What to Know About ASC 820-10 Fair Value Measurement

Accounting Standards Codification (ASC) 820, Fair Value Measurement, provides a framework for measuring fair value within U.S. Generally Accepted Accounting Principles (GAAP). Issued by the Financial Accounting Standards Board (FASB), the standard does not create new requirements to measure assets at fair value, but specifies how to measure it when other rules permit it. The objective is to create a consistent method for fair value measurements, enhancing the transparency and reliability of financial statements. This standard applies to most financial instruments and other assets and liabilities measured at fair value for reporting purposes.

The Concept of Fair Value

ASC 820 defines fair value as the “exit price,” which is the price that would be received to sell an asset or paid to transfer a liability. This measurement occurs in an orderly transaction between market participants at the measurement date. The focus on an exit price distinguishes it from an “entry price,” which is the price paid to acquire an asset or the amount received to assume a liability.

An “orderly transaction” assumes the transaction is not a forced sale or liquidation and presumes exposure to the market for customary marketing activities. The transaction is viewed from the perspective of market participants, defined as knowledgeable, independent buyers and sellers in the principal market for the asset or liability.

In determining the market, a company must first identify the principal market, which is the market with the greatest volume and level of activity. If a principal market cannot be identified, the company uses the most advantageous market. This is the market that maximizes the amount received to sell the asset or minimizes the amount paid to transfer the liability, after taking into account transaction and transportation costs.

For nonfinancial assets, such as property or equipment, fair value is determined based on their “highest and best use.” This principle requires valuing the asset based on the use that would maximize its value, as determined by market participants, even if the reporting entity has a different intended use. For example, a parcel of land used for industrial storage must be valued as a site for commercial development if market participants would value it higher for that use.

The Fair Value Hierarchy

A component of ASC 820 is the fair value hierarchy, which categorizes the inputs used in valuation techniques into three levels. This hierarchy prioritizes the inputs to valuation techniques, not the valuation techniques themselves. 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.

Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity can access at the measurement date. An active market is one where transactions for the asset or liability occur with sufficient frequency and volume to provide ongoing pricing information. A common example of a Level 1 input is the closing price of a publicly traded stock on a major exchange.

Level 2 inputs are observable inputs other than Level 1 quoted prices. These inputs are directly or indirectly observable and include:

• Quoted prices for similar assets or liabilities in active markets
• Quoted prices for identical or similar assets in non-active markets
• Observable inputs other than quoted prices, such as interest rates, yield curves, and credit spreads

For instance, a corporate bond that trades infrequently might be valued using a benchmark yield curve and the issuer’s credit spread.

Level 3 inputs are unobservable inputs for the asset or liability, used only when observable inputs are not available. These inputs reflect the entity’s own assumptions about what market participants would use, based on the best information available. Valuing a private company investment is a classic example, as it often requires a discounted cash flow model that relies on internal financial projections.

Valuation Approaches and Techniques

ASC 820 outlines three valuation approaches: the market approach, the income approach, and the cost approach. While the hierarchy categorizes inputs, these approaches are the methods used to arrive at a valuation. A company may use one or more of these approaches for a given measurement.

The market approach uses prices and other information from market transactions involving identical or comparable assets or liabilities. A common technique is using market multiples derived from a set of comparable companies or transactions. For example, to value a private business, an analyst might apply a price-to-earnings ratio from similar public companies to the private company’s earnings.

The income approach converts future amounts, such as cash flows or earnings, to a single, discounted present value amount. This approach is based on the income an asset is expected to generate over its life. The most widely recognized technique is the discounted cash flow (DCF) analysis, which projects future cash flows and discounts them to the present using a rate reflecting risk and the time value of money.

The cost approach reflects the amount currently required to replace the service capacity of an asset, known as current replacement cost. This approach is often used for tangible assets without a readily determinable market or income stream, such as specialized manufacturing equipment. The valuation is based on the cost to acquire or construct a substitute asset of comparable utility, adjusted for deterioration and obsolescence.

Disclosure Requirements

ASC 820 mandates extensive disclosures to provide users with insight into the valuation techniques and inputs used to measure fair value. These requirements are both quantitative and qualitative. A primary quantitative disclosure is a table presenting assets and liabilities measured at fair value, segregated by their level within the fair value hierarchy (Level 1, 2, or 3).

For assets and liabilities categorized as Level 3, companies must also provide a detailed reconciliation showing the changes in the balance during the reporting period. This reconciliation details purchases, sales, issuances, settlements, and transfers in or out of Level 3.

Qualitative disclosures provide context for the fair value measurements. For Level 2 and Level 3 measurements, companies must describe the valuation techniques and the inputs used. For Level 3 measurements, the company must also provide a narrative description of the sensitivity of the fair value measurement to changes in significant unobservable inputs. Updates like ASU 2022-03 require specific disclosures for equity securities with contractual sale restrictions, including the nature and duration of the restrictions.