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What are the Appropriate Disclosures Required when Virtual Currencies are Measured at Fair Value?

Author: Alexander J. Sannella, Ph.D., CPA; Professor of Accounting; Department of Accounting and Information  Systems; Rutgers Business School; Newark, New Jersey.1

The statements in this document should not be treated as legal, tax, or accounting advice. The document is  intended to provide general information only. If a person would like such advice, they should seek professional  advice with regard to their specific facts. 

The statements in this document reflect guidance issued as of February 5, 2020.

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The use of fair value as a measurement basis under US GAAP has increased significantly over  the past 20 years. Measurements using fair value are generally viewed as more relevant for  decision making and provide more timely information. However, it is often the case that fair  values are based on market comparables or a model built on management assumptions and  unobservable inputs. As a result, the faithful representation and reliability of such measures  could be eroded. In order to improve user confidence in the fair value information provided, the FASB expanded the disclosures required whenever assets or liabilities are reported at fair  value. The centerpiece of this disclosure is the fair value hierarchy. 

The fair value hierarchy was designed by the FASB to prioritize the inputs used in the valuation techniques. Note this hierarchy does not prioritize or rank the valuation techniques but simply  ranks the level of reliability of the inputs used in the valuation process.  

The key variable in the hierarchy is whether the inputs to the valuation process are observable  or unobservable. The FASB emphasizes that one should maximize the use of observable inputs in  determining fair value. So, the highest reliability ranking is given to quoted market prices in active markets for identical assets or liabilities (i.e., observable) and the lowest priority is given to the  use of unobservable inputs created by utilization of the reporting entity’s assumptions or  projections. The resulting hierarchy uses “Levels”, with Level 1 representing the most reliable  inputs and Level 3 the least reliable. The use of levels clearly signals that the issuer of the financial  statements is informing the market to “let the buyer beware.” 

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities  that the reporting entity has the ability to access at the measurement date. An active market for  the asset or liability is a market in which transactions for the asset or liability occur with sufficient  frequency and volume to provide pricing information on an ongoing basis. A quoted price in an  active market provides the most reliable evidence of fair value and must be used to measure fair value whenever available. A basic example would be a NYSE quote for equity shares held by the entity. 

Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable  for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar (comparable) assets or liabilities in active markets. In addition, Level 2 inputs would  include quoted prices for identical or similar (comparable) assets or liabilities in markets that  are not active or liquid, such as markets in which there are few transactions for the asset or  liability. Inputs other than quoted prices that are observable for the asset or liability such as  interest rates or credit risks or inputs that are derived principally from or corroborated by  observable market data by correlation or other means are also included in Level 2. 

An example of an asset using Level 2 inputs is an interest rate swap. Here, the value of the swap  is derived from the underlying, observable interest rates and market determined risk premiums.  

Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs will be used  to measure fair value to the extent that observable inputs are not available, including when  assets and liabilities are trading in highly illiquid markets. Unobservable inputs reflect  managements’ own assumptions about the assumptions that market participants would use in  pricing the asset or liability, including assumptions about risk. An example of a Level 3 valuation  would include option pricing models use to value derivative securities. 

It should be noted that the lowest level drives the classification. For example, if a valuation uses  a Level 1 and a Level 3 input, the entire valuation is ranked as a Level 3. So, if a management  valuation model uses an observed market rate to discount estimated future cash flows, the  interest rate used is a Level 1 input but the estimated cash flows are Level 3 inputs. As a result,  the entire valuation from this model would be classified as a Level 3. 

Finally, the fair value disclosures require the presentation of a roll-forward schedule that includes  the amount of unrealized gain or loss that is reported in earnings and the amount reported as  other comprehensive income for Level 3 classified assets and liabilities. 

The fair value hierarchy was implemented prior to the advent of virtual currencies but it applies  to those cases where GAAP currently permits measuring virtual currencies at fair value. 

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1Written by Alexander J. Sannella, Ph.D., CPA; Professor of Accounting; Department of Accounting and Information  Systems; Rutgers Business School; Newark, New Jersey.  The author is writing on his own behalf and none of the statements should be  attributed to Rutgers Business School.

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