or among market makers (for example, some brokered markets), or in which little information is released publicly (for example, a principal-to-principal market)
  • 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, and credit spreads)
  • Inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs)

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 the inputs relate to items that are comparable to the asset or liability, and the volume and 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.

Level 3 inputs

Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs should be used to measure fair value to the extent that 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. However, the fair value measurement objective remains the same; that is, an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs should reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk.

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 should make adjustments if reasonably available information indicates that other market participants would use different data or if there is something particular to the reporting entity that is not available to other market participants. In developing unobservable inputs, the reporting entity need not undertake exhaustive efforts to obtain information about market participant assumptions. However, the reporting entity should take into account all information about market participant assumptions that is reasonably available.

Disclosures

For assets and liabilities measured at fair value, whether on a recurring or nonrecurring basis, FASB ASC 820-10-50 specifies the required disclosures concerning the inputs used to measure fair value, and explains that the reporting entity should disclose information that enables users of its financial statements to assess

  1. for assets and liabilities measured at fair value on a recurring basis in periods subsequent to initial recognition or measured on a nonrecurring basis in periods subsequent to initial recognition, the valuation techniques and inputs used to develop those measurements; and
  2. for recurring fair value measurements using significant unobservable inputs (level 3), the effect of the measurements on earnings for the period.

To meet the disclosure requirements of FASB ASC 820-10, a reporting entity should consider all of the following:

  • The level of detail necessary to satisfy the disclosure requirements
  • How much emphasis to place on each of the various requirements
  • How much aggregation or disaggregation to undertake
  • Whether users of financial statements need additional information to evaluate the quantitative information disclosed

In addition to the preceding, FASB ASC 820 provides other certain disclosures such as the following:

  • Liabilities issued with an inseparable third party credit enhancement
  • Fair value measurement of investments in certain entities that calculate net asset value per share (or its equivalent)
  • Changes in valuation techniques or their application

Knowledge check

  1. Which statement describes the concepts of highest and best use and valuation premise in a fair value measurement?
    1. It refers to the use of an asset by market participants that would minimize the loss of the asset or group of assets.
    2. It is relevant when measuring the fair value of financial assets.
    3. It refers to the use of an asset by market participants that would maximize the value of the asset or group of assets.
    4. It is determined based upon the transfer price of the asset to market participants.
  2. To increase consistency and comparability in fair value measurements and related disclosures, the fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into
    1. Two broad levels.
    2. Three broad levels.
    3. Four broad levels.
    4. Five broad levels.
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