ASC 820 Fair Value Hierarchy: Level 1, 2, and 3 Inputs for the CPA Exam

Fair Value Measurement Under ASC 820

ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This is an exit price concept, not an entry price. Fair value measurement is foundational to many areas of accounting -- it applies to financial instruments, business combinations, impairment testing, and more. Understanding the fair value hierarchy is essential for the CPA FAR exam.

The Fair Value Hierarchy

ASC 820 establishes a three-level hierarchy of inputs used in fair value measurement, prioritizing the use of observable market data over unobservable entity-specific assumptions. The level of the hierarchy within which a fair value measurement falls is determined by the lowest level input that is significant to the measurement.

Level 1 Inputs

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date. Level 1 provides the most reliable evidence of fair value and should be used whenever available. An active market is one in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis.

Examples include publicly traded equity securities with readily available market prices on exchanges, U.S. Treasury securities, and exchange-traded derivatives. An entity generally should not adjust a Level 1 price except in limited circumstances, such as when the entity holds a large block of identical securities and the market could not absorb the entire block without affecting the price (a blockage factor). However, ASC 820 prohibits the use of blockage factors for Level 1 measurements.

Level 2 Inputs

Level 2 inputs are inputs other than quoted prices in active markets that are observable for the asset or liability, either directly or indirectly. Examples include:

• Quoted prices for similar (but not identical) 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, such as interest rates, yield curves, credit spreads, and volatilities.
• Market-corroborated inputs -- inputs derived principally from or corroborated by observable market data.

Level 2 measurements may require adjustments to the observable inputs, such as adjustments for condition, location, or the extent to which inputs relate to comparable assets. If significant adjustments use unobservable data, the measurement may fall to Level 3.

Level 3 Inputs

Level 3 inputs are unobservable inputs for the asset or liability that reflect the reporting entity's own assumptions about what market participants would use. Level 3 measurements rely on the best information available in the circumstances, including the entity's own data, but must still reflect a market participant perspective. They are used only when observable inputs are not available.

Examples include projected cash flows used in a discounted cash flow model for a unique asset, assumed volatility in an option pricing model when no market-implied volatility is observable, and management's estimate of a contingent consideration obligation. Level 3 fair values require the most extensive disclosures, including quantitative information about unobservable inputs and a sensitivity analysis.

Valuation Techniques

ASC 820 identifies three valuation approaches that may be used to measure fair value:

1. Market approach: Uses prices and other relevant information from market transactions involving identical or comparable assets or liabilities. This includes matrix pricing for debt securities.
2. Income approach: Converts future amounts (such as cash flows or earnings) to a single discounted present value. Includes discounted cash flow models, option pricing models, and the multi-period excess earnings method.
3. Cost approach: Based on the amount currently required to replace the service capacity of an asset (replacement cost). This is most commonly used for tangible assets.

The entity should use the approach that is most representative of fair value in the circumstances and for which sufficient data are available. Multiple approaches may be used to corroborate the result.

Disclosure Requirements

For recurring fair value measurements, entities must disclose the fair value at the reporting date, the level within the hierarchy, transfers between Level 1 and Level 2 (and the reasons for the transfers), and, for Level 3 measurements, a reconciliation from beginning to ending balances showing total gains or losses (and where reported), purchases, sales, issuances, settlements, and transfers in and out of Level 3. Entities must also disclose the valuation techniques and inputs used.

Exam Preparation Tips

• Memorize the hierarchy: Level 1 (quoted prices, identical, active market), Level 2 (observable but not Level 1), Level 3 (unobservable).
• Know that the hierarchy level is determined by the lowest level input that is significant to the measurement, not the highest.
• Understand the three valuation approaches and when each is appropriate.
• Remember that blockage factors are prohibited for Level 1 measurements.
• Be prepared for questions requiring classification of specific fair value measurements into the correct hierarchy level.