4.3 Fair value measurement and disclosures

Fair value measurement is crucial in financial reporting, providing a standardized way to value assets and liabilities. It's based on market participant assumptions and uses various techniques to determine the price in an orderly transaction.

The fair value hierarchy categorizes inputs into three levels, prioritizing observable market data. This topic covers valuation approaches, input classification, and required disclosures, helping accountants accurately report financial instrument values in line with accounting standards.

Fair Value Measurement Concepts

Definition and Key Principles

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• Fair value refers to the price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date
• Assumes transaction occurs in principal market or most advantageous market for the asset or liability
• Considers characteristics market participants would factor into pricing (condition, location, restrictions)
• Applies concept of highest and best use for non-financial assets
• Assumes market participants act independently, knowledgeably, and in their economic best interest
• Reflects non-performance risk in liability valuations, including entity's own credit risk
• Maximizes use of observable inputs and minimizes unobservable inputs

Market Participant Assumptions

• Independent parties able to transact for the asset or liability
• Knowledgeable about the item being measured
• Willing and able to enter into a transaction
• Acting in their own economic best interest
• Would consider asset characteristics like condition and location
• Would use the asset in its highest and best use (for non-financial assets)

Key Considerations in Fair Value Measurement

• Principal market takes precedence over most advantageous market
• Entry price may differ from exit price used for fair value
• Transaction costs excluded from fair value measurement
• Highest and best use determined from market participant perspective, even if different from current use
• Blockage factors not considered when valuing financial instruments traded in an active market
• Non-performance risk reflected in liability fair values (credit risk)
• Measurement considers characteristics specific to the asset or liability

Valuation Techniques for Financial Instruments

Market Approach

• Uses prices and information from market transactions of identical or comparable assets/liabilities
• Techniques include market multiples and matrix pricing
• Most directly fulfills the fair value definition
• Preferred when recent transactions of identical items are available
• Adjustments may be needed for differences between the measured item and market comparables
• Examples of market inputs (stock prices, commodity prices)

Income Approach

• Converts future cash flows or income/expenses to a single current discounted amount
• Reflects current market expectations about future amounts
• Techniques include present value methods, option pricing models, multi-period excess earnings
• Incorporates time value of money and risk premiums
• Discount rates should reflect assumptions consistent with inherent risks
• Examples of income approach applications (bonds, derivatives, business valuations)

Cost Approach

• Reflects amount required to replace the service capacity of an asset (current replacement cost)
• Considers physical deterioration, functional obsolescence, and economic obsolescence
• Often used for tangible assets like property, plant and equipment
• May be combined with other approaches for more complex valuations
• Assumes market participant would not pay more than replacement cost
• Examples of cost approach use (real estate, equipment valuation)

Specialized Techniques

• Option pricing models (Black-Scholes-Merton formula, binomial model) for options and complex instruments
• Present value techniques for items without direct market prices
• Yield-to-maturity and discounted cash flow analysis for debt instruments
• Credit/debit valuation adjustments (CVA/DVA) to reflect counterparty and own credit risk

Fair Value Hierarchy and Inputs

Level 1 Inputs

• Quoted prices in active markets for identical assets or liabilities
• Most reliable evidence of fair value
• Used without adjustment when available
• Examples (stock prices on major exchanges, government bond prices)
• Preferred input when measuring fair value
• Level 1 inputs take precedence over other valuation inputs

Level 2 Inputs

• Observable inputs other than Level 1 quoted prices
• Include quoted prices for similar assets/liabilities in active markets
• Quoted prices for identical or similar items in non-active markets
• Observable inputs like interest rates, yield curves, volatilities
• Inputs corroborated by observable market data
• Examples (interest rate swaps, foreign currency forwards)

Level 3 Inputs

• Unobservable inputs used when relevant observable inputs unavailable
• Reflect reporting entity's own assumptions about market participant assumptions
• Developed using best information available in the circumstances
• Examples (long-dated option contracts, private equity investments)
• Require additional disclosures due to subjectivity
• Used as a last resort when observable inputs not available

Hierarchy Application

• Fair value hierarchy prioritizes inputs, not valuation techniques
• Categorization based on lowest level input significant to entire measurement
• Significance judged against entire fair value measurement
• Transfers between levels recognized at end of reporting period
• Disclosures required for transfers between Level 1 and Level 2

Fair Value Measurement Disclosures

Valuation Techniques and Inputs

• Disclose techniques and inputs for recurring and non-recurring fair value measurements
• Describe any changes in valuation techniques and reasons for the change
• Quantitative information on significant unobservable inputs for Level 3 measurements
• Narrative description of sensitivity to changes in unobservable inputs for Level 3
• Interrelationships between inputs and how they affect fair value measurement

Level 3 Reconciliations and Transfers

• Reconcile opening to closing balances for Level 3 measurements
• Separate disclosure of changes during period (gains/losses, purchases, sales, transfers)
• Disclose amount of total gains or losses attributable to unrealized changes
• Reasons for transfers into or out of Level 3
• Entity's policy for determining when transfers between levels occur

Additional Required Disclosures

• Fair value hierarchy level for items not measured at fair value but fair value disclosed
• For non-financial assets, highest and best use if different from current use
• Presence of third-party evidence in developing unobservable inputs
• Description of valuation processes for Level 3 measurements
• Sensitivity analysis for financial instruments using Level 3 inputs
• If highest and best use differs from current use, reason for difference

Disclosure Presentation

• Information provided by class of asset or liability
• Classes determined based on nature, characteristics, and risks
• More disaggregation for Level 3 measurements
• Both narrative and tabular formats used as appropriate
• Sufficient detail to allow reconciliation to line items in financial statements