Fair Value Measurement
Fair Value Definition
Under ASC 820, fair value is defined 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. This is an exit price — the price from the perspective of a seller, not a buyer. :::info Key Concepts
- Orderly transaction — not a forced sale or liquidation
- Market participants — independent, knowledgeable, willing, and able parties
- Measurement date — the date of the financial statements (or interim measurement date) :::
Principal Market vs. Most Advantageous Market
Fair value is determined based on transactions in:
- Principal market — the market with the greatest volume and activity for the asset or liability
- Most advantageous market — if no principal market exists, the market that maximizes the amount received (for assets) or minimizes the amount paid (for liabilities) after considering transaction costs
:::tip Exam Tip
Transaction costs are used to determine the most advantageous market but are not included in the fair value measurement itself. Transport costs (costs to move the asset to the market) are included in the measurement.
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Example: Bear Co. holds a commodity that trades in two active markets:
Market Price Transaction Costs Transport Costs Net Proceeds Market A $105 $3 $2 $100 Market B $103 $1 $1 $101 Market B is the most advantageous market ($101 > $100). However, the fair value reported excludes transaction costs:
Valuation Approaches
ASC 820 identifies three acceptable approaches for measuring fair value:
1. Market Approach
Uses prices and other relevant information from market transactions involving identical or comparable assets/liabilities.
| Technique | Description |
|---|---|
| Quoted prices | Directly observable market prices |
| Matrix pricing | Used for fixed-income securities based on benchmark quoted prices |
| Market multiples | Comparable company analysis using P/E, EV/EBITDA, etc. |
| Example: Gies Co. holds 1,000 shares of a publicly traded stock. The closing price is $45 per share: |
2. Cost Approach
Reflects the amount required to replace the service capacity of an asset (current replacement cost). Often used for tangible assets.
Example: MAS Inc. owns a specialized machine. A new equivalent machine costs $200,000, but the existing machine has 40% of its useful life remaining:
3. Income Approach
Converts future amounts (cash flows, earnings) to a single present value. Techniques include:
| Technique | Description |
|---|---|
| Discounted cash flow (DCF) | PV of expected future cash flows |
| Option pricing models | Black-Scholes, binomial models |
| Multi-period excess earnings | Used for intangible assets |
| Example: Kingfisher Industries values a patent using DCF. Expected annual cash flows are $50,000 for 5 years, discounted at 8%: |
Fair Value Hierarchy
ASC 820 establishes a three-level hierarchy based on the observability of inputs used in valuation techniques. Level 1 inputs are most reliable; Level 3 inputs are least reliable.
Level 1 — Quoted Prices in Active Markets
- Unadjusted quoted prices for identical assets or liabilities in active markets
- Most reliable measurement
- Examples: NYSE-listed stock prices, commodity exchange prices
info
Level 1 inputs should be used without adjustment. A "blockage factor" (discount for holding a large block of shares) is not permitted for Level 1 measurements.
Level 2 — Observable Inputs Other Than Level 1
- Quoted prices for similar (not identical) assets or liabilities in active markets
- Quoted prices for identical or similar items in inactive markets
- Observable inputs such as interest rates, yield curves, credit spreads
- Inputs derived from or corroborated by observable market data Examples:
- Interest rate swaps priced using the LIBOR/SOFR yield curve
- Real estate valued using comparable sales in the area
- Corporate bonds priced using benchmark Treasury rates plus a credit spread
Level 3 — Unobservable Inputs
- Entity-developed inputs reflecting the entity's own assumptions about what market participants would use
- Used when observable inputs are not available
- Require the most disclosure Examples:
- Long-term cash flow projections for a private company
- Internally developed discount rates
- Assumptions about future technology adoption rates
Classification Rules
| Scenario | Level |
|---|---|
| NYSE-traded equity security | Level 1 |
| OTC bond priced with observable yield curves | Level 2 |
| Private company valued with internal DCF model | Level 3 |
| Real estate appraised using comparable sales | Level 2 |
| Goodwill tested for impairment using internal projections | Level 3 |
The entire fair value measurement is classified based on the lowest level input that is significant to the measurement. If a Level 2 measurement uses a significant Level 3 input, the entire measurement is classified as Level 3.
Fair Value Disclosures
Entities must disclose information to help users assess:
1. Valuation Techniques and Inputs
- Description of the valuation technique(s) used (market, cost, income)
- Key inputs and assumptions
- Any changes in techniques from prior periods and the reason
2. Level 3 Measurement Uncertainty
For recurring Level 3 measurements, entities must disclose:
- A reconciliation of beginning to ending balances (showing purchases, sales, gains/losses, transfers)
- The amount of total gains or losses included in earnings and where they are reported
- Sensitivity analysis — how changes in unobservable inputs would affect fair value
3. Impact on Financial Performance
- Unrealized gains and losses for assets/liabilities still held at the reporting date
- Transfers between Level 1, 2, and 3 (and reasons)
4. Required Disclosures Summary
| Measurement Type | Fair Value | Level | Technique | Inputs |
|---|---|---|---|---|
| Recurring | Required | Required | Required | Required |
| Nonrecurring | Required | Required | Required | Required |
Example disclosure: BIF Partners reports an investment property at fair value of $1,200,000 (Level 3). The income approach was used with a capitalization rate of 7.5% applied to net operating income. A 50-basis-point change in the cap rate would change the fair value by approximately ±$80,000.
Exceptions to Fair Value Measurement
Certain items are excluded from ASC 820's scope or have specific measurement exceptions:
| Exception | Standard |
|---|---|
| Inventory measured at NRV | ASC 330 |
| Leases | ASC 842 |
| Share-based payment transactions | ASC 718 |
| ARO initial measurement | ASC 410 |
| Retirement benefit plan assets | ASC 715/960 |
| Additionally, certain practical expedients exist: |
- Net asset value (NAV) per share may be used as a practical expedient for investments in certain funds (hedge funds, private equity) that do not have readily determinable fair values
- This NAV practical expedient measurement is not classified within the fair value hierarchy
Fair Value Option
Under ASC 825, entities may elect to measure certain financial assets and liabilities at fair value (the "fair value option"). Once elected, the choice is irrevocable for that instrument. Illini Entertainment elects the fair value option for a $500,000 note payable. At year-end, the fair value of the note is $480,000:
Changes in fair value attributable to instrument-specific credit risk for liabilities measured under the fair value option are reported in OCI, not net income (ASU 2016-01).
Summary
:::note Chapter Checklist
- Define fair value as an exit price in an orderly transaction
- Distinguish principal market from most advantageous market
- Apply the three valuation approaches (market, cost, income)
- Classify measurements within the Level 1/2/3 hierarchy
- Determine the overall level based on the lowest significant input
- Understand required disclosures, especially for Level 3 measurements
- Identify exceptions and the NAV practical expedient
- Know the fair value option and where credit risk changes are reported :::