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 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 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 and minimizes
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 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 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
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