ASC 820 Fair Value Measurement Requirements

Accounting Standards Codification (ASC) 820, from the Financial Accounting Standards Board (FASB), provides the guide for fair value measurements under U.S. Generally Accepted Accounting Principles (GAAP). It creates a standardized framework for determining and disclosing the fair value of assets and liabilities. This consistency enhances the comparability and transparency of financial statements, giving investors a clearer view of a company’s financial position.

The standard applies when another accounting rule requires or permits an item to be measured at fair value. ASC 820 does not dictate when to use fair value, but how to measure it once mandated. The standard ensures that fair value measurements are reliable and reflect current market conditions instead of company-specific views.

The Fair Value Framework

ASC 820 defines fair value 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,” reflecting the value from selling an asset or transferring a liability, not the price paid to acquire it. The framework is built on several concepts that guide its application.

The valuation must assume an “orderly transaction,” which is a hypothetical transaction with enough market exposure to allow for normal marketing activities, not a forced sale. This transaction occurs between “market participants,” defined as buyers and sellers who are independent, knowledgeable, and both able and willing to transact.

A company must identify the market where the transaction would occur. The valuation should be based on the “principal market,” which is the one with the greatest volume and activity for the asset or liability. If no principal market exists, the company must use the “most advantageous market,” which maximizes the sale price or minimizes the transfer payment after considering transaction costs. Transaction costs help determine the market but are not included in the final fair value measurement.

The framework clarifies how to treat contractual restrictions on the sale of an equity security. Such a restriction is a characteristic of the entity holding the security, not a feature of the security itself. Therefore, the restriction is not considered when measuring the security’s fair value.

For nonfinancial assets like property or equipment, the framework uses the concept of “highest and best use.” This principle requires valuing the asset based on the use that would maximize its value from a market participant’s perspective, regardless of its current use. This potential use must be physically possible, legally permissible, and financially feasible. For instance, land used for storage might have a higher value if developed for retail, and its fair value must reflect that potential.

The Fair Value Hierarchy

ASC 820 establishes a three-level hierarchy to increase consistency in fair value measurements. This hierarchy categorizes the inputs used in valuation techniques, not the techniques themselves. A measurement’s classification is determined by the lowest-level input that is significant to the entire measurement.

Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the entity can access. An active market has transactions with enough frequency and volume to provide ongoing pricing information. Examples include publicly traded stocks, U.S. Treasury securities, and shares in actively traded mutual funds.

Level 2 inputs are observable inputs other than the quoted prices included within Level 1. These inputs are developed using market data, such as publicly available information about actual events or transactions. They reflect the assumptions market participants would use when pricing the asset or liability.

Examples of Level 2 inputs include quoted prices for similar assets in active markets or for identical assets in inactive markets. Other examples are inputs derived from observable market data, such as interest rate yield curves, credit spreads, and volatility measures used to value derivatives.

Level 3 inputs are unobservable inputs for the asset or liability. These inputs reflect the reporting entity’s own assumptions about what market participants would use in pricing. Level 3 inputs are used only when observable inputs are not available, which indicates little to no market activity for the item.

Valuations using Level 3 inputs require significant judgment and are based on internal models or data. Examples of items valued using Level 3 inputs include:

• Private equity investments
• Contingent consideration in a business combination
• Complex derivatives
• Asset retirement obligations

Because these measurements are subjective, they require more extensive disclosures.

Valuation Approaches and Techniques

ASC 820 outlines three valuation approaches to measure fair value: the market approach, the income approach, and the cost approach. A company may use one or more of these for a measurement, depending on the asset or liability and the availability of information. The goal is to estimate the price of an orderly transaction between market participants.

The market approach uses prices and other information from market transactions involving identical or comparable items. This approach is based on determining an asset’s value by looking at recent sale prices of similar assets. A common technique is using market multiples, such as applying revenue or earnings multiples from comparable public companies to value private company stock.

The income approach converts future amounts, like cash flows or earnings, to a single discounted amount. An asset’s value is linked to the present value of the future economic benefits it is expected to generate. A widely used technique is the discounted cash flow (DCF) method, which projects future cash flows and discounts them to the present using an appropriate risk-adjusted rate. Another technique, used for intangible assets like trademarks, is the relief-from-royalty method, which estimates royalty payments saved by owning the asset.

The cost approach reflects the amount currently required to replace an asset’s service capacity, known as current replacement cost. A prudent investor would not pay more for an asset than its replacement cost. This approach is used for tangible assets like buildings and machinery, especially those that are not income-generating and lack an active market. The valuation starts with the cost of a new, similar asset and adjusts for physical, functional, and economic obsolescence.

Required Disclosures

ASC 820 mandates disclosures to give financial statement users insight into how fair value measurements were derived and their potential variability. These disclosures help users understand the valuation techniques and inputs used. The requirements are tiered, with more information required for measurements that rely on less observable inputs.

A primary requirement is a table showing assets and liabilities measured at fair value on a recurring or nonrecurring basis. This table must segregate the measurements by their level within the fair value hierarchy. This format allows investors to assess the proportion of items valued using quoted market prices versus those valued using models.

For measurements in Level 2 and Level 3, companies must describe the valuation technique(s) and inputs used. For example, if using a discounted cash flow model to value an intangible asset, a company would disclose the technique and significant unobservable inputs. These inputs could include the discount rate and revenue growth assumptions.

The most extensive disclosures are for recurring Level 3 measurements. For these, a company must provide a reconciliation of the beginning and ending balances for the period. This reconciliation must separately show changes from total gains or losses, purchases, sales, issuances, and settlements. This roll-forward helps users understand the changes in these subjective measurements.

For Level 3 measurements, entities must also provide quantitative information about the significant unobservable inputs used. A narrative description of the measurement’s sensitivity to changes in these inputs is also required. This helps users understand the potential impact of changing assumptions on the reported fair value.

Specific disclosures are also required for equity securities subject to contractual sale restrictions. Companies must disclose the nature and duration of the restrictions and the fair value of the affected securities.