Accounting Applications
Financial reporting uses different measurements in different situations—historical cost for equipment, net realizable value for inventories, or fair value for investments. The FASB increasingly is requiring the use of fair values in the measurement of assets and liabilities. According to the FASB’s recent guidance on fair value measurements (ASC 820-10-05, FAS-57, Fair Value Measurements), the most useful fair value measures are based on market prices in active markets. Within the fair value hierarchy these are referred to as Level 1. Level 1 fair value measures are the most reliable because they are based on quoted prices, such as a closing stock price in the financial dailies and online finance sites.
However, for many assets and liabilities, market-based fair value information is not readily available. In these cases, fair value can be estimated based on the expected future cash flows related to the asset or liability. Such fair value estimates are generally considered Level 3 (least reliable) in the fair value hierarchy because they are based on unobservable inputs, such as a company’s own data or assumptions related to the expected future cash flows associated with the asset or liability. As discussed in the fair value guidance, present value techniques are used to convert expected cash flows into present values, which represent an estimate of fair value. This issue is covered in depth in Chapter 2.
Because of the increased use of present values in this and other contexts, it is important to understand present value techniques. The timing of the returns on an investment has an important effect on the worth of the investment (asset). Similarly, the timing of debt repayment has an important effect on the value of the debt commitment (liability).
GAAP addresses present value as a measurement basis for a broad array of transactions, such as accounts and notes receivable and payable, leases, pensions and other postretirement benefits, and long-term asset impairments. More are listed below.
Fair Value Measurements
ASC 820-10-05, FAS157 (Fair Value Measurements) states that a fair value measurement reflects current market participant assumptions about future inflows of the asset and future outflows of the liability. A fair value measurement incorporates the attributes of the particular asset or liability (e.g., location, condition). In formulating fair value, consideration is given to the exchange price, which refers to the market price at the measurement date in an orderly transaction between the parties to sell the asset or transfer the liability. The focus is on the price that would be received to sell the asset or paid to transfer the liability (exit price), not the price that would be paid to buy the asset or received to assume the liability (entry price).
The asset or liability may be by itself (e.g., financial security, operating asset) or a group of assets or liabilities (e.g., asset group, reporting unit).
The Fair Value Hierarchy
A hierarchy list of fair value distinguishes between (1) assumptions based on market data from independent outside sources (observable inputs) and (2) assumptions by the company itself (unobservable inputs). The use of unobservable inputs allows for situations in which there is minimal or no market activity for the asset or liability at the measurement date. Valuation methods used to measure fair value shall maximize the use of observable inputs and minimize the use of unobservable ones.
Risk and Restrictions
An adjustment for risk should be made in a fair value measurement when market participants would include risk in the pricing of the asset or liability. Nonperformance risk of the obligation and the entity’s credit risk should be noted. Further, consideration should be given to the effect of a restriction on the sale or use of an asset that impacts its price.
The Difference between the Principal Market and the Most Advantageous Market
In a fair value measurement, we assume that the transaction occurs in the principal (main) market for the asset or liability. This is the market in which the company would sell the asset or transfer the liability with the greatest volume. If a principal market is nonexistent, then the most advantageous market should be used. This is the market in which the business 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 taking into account any transaction costs. The fair value measurement should incorporate transportation costs for the asset or liability.
Valuation Approaches
In fair value measurement, valuation techniques based on the market, income, and cost approaches may be used. The market approach uses prices for market transactions for identical or comparable assets or liabilities. The income approach uses valuation techniques to discount future cash flows to a present value amount. The cost approach is based on the current replacement cost such as the cost to buy or build a substitute comparable asset after adjusting for obsolescence. Input availability and reliability related to the asset or liability may impact the choice of the most suitable valuation method.
A single or multiple valuation technique may be needed, depending on the situation. For example, a single valuation method would be used for an asset having quoted market prices in an active market for identical assets. A multiple valuation method would be used to value a reporting unit.
The Three Levels of Fair Value Hierarchy
The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. Level 1, the highest priority, assigns quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 3, the lowest priority, is assigned