ASC 820 Fair Value: Measurement and Disclosures

Accounting Standards Codification (ASC) 820 provides the framework for measuring fair value under U.S. Generally Accepted Accounting Principles (GAAP). The standard establishes a consistent definition of fair value, a structure for its measurement, and detailed disclosure requirements. This framework aims to increase the consistency and comparability of these measurements across companies, helping investors and other stakeholders make more informed decisions.

ASC 820 defines fair value as an “exit price,” which is the price received to sell an asset or paid to transfer a liability. This concept assumes an orderly transaction between market participants on the measurement date. Fair value is a market-based measurement reflecting current economic conditions, not an entity-specific value or historical cost.

The Fair Value Hierarchy

ASC 820 establishes a three-level hierarchy to categorize the inputs used in valuation techniques. This framework prioritizes inputs, giving the highest rank to observable data and the lowest to unobservable data that requires significant judgment. The classification of a fair value measurement within the hierarchy is determined by the lowest level of input that is significant to the entire measurement. This means if a significant input is unobservable, the entire measurement is classified in the lowest tier.

Level 1 Inputs

Level 1 inputs are unadjusted quoted prices in active markets for assets or liabilities identical to those being measured. An active market is one with sufficient transaction frequency and volume to provide ongoing pricing information. When a quoted price for an identical item in an active market is available, it must be used to measure fair value without adjustment. Examples include stocks actively traded on a major public exchange and U.S. Treasury bonds, which have readily observable prices.

Level 2 Inputs

Level 2 inputs are observable data points other than the quoted prices of Level 1. These inputs are developed using and can be corroborated by market data. Examples include quoted prices for similar assets in active markets or for identical assets in inactive markets. Other inputs are interest rates, yield curves, and valuation multiples from comparable businesses, as well as corporate bonds or certain derivatives valued with observable data.

Level 3 Inputs

Level 3 inputs are unobservable and are used when there is little to no market activity for the asset or liability. These inputs reflect the reporting entity’s own assumptions about what market participants would use to price the item, based on the best available information. This level relies on internal data and models. Examples include private equity investments, unique intangible assets, goodwill, and financial forecasts developed using a company’s own data.

Valuation Approaches and Techniques

ASC 820 outlines three broad valuation approaches. Companies must use techniques appropriate for the circumstances and for which sufficient data is available, maximizing the use of observable inputs. Depending on the asset or liability, a single technique or multiple techniques may be necessary to determine the most representative fair value.

The Market Approach

The market approach uses prices and other information from market transactions involving identical or comparable assets or liabilities. One technique uses market multiples derived from a set of comparable transactions or companies. For example, when valuing a private business, an analyst might apply a multiple from recent sales of similar companies to the subject company’s earnings or revenue. This approach is based on what market participants have recently paid for similar assets.

The Income Approach

The income approach converts future amounts, like cash flows or earnings, into a single discounted amount. This method is based on the value an asset is expected to produce in the future. A common technique is the discounted cash flow (DCF) method, which forecasts an asset’s future cash flows and discounts them to their present value. The sum of these discounted cash flows provides an estimate of the asset’s fair value.

The Cost Approach

The cost approach reflects the amount currently required to replace the service capacity of an asset, also known as the current replacement cost. This approach is based on the principle that a buyer would not pay more for an asset than its replacement cost. It is most commonly used for tangible assets like property, plant, and equipment. When applying this approach, an adjustment for all forms of obsolescence is necessary to reflect the asset’s true current service capacity.

Principal (or Most Advantageous) Market

The valuation under ASC 820 assumes a transaction in the principal market for the asset or liability. The principal market is the one with the greatest volume and level of activity for that item. If a principal market cannot be identified, the valuation should use the most advantageous market. This is the market that maximizes the sale price of an asset or minimizes the transfer cost of a liability, after transaction and transportation costs.

Highest and Best Use

For nonfinancial assets like real estate, ASC 820 requires using the “highest and best use” principle. This means the fair value measurement must consider the use of the asset by market participants that would maximize its value, regardless of the entity’s intended use. The highest and best use must be physically possible, legally permissible, and financially feasible. For instance, land used for parking must be valued based on its potential for commercial development if market participants would value it that way.

Required Financial Statement Disclosures

The disclosure requirements in ASC 820 provide financial statement users with information to assess the valuation techniques and inputs used to develop fair value measurements. These disclosures offer transparency into the reliability of the figures presented. This helps investors and analysts understand the degree of subjectivity involved in the valuations.

Quantitative Disclosures

Companies must provide a quantitative disclosure of fair value measurements, categorized by their level within the hierarchy. This is presented in a table showing the amounts for each class of asset and liability attributable to Level 1, Level 2, and Level 3 inputs. This format allows users to see the breakdown of fair value measurements. The company must also provide enough information to reconcile these disclosed amounts back to the line items on the statement of financial position.

Qualitative Disclosures

For fair value measurements in Level 2 and Level 3, companies must provide qualitative disclosures. This includes a description of the valuation techniques and the specific inputs used. If a company changes its valuation approach or technique, it must disclose the change and the reasons for it. This context helps users understand the methodologies behind the numbers when they are not derived directly from active market quotes.

Specific Level 3 Disclosures

Level 3 measurements are subject to the most extensive disclosure requirements due to their subjectivity. For recurring Level 3 fair value measurements, public companies must provide a detailed reconciliation of the beginning and ending balances. This reconciliation must separately show total gains or losses, purchases, sales, issuances, settlements, and any transfers into or out of Level 3. A company must also provide quantitative information about the significant unobservable inputs used, such as the discount rate and cash flow growth rate assumptions in a DCF model.