While “what” is required or permitted to be measured at fair value and “when” it is required or permitted to be measured at fair value is addressed in separate topics in the accounting guidance, there is a principle-based fair value framework provided in ASC 820 and IFRS 13 that must be applied that increases consistency and comparability of fair value measurements in financial reporting. Show
 Fair value is defined in both frameworks 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. Key concepts to this definition include: The Transaction: A fair value measurement assumes the transaction to sell the asset or transfer the liability takes place in the principal market. The Price: Fair value is the price that would be received to sell an asset or paid to transfer a liability under current market conditions. In other words, it is an exit price. Market Participants: Fair value of an asset or a liability must be measured using the assumptions that market participants would use when pricing the asset or liability, assuming that market participants act in their best economic interest. Orderly Transaction: An orderly transaction is a transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities. Determining these components of fair value and applying the principles of the fair value framework are not always straightforward. Significant judgment and assumptions are sometimes needed to estimate fair value, which can include determining the principal market, establishing an exit price, identifying the type of transaction, and determining the market participant’s perspective. Let’s review some of the accounting issues and key principles of the fair value framework. Principal MarketAs we discussed, fair value is the exit price in the principal market. But what is meant by the principal market? And how does one go about determining it? ASC 820 indicates that the principal market should be determined based on the market with the greatest volume and level of activity for the asset or liability. In the absence of contrary evidence, the market in which an entity would normally enter into a transaction is presumed to be the principal market. If the principal market is not determinable, then the most advantageous market should be used to determine fair value. A reporting entity does not need to undertake an exhaustive search of all possible markets to identify the principal market or, in the absence of a principal market, the most advantageous market, but it should take into account all information that is reasonably available. It is also important to note that different entities may have different principal markets for identical assets or liabilities depending on their activities and which markets they can access. Valuation Techniques to Determine Fair Value of Financial AssetsValuation techniques that are appropriate to the circumstances, and for which sufficient data are available, should be used to measure fair value. ASC 820 identifies the following three valuation approaches: Market Approach – A valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (i.e., similar) assets, liabilities, or a group of assets and liabilities, such as a business. Income Approach – A valuation technique that converts future amounts (e.g., cash flows, or income and expenses) to a single current (i.e., discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts. Cost Approach – A valuation technique that reflects the amount that would currently be required to replace the service capacity of an asset (i.e., current replacement cost). The objective of using a valuation technique is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. Evaluation of the merits of the valuation techniques should be done to determine which one to apply or whether to weight the results of different valuation techniques. Highest and Best Use ConceptWhen determining the fair value of a nonfinancial asset, it is important to base the measurement on the asset’s highest and best use. ASC 820 requires that a fair value measurement of a nonfinancial asset take into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use. The highest and best use of a nonfinancial asset might provide maximum value to market participants through its use in combination with other assets as a group (as installed or otherwise configured for use) or in combination with other assets and liabilities (for example, as a business). The highest and best use is determined from the perspective of market participants. Net Asset Value as a Practical Expedient for Fair ValueSome reporting entities, such as investment companies, frequently invest in funds and other alternative investments. It is not easy to value alternative investments because sales are typically private and not available to the public. These types of investments usually report Net Asset Value or NAV. NAV is the amount of net assets, recorded at fair value with changes in fair value recorded within profit or loss, attributable to each share, or unit, of the fund. The FASB permits but does not require the use of NAV as a practical expedient for fair value if certain conditions are met. IFRS does not contain a practical expedient for estimating fair value of certain investments using NAV. Under U.S. GAAP, investors may use net asset value (NAV) to estimate the fair value of investments in investment companies that do not have a readily determinable fair value if:
The Fair Value HierarchyTo increase consistency and comparability in fair value measurements and related disclosures, ASC 820 establishes a fair value hierarchy that categorizes the inputs used in valuation techniques to measure fair value into three broad levels. Fair value measurements must be categorized in their entirety based on the lowest level input that is significant to the entire measurement. What is the fair value of an asset based on?Fair value is the estimated price at which an asset is bought or sold when both the buyer and seller freely agree on a price. Individuals and businesses may compare current market value, growth potential, and replacement cost to determine the fair value of an asset.
How does fair value determine fair value?15 A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under current market conditions.
When determining the fair value of an asset which of the following is included in the exit price?Under ASC 820, fair value is based on the exit price (the price that would be received to sell an asset or paid to transfer a liability), not the transaction price or entry price (the price that was paid for the asset or that was received to assume the liability).
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