FASB Statement No. 157, Fair Value Measurements, defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. To increase consistency and comparability in fair value measurements and related disclosures, Statement No. 157 establishes a fair value hierarchy, which prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. Following is a brief review of the fair value hierarchy; however, Statement No. 157 should be consulted in its entirety for complete guidance.
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. A quoted price in an active market provides the most reliable evidence of fair value and should be used to measure fair value whenever available, except as follows:
- If the reporting entity holds a large number of similar assets or liabilities that are required to be measured at fair value, a quoted price in an active market might be available but not readily accessible for each of those assets or liabilities individually. In that case, fair value may be measured using an alternative pricing method that does not rely exclusively on quoted prices
as a practical expedient. However, the use of an alternative pricing method renders the fair value measurement a lower level measurement.
- In some situations, a quoted price in an active market might not represent fair value at the measurement date. That might be the case if, for example, significant events (principal-to-principal transactions, brokered trades, or announcements) occur after the close of a market but before the measurement date. The reporting entity should establish and consistently apply a policy for identifying those events that might affect fair value measurements. However, if the quoted price is adjusted for new information, the adjustment renders the fair value measurement a lower level measurement.
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. If the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability. Level 2 inputs include the following:
- Quoted prices for similar assets or liabilities in active markets.
- Quoted prices for identical or similar assets or liabilities in markets that are not active.
- Inputs other than quoted prices that are observable for the asset or liability.
- Inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs).
Adjustments to Level 2 inputs will vary depending on factors specific to the asset or liability. Those factors include the condition and/or location of the asset or liability, the extent to which the inputs relate to items that are comparable to the asset or liability, and the volume and level of activity in the markets within which the inputs are observed. An adjustment that is significant to the fair value measurement in its entirety might render the measurement a Level 3 measurement, depending on the level in the fair value hierarchy within which the inputs used to determine the adjustment fall.
Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs should be used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. Unobservable inputs should reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability (including assumptions about risk). The reporting entity’s own data used to develop unobservable inputs should be adjusted if information is reasonably available without undue cost and effort that indicates that market participants would use different assumptions.
As explained above, the level is determined by the inputs used to determine fair value. There are some misperceptions about how to determine where in the hierarchy a fair value measurement falls. For example, one misperception is that the valuation model utilized affects the level determination. Instead, one must analyze the inputs used in the model to determine their significance and the hierarchy level.
The inputs with the most significance will determine the level of the fair value measurement.
Another misperception is that the higher the risk is, the lower in the hierarchy the fair value measurement falls. For example, if the counterparty credit risk is high and that input is significant, it has been assumed that the fair value measurement is Level 3. However, the correct answer is based on how observable the counterparty credit risk is. If an entity’s credit-risk rating is published and/or available from many sources, that would be considered observable and a Level 2 input, therefore making the fair value measurement a Level 2. However, if the risk rating is determined using data gathered by a client and not from observable sources, the input would be Level 3. |
