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.
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.
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.