ASU 2011-04’s Amendments to Topic 820 Fair Value

In May 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2011-04. This update refined and clarified existing principles of fair value to improve the consistency and comparability of these measurements.

A driver for ASU 2011-04 was aligning U.S. Generally Accepted Accounting Principles (GAAP) with International Financial Reporting Standards (IFRS). The FASB sought a uniform approach to measuring and disclosing fair value, making financial statements more understandable across jurisdictions. The update amended the guidance within the FASB’s Accounting Standards Codification (ASC) Topic 820.

Foundational Principles of Fair Value (Topic 820)

ASC Topic 820 establishes that fair value is an “exit price,” which is the price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. An orderly transaction assumes market exposure for a period before the measurement date to allow for customary marketing activities and is not a forced liquidation or distressed sale.

Topic 820 uses a fair value hierarchy that categorizes valuation inputs into three levels. This hierarchy prioritizes inputs, giving the highest priority to quoted prices in active markets and the lowest to unobservable inputs. A measurement’s classification is determined by the lowest level input that is significant to the entire measurement, which increases consistency and transparency.

Level 1 inputs are quoted prices in active markets for identical assets or liabilities the entity can access. An example is a publicly traded stock on a major exchange. Its value is determined by multiplying the shares held by the closing price on the measurement date, which is readily available and requires no adjustment.

Level 2 inputs are observable inputs other than the quoted prices included in Level 1. These include quoted prices for similar assets in active markets, prices for identical assets in inactive markets, and other observable inputs like interest rates. For example, a corporate bond that is not actively traded could be valued using the yield of similar bonds from companies with comparable credit ratings.

Level 3 inputs are unobservable inputs for the asset or liability, used when observable inputs are not available. This applies when there is little to no market activity for the item. An example is a private equity investment in a startup, where an entity might use a discounted cash flow (DCF) model based on internal assumptions for future cash flows and discount rates.

Significant Measurement Amendments from ASU 2011-04

ASU 2011-04 introduced specific amendments that refined how fair value is measured under Topic 820 without altering its principles. The changes clarified application and increased consistency by providing detailed guidance in areas that previously had diverse practices.

One clarification relates to valuing nonfinancial assets, like property, plant, and equipment. The fair value of such an asset must be based on its “highest and best use” from a market participant’s perspective, even if the entity uses it differently. For example, land used for a warehouse must be valued based on its potential for residential construction if that represents its highest and best use to market participants.

The guidance also addressed applying premiums and discounts. ASU 2011-04 clarifies these adjustments are appropriate only if market participants would factor them into the price. For instance, a control premium could be applied when valuing a controlling block of shares. The premium or discount must be a characteristic of the asset or liability, not a characteristic of the entity’s holding of it.

Another amendment provided instructions for measuring the fair value of an entity’s own equity instruments, such as shares issued in a business combination. The fair value of these instruments is measured from the perspective of a market participant holding the instrument as an asset. A contractual restriction on the sale of an equity security is not part of its fair value, as the restriction is a characteristic of the holder, not the security.

The update introduced a practical expedient called the “portfolio exception.” This allows an entity to measure the fair value of a group of financial assets and liabilities based on its net exposure to a market or credit risk. This exception is permitted only if the entity manages the group of instruments based on its net risk exposure, which reflects how many financial institutions operate.

Enhanced Disclosure Mandates

ASU 2011-04 expanded the disclosure requirements in the notes to financial statements. The goal was to give users a clearer view of the valuation techniques and inputs used, especially for measurements relying on subjective, unobservable inputs. These disclosures are designed to show the degree of subjectivity in the measurements.

For fair value measurements, the update requires several new disclosures:

• A detailed reconciliation of the opening and closing balances for assets and liabilities measured using Level 3 inputs. This must separately present total gains or losses recognized in net income and disclose purchases, sales, issuances, and settlements.
• Quantitative information about the significant unobservable inputs used in Level 3 measurements. For instance, if a discounted cash flow model is used, the entity must disclose the discount rate and revenue growth assumptions.
• A description of the valuation processes used. For Level 3 measurements, this includes how the entity decides its valuation policies and analyzes changes in fair value measurements between periods.
• The fair value hierarchy level for any assets and liabilities not measured at fair value on the balance sheet but for which fair value is disclosed in the footnotes, such as certain long-term debt.
• A narrative disclosure about the sensitivity of a Level 3 measurement to changes in its significant unobservable inputs, describing how a change to a reasonably possible alternative would affect the fair value.

Convergence with IFRS 13

A motivation for ASU 2011-04 was the joint project between the FASB and the International Accounting Standards Board (IASB) to converge their guidance on fair value measurement. The amendments were developed with the IASB’s creation of IFRS 13, “Fair Value Measurement.” The objective was a single, global framework to enhance the comparability of financial statements prepared under U.S. GAAP and IFRS.

Previously, U.S. GAAP and IFRS had separate and sometimes divergent guidance, creating inconsistencies that made it difficult to compare companies. The issuance of ASU 2011-04 and IFRS 13 reduced these differences and promoted a common language for financial reporting.

The amendments aligned the definition of fair value, the measurement framework, and disclosure requirements in U.S. GAAP with those in IFRS 13. Both standards now define fair value as an exit price, use the same three-level hierarchy, and require similar disclosures. While the core principles are aligned, subsequent amendments to U.S. GAAP have created some differences.

This convergence benefits both preparers and users of financial statements. It simplifies financial statement preparation for multinational companies and allows investors to make more direct comparisons of companies globally. The alignment achieved by ASU 2011-04 and IFRS 13 was a step toward a single set of global accounting standards.