7.1 Fair Value Hierarchy and Measurement Techniques
3 min read•august 7, 2024
Fair value accounting is crucial in financial reporting, providing a standardized way to measure assets and liabilities. The fair value hierarchy categorizes inputs into three levels, from most to least reliable, helping investors understand the certainty of valuations.
Valuation techniques like market, income, and cost approaches are used to determine fair value. These methods consider market data, future cash flows, and replacement costs, respectively, to arrive at accurate asset and liability valuations in financial statements.
Fair Value Hierarchy
Definition and Levels
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- Fair value represents 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
- 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 (most reliable)
- inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly
- Includes 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 (interest rates, yield curves, volatilities), and inputs that are derived principally from or corroborated by observable market data by correlation or other means
- inputs are for the asset or liability that reflect the reporting entity's own assumptions about the assumptions that market participants would use in pricing the asset or liability (least reliable)
Observable and Unobservable Inputs
- are inputs that 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
- Examples include 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, and inputs other than quoted prices that are observable for the asset or liability (interest rates, yield curves, volatilities)
- 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
- Reflect the reporting entity's own assumptions about the assumptions that market participants would use in pricing the asset or liability developed based on the best information available in the circumstances
Valuation Techniques
Market Approach
- Uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities, or a group of assets and liabilities
- Valuation techniques consistent with the include matrix pricing, which is a mathematical technique used principally to value without relying exclusively on quoted prices for the specific securities
- Instead, debt securities are valued by reference to other securities that are considered comparable in rating, yield, due date, and other characteristics
Income Approach
- Uses valuation techniques to convert future amounts (cash flows or earnings) to a single present amount (discounted)
- Valuation techniques consistent with the include present value techniques, option-pricing models (Black-Scholes-Merton formula or a binomial model), and the multi-period excess earnings method
- Present value techniques use a discount rate to calculate the present value of future cash flows or earnings
- Option-pricing models incorporate present value techniques and reflect both the time value and intrinsic value of an option
Cost Approach
- Based on the amount that currently would be required to replace the service capacity of an asset (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 ) or tax purposes (based on specified service lives)
Key Terms to Review (21)
Control Premium: A control premium is the additional amount an investor is willing to pay over the current market price for a controlling interest in a company. This premium reflects the value of having control over the company’s operations, strategic decisions, and financial policies, which can lead to greater profitability and decision-making power. Understanding control premiums is essential in evaluating the fair value of a business, particularly in mergers and acquisitions.
Cost Approach: The cost approach is a valuation method that estimates the value of an asset based on the cost to replace or reproduce it, minus any depreciation. This approach is particularly useful for assessing the value of unique assets, where market data may be scarce, and it emphasizes the relationship between the asset's cost and its current worth. It plays a critical role in fair value measurement and informs disclosure requirements, ensuring transparency in how values are determined.
Debt Securities: Debt securities are financial instruments that represent a loan made by an investor to a borrower, typically in the form of bonds or notes. These instruments provide investors with fixed interest payments over a specified period, and the return of principal at maturity, making them an essential component of investment portfolios and financial markets.
Derivatives: Derivatives are financial contracts whose value is derived from the performance of an underlying asset, index, or rate. They are crucial tools in the financial services industry for managing risk, speculating on future price movements, and enhancing returns through leverage.
Equity Securities: Equity securities represent ownership in a company, typically in the form of stocks or shares. When individuals or institutions purchase equity securities, they gain a claim on the company's assets and earnings, and their value can fluctuate based on the company's performance and market conditions. Understanding equity securities is essential for evaluating an organization's financial health and its potential for growth.
Estimation Uncertainty: Estimation uncertainty refers to the doubt that exists about the accuracy of estimates made in financial reporting, particularly in relation to fair value measurements. This uncertainty arises from the inherent subjectivity involved in assessing values when market prices are not readily available. Understanding estimation uncertainty is crucial for stakeholders as it affects the reliability of financial statements and the decisions made based on them.
FASB ASC 820: FASB ASC 820, also known as the Fair Value Measurement standard, provides a framework for measuring fair value and requires disclosures about fair value measurements. It establishes a consistent definition of fair value, enhancing the comparability and transparency of financial reporting across entities. This standard is crucial for understanding the fair value hierarchy and measurement techniques used in various financial reporting contexts.
Historical cost: Historical cost refers to the original monetary value of an asset when it was acquired, recorded at the time of purchase. This concept is fundamental in accounting and financial reporting, as it provides a consistent basis for valuing assets on the balance sheet. Historical cost does not account for changes in market value or inflation, making it a more stable yet sometimes less relevant measure in today’s rapidly changing economic environment.
IFRS 13: IFRS 13 is an International Financial Reporting Standard that provides guidance on how to measure fair value and establishes a framework for fair value measurement and disclosure requirements. This standard plays a crucial role in defining fair value, specifying how it should be calculated, and outlining the hierarchy of inputs used in measurements, which are essential for transparency and comparability in financial reporting.
Income approach: The income approach is a method used to estimate the value of an asset based on the income it generates, typically using present value calculations to determine the expected future cash flows. This approach connects closely with fair value measurement, emphasizing how the potential income from an asset influences its valuation and plays a crucial role in financial reporting. It also ties into the assessment of disclosures that provide insight into the assumptions and methods used in determining fair values.
Level 1: Level 1 refers to the highest tier in the fair value hierarchy established by accounting standards, which prioritizes inputs based on their reliability and market observability. This level relies solely on quoted prices in active markets for identical assets or liabilities, ensuring that the measurements are based on actual market transactions rather than estimates or models. It emphasizes the use of observable data and reduces subjectivity in valuing financial instruments.
Level 2: Level 2 refers to the second tier of the fair value hierarchy used to measure the fair value of assets and liabilities. This level encompasses inputs that are observable for the asset or liability, either directly or indirectly, but are not quoted prices in active markets, distinguishing it from Level 1 which relies on active market prices.
Level 3: Level 3 refers to the highest tier in the fair value hierarchy established under accounting standards, which is used to measure the fair value of assets and liabilities. This level is characterized by the use of unobservable inputs, meaning that the values are determined based on the entity's own assumptions about market conditions and pricing rather than observable market data. As such, Level 3 measurements can introduce a higher degree of subjectivity and uncertainty compared to Levels 1 and 2.
Level of Inputs Used: The level of inputs used refers to the categorization of the inputs used in fair value measurement based on their observability and reliability. It is a crucial aspect that determines how data is sourced for valuing an asset or liability, which can significantly impact the reported fair value in financial statements.
Liquidity discount: A liquidity discount is a reduction in the value of an asset due to its lack of marketability or the difficulty of converting it into cash quickly without significant loss in value. This concept is crucial when determining the fair value of assets, especially those that may not have a readily available market, as it reflects the additional risk and potential costs associated with selling illiquid assets compared to liquid ones.
Market approach: The market approach is a valuation technique that estimates the fair value of an asset or liability based on the current market prices of similar items. It emphasizes the importance of observable market data and transactions to determine value, making it a key component in various valuation practices, especially when assessing financial instruments and assets. This approach connects deeply with fair value measurement, addressing how market conditions influence valuations, the challenges faced in gathering accurate data, and the essential disclosure requirements needed to inform stakeholders.
Market Illiquidity: Market illiquidity refers to a situation in which an asset cannot be quickly sold or bought in the market without causing a significant impact on its price. This condition often arises when there are few buyers and sellers, leading to larger spreads between bid and ask prices. Understanding market illiquidity is crucial for accurately measuring fair value and assessing the potential risks associated with different assets within the fair value hierarchy.
Net Realizable Value: Net realizable value (NRV) is the estimated selling price of an asset in the ordinary course of business minus the estimated costs of completion, disposal, and transportation. This concept is crucial for determining the value of assets on financial statements, ensuring that they are not overstated. Understanding NRV is essential as it directly impacts inventory valuation and the assessment of accounts receivable, reflecting the true economic benefits expected from those assets.
Observable inputs: Observable inputs refer to data used in measuring fair value that can be directly observed from the market, such as quoted prices for identical assets or liabilities in active markets. These inputs are crucial for ensuring that valuations reflect current market conditions and provide transparency in financial reporting. They help establish a reliable basis for determining the value of financial instruments and reduce subjectivity in the valuation process.
Unobservable inputs: Unobservable inputs are inputs used in fair value measurement that are not based on observable market data and cannot be validated through direct market transactions. They typically rely on the issuer's own assumptions or estimates, making them crucial in assessing the value of complex financial instruments where market data is scarce. This concept is essential for understanding how values are derived in less liquid markets and plays a significant role in the evaluation of financial instruments and their reporting.
Valuation Techniques Employed: Valuation techniques employed refer to the methodologies and approaches used to determine the fair value of an asset or liability. These techniques play a crucial role in financial reporting, as they help ensure that values reflect the current market conditions and specific circumstances of the asset or liability being assessed. Understanding these techniques is essential for accurate financial disclosures and compliance with regulatory standards.