Fair Value Measurement Hierarchy (ASC 820): CPA FAR Exam Guide
Master the three-level fair value hierarchy under ASC 820 for the CPA FAR exam. Covers measurement techniques, inputs, and disclosure requirements.
Overview of ASC 820: Fair Value Measurement
ASC 820 defines fair value, establishes a framework for measuring fair value, and requires disclosures about fair value measurements. Fair value is defined 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 exit price concept is central to the standard and is tested frequently on the CPA FAR exam.
The Fair Value Hierarchy
ASC 820 establishes a three-level hierarchy that prioritizes the inputs used in fair value measurements. The hierarchy gives the highest priority to quoted prices in active markets (Level 1) and the lowest priority to unobservable inputs (Level 3).
Level 1 Inputs
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. Examples include publicly traded equity securities, US Treasury securities, and exchange-traded derivative contracts. Level 1 provides the most reliable evidence of fair value and must be used without adjustment when available.
An active market is one in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.
Level 2 Inputs
Level 2 inputs are inputs other than quoted prices included in Level 1 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 in markets that are not active
- Inputs other than quoted prices that are observable, such as interest rates, yield curves, credit spreads, and implied volatilities
- Market-corroborated inputs (inputs derived from or corroborated by observable market data)
Level 2 measurements may require adjustments to quoted prices, such as adjustments for condition, location, or differences between the quoted asset and the asset being measured.
Level 3 Inputs
Level 3 inputs are unobservable inputs that reflect the entity's own assumptions about the assumptions market participants would use in pricing the asset or liability. These are used when observable inputs are not available. Examples include an entity's own cash flow projections, internally developed pricing models, and assumptions about risk premiums.
Level 3 measurements are the least reliable and require the most extensive disclosures. Entities must still use the best information available and must adjust their own assumptions to reflect market participant perspectives, not entity-specific factors.
Valuation Techniques
ASC 820 identifies three valuation approaches:
- Market approach: Uses prices and other relevant information from market transactions involving identical or comparable assets or liabilities. This includes the use of market multiples.
- Income approach: Converts future amounts (such as cash flows or earnings) to a single present value. Techniques include present value calculations, option-pricing models, and the multi-period excess earnings method.
- Cost approach: Reflects the amount required to replace the service capacity of an asset (replacement cost). This is often used for tangible assets.
Entities should use valuation techniques consistent with one or more of these approaches. The technique used should maximize observable inputs and minimize unobservable inputs.
Recurring vs. Nonrecurring Fair Value Measurements
Recurring measurements are those required at each reporting period (such as investments measured at fair value through net income or available-for-sale securities). Nonrecurring measurements are triggered by specific events (such as long-lived asset impairment or assets acquired in a business combination). The disclosure requirements differ: recurring measurements require a reconciliation of beginning and ending balances for Level 3 items, while nonrecurring measurements do not.
Disclosure Requirements
ASC 820 requires extensive disclosures, including the fair value measurements at the end of the period, the level within the hierarchy, the valuation techniques and inputs used, transfers between levels, and for Level 3 measurements, a reconciliation of opening and closing balances including gains and losses, purchases, sales, and issuances.
Exam Preparation Tips
- Know the three levels of the fair value hierarchy and be able to classify specific inputs into the correct level.
- Remember that the overall classification of a fair value measurement is based on the lowest-level input that is significant to the measurement.
- Understand the three valuation approaches (market, income, cost) and when each is appropriate.
- Fair value is an exit price from the perspective of a market participant, not an entity-specific value.
- Level 3 measurements require the most extensive disclosures, including a rollforward of balances.
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