It is a challenge to measure and disclose fair value clearly and consistently, with its tangle of standards and requirements.
To add some clarity to the issue, the U.S. and international accounting standards boards recently implemented their converged fair value measurement and disclosure requirements.
For public entities, the new guidance began for interim and annual periods beginning after Dec. 15, 2011. For nonpublic entities, the amendments became effective in annual periods beginning after Dec. 15, 2011 (calendar-year 2012 financial statements).
From the perspective of the Financial Accounting Standards Board (FASB), the guidance is in Accounting Standards Update (ASU) 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.
In U.S. generally accepted accounting principles (GAAP), new guidance amends current literature – in FASB Accounting Standards Codification (FASB ASC) Topic 820, Fair Value Measurement – associated with fair value measurements and disclosures.
Highest and best use concept
The amendments include a clarification that the highest and best use and valuation premise concepts apply only in measuring fair value of nonfinancial assets.
This conclusion is based, in part, upon the assumption that financial assets and liabilities do not have alternative uses.
An important notion underlying the highest and best use concept is that this particular use needs to be one that is physically possible, legally permissible and financially feasible.
Instruments classified within equity
The fair value of an instrument classified in the equity section of the statement of financial position should be measured from the perspective of a market participant that holds that instrument as an asset.
Before the recent amendments, FASB ASC 820 did not provide any specific guidance on measuring fair value of financial instruments classified within equity.
Simplified fair value hierarchy
Level 1 Measurement based on actual prices quoted in an active market for identical assets or liabilities and regularly available to market participants
Level 2 Measurement based on directly or indirectly observable market data – other than actual quoted prices – with any adjustments being insignificant in determining fair value and any assumptions being those an unrelated party would use in estimating fair value
Level 3 Measurement based on unobservable inputs – such as the reporting entity’s internal information or assumptions not based on independent sources – but keeping in mind the assumptions a third party would use in estimating fair value
Premiums and discounts.
As amended, the guidance in FASB ASC 820 now indicates that premiums or discounts may be applied in a fair value measurement, to the extent that they are consistent with the unit of account and market participants would consider them in a transaction for the asset or liability. However, the guidance still does not permit adjustments commonly referred to as “blockage” factors (discounts for an asset bought or sold in a large volume) in determining fair value measurements.
Incremental disclosure issues
Some specific disclosures that need to be considered to appropriately implement the new guidance include, but are not limited to, the following:
- For items that are not measured at fair value in the statement of financial position, but where fair value is required to be disclosed in notes to the financial statements, disclose the level within the three-level fair value hierarchy in which that measurement is categorized.
- For Level 3 measurements, based on “unobservable” inputs for which market data are not available, disclose the valuation processes used, and provide a narrative description of the sensitivity of the fair value measurement in changes to unobservable inputs and interrelationships between those unobservable inputs.
- Disclose the use of a nonfinancial asset if it differs from the highest and best use assumed in fair value measurement.
Disclosure relief for entities other than public entities
The amendments apply to all reporting entities that are required or permitted to measure or disclose the fair value of an asset, a liability or an instrument classified in equity in the financial statements.
With that said, some of the disclosures required in the amended guidance are not applicable in financial statements of non-issuers. These include:
- Information about transfers between Level 1 and Level 2 of the fair value hierarchy
- Information about the sensitivity of a fair value measurement categorized within Level 3 of the fair value hierarchy to changes in unobservable inputs and any interrelationships between those unobservable inputs
- The categorization by level within the fair value hierarchy for items that are not measured at fair value in the statement of financial position but for which the fair value of those items is required to be disclosed in the notes to the financial statements.