10.3 Valuation Techniques

10.3.1 General

ASC 820-10

Valuation Techniques

35-24 A reporting entity shall use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs.

35-24A 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. Three widely used valuation approaches are the market approach, cost approach, and income approach. The main aspects of valuation techniques consistent with those approaches are summarized in paragraphs 820-10-55-3A through 55-3G. An entity shall use valuation techniques consistent with one or more of those approaches to measure fair value.

35-27 The Examples in Section 820-10-55 illustrate the judgments that might apply when a reporting entity measures assets and liabilities at fair value in different valuation situations.

Fair Value Hierarchy

35-38 The availability of relevant inputs and their relative subjectivity might affect the selection of appropriate valuation techniques (see paragraph 820-10-35-24). However, the fair value hierarchy prioritizes the inputs to valuation techniques, not the valuation techniques used to measure fair value. For example, a fair value measurement developed using a present value technique might be categorized within Level 2 or Level 3, depending on the inputs that are significant to the entire measurement and the level of the fair value hierarchy within which those inputs are categorized.

ASC 820-10 — Glossary

Cost Approach

A valuation approach that reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost).

Income Approach

Valuation approaches that convert future amounts (for example, cash flows or income and expenses) to a single current (that is, discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts.

Market Approach

A valuation approach that uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business.

An entity must use judgment, and will often need to engage valuation specialists, to determine the appropriate valuation technique(s) for measuring the fair value of an asset, liability, or equity instrument in accordance with ASC 820. This determination will often depend on the nature of the item being valued, As discussed in Section 10.3.2, an entity may determine that it is appropriate to use multiple valuation techniques to measure the fair value of an asset, liability, or equity instrument. Further, as discussed in ASC 820-10-35-38, an entity should consider the observability of the inputs into a specific valuation technique in determining which technique(s) to use.

ASC 820-10-55-3A through 55-3G below describe three widely used valuation techniques — the market approach, cost approach, and income approach.

ASC 820-10

Market Approach

55-3A The market approach uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business.

55-3B For example, valuation techniques consistent with the market approach often use market multiples derived from a set of comparables. Multiples might be in ranges with a different multiple for each comparable. The selection of the appropriate multiple within the range requires judgment, considering qualitative and quantitative factors specific to the measurement.

55-3C Valuation techniques consistent with the market approach include matrix pricing. Matrix pricing is a mathematical technique used principally to value some types of financial instruments, such as debt securities, without relying exclusively on quoted prices for the specific securities, but rather relying on the securities’ relationship to other benchmark quoted securities.

Cost Approach

55-3D The cost approach reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost).

55-3E From the perspective of a market participant seller, the price that would be received for the asset is based on the cost to a market participant buyer to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence. That is because a market participant buyer would not pay more for an asset than the amount for which it could replace the service capacity of that asset. Obsolescence encompasses physical deterioration, functional (technological) obsolescence, and economic (external) obsolescence and is broader than depreciation for financial reporting purposes (an allocation of historical cost) or tax purposes (using specified service lives). In many cases, the current replacement cost method is used to measure the fair value of tangible assets that are used in combination with other assets or with other assets and liabilities.

Income Approach

55-3F The income approach converts future amounts (for example, cash flows or income and expenses) to a single current (that is, discounted) amount. When the income approach is used, the fair value measurement reflects current market expectations about those future amounts.

55-3G Those valuation techniques include, for example, the following:

Present value techniques
Option-pricing models, such as the Black-Scholes-Merton formula or a binomial model (that is, a lattice model), that incorporate present value techniques and reflect both the time value and the intrinsic value of an option
The multiperiod excess earnings method, which is used to measure the fair value of some intangible assets.

10.3.1.1 Present Value Techniques

ASC 820-10

Present Value Techniques

55-4 Paragraphs 820-10-55-5 through 55-20 describe the use of present value techniques to measure fair value. Those paragraphs focus on a discount rate adjustment technique and an expected cash flow (expected present value) technique. Those paragraphs neither prescribe the use of a single specific present value technique nor limit the use of present value techniques to measure fair value to the techniques discussed. The present value technique used to measure fair value will depend on facts and circumstances specific to the asset or liability being measured (for example, whether prices for comparable assets or liabilities can be observed in the market) and the availability of sufficient data.

The Components of a Present Value Measurement

55-5 Present value (that is, an application of the income approach) is a tool used to link future amounts (for example, cash flows or values) to a present amount using a discount rate. A fair value measurement of an asset or a liability using a present value technique captures all of the following elements from the perspective of market participants at the measurement date:

An estimate of future cash flows for the asset or liability being measured.
Expectations about possible variations in the amount and timing of the cash flows representing the uncertainty inherent in the cash flows.
The time value of money, represented by the rate on risk-free monetary assets that have maturity dates or durations that coincide with the period covered by the cash flows and pose neither uncertainty in timing nor risk of default to the holder (that is, a risk-free interest rate). For present value computations denominated in nominal U.S. dollars, the yield curve for U.S. Treasury securities determines the appropriate risk-free interest rate.
The price for bearing the uncertainty inherent in the cash flows (that is, a risk premium).
Other factors that market participants would take into account in the circumstances.
For a liability, the nonperformance risk relating to that liability, including the reporting entity’s (that is, the obligor’s) own credit risk.

General Principles

55-6 Present value techniques differ in how they capture the elements in the preceding paragraph. However, all of the following general principles govern the application of any present value technique used to measure fair value:

Cash flows and discount rates should reflect assumptions that market participants would use when pricing the asset or liability.
Cash flows and discount rates should take into account only the factors attributable to the asset or liability being measured.
To avoid double counting or omitting the effects of risk factors, discount rates should reflect assumptions that are consistent with those inherent in the cash flows. For example, a discount rate that reflects the uncertainty in expectations about future defaults is appropriate if using contractual cash flows of a loan (that is, a discount rate adjustment technique). That same rate should not be used if using expected (that is, probability-weighted) cash flows (that is, an expected present value technique) because the expected cash flows already reflect assumptions about the uncertainty in future defaults; instead, a discount rate that is commensurate with the risk inherent in the expected cash flows should be used.
Assumptions about cash flows and discount rates should be internally consistent. For example, nominal cash flows, which include the effect of inflation, should be discounted at a rate that includes the effect of inflation. The nominal risk-free interest rate includes the effect of inflation. Real cash flows, which exclude the effect of inflation, should be discounted at a rate that excludes the effect of inflation. Similarly, after-tax cash flows should be discounted using an after-tax discount rate. Pretax cash flows should be discounted at a rate consistent with those cash flows.
Discount rates should be consistent with the underlying economic factors of the currency in which the cash flows are denominated.

Risk and Uncertainty

55-7 A fair value measurement using present value techniques is made under conditions of uncertainty because the cash flows used are estimates rather than known amounts. In many cases, both the amount and timing of the cash flows are uncertain. Even contractually fixed amounts, such as the payments on a loan, are uncertain if there is risk of default.

55-8 Market participants generally seek compensation (that is, a risk premium) for bearing the uncertainty inherent in the cash flows of an asset or a liability. A fair value measurement should include a risk premium reflecting the amount that market participants would demand as compensation for the uncertainty inherent in the cash flows. Otherwise, the measurement would not faithfully represent fair value. In some cases, determining the appropriate risk premium might be difficult. However, the degree of difficulty alone is not a sufficient reason to exclude a risk premium.

55-9 Present value techniques differ in how they adjust for risk and in the type of cash flows they use. For example:

The discount rate adjustment technique (see paragraphs 820-10-55-10 through 55-12) uses a risk-adjusted discount rate and contractual, promised, or most likely cash flows.
Method 1 of the expected present value technique (see paragraph 820-10-55-15) uses risk-adjusted expected cash flows and a risk-free rate.
Method 2 of the expected present value technique (see paragraph 820-10-55-16) uses expected cash flows that are not risk adjusted and a discount rate adjusted to include the risk premium that market participants require. That rate is different from the rate used in the discount rate adjustment technique.

Discount Rate Adjustment Technique

55-10 The discount rate adjustment technique uses a single set of cash flows from the range of possible estimated amounts, whether contractual or promised (as is the case for a bond) or most likely cash flows. In all cases, those cash flows are conditional upon the occurrence of specified events (for example, contractual or promised cash flows for a bond are conditional on the event of no default by the debtor). The discount rate used in the discount rate adjustment technique is derived from observed rates of return for comparable assets or liabilities that are traded in the market. Accordingly, the contractual, promised, or most likely cash flows are discounted at an observed or estimated market rate for such conditional cash flows (that is, a market rate of return).

55-11 The discount rate adjustment technique requires an analysis of market data for comparable assets or liabilities. Comparability is established by considering the nature of the cash flows (for example, whether the cash flows are contractual or noncontractual and are likely to respond similarly to changes in economic conditions), as well as other factors (for example, credit standing, collateral, duration, restrictive covenants, and liquidity). Alternatively, if a single comparable asset or liability does not fairly reflect the risk inherent in the cash flows of the asset or liability being measured, it may be possible to derive a discount rate using data for several comparable assets or liabilities in conjunction with the risk-free yield curve (that is, using a build-up methodology). Paragraph 820-10-55-33 illustrates the build-up methodology.

55-12 When the discount rate adjustment technique is applied to fixed receipts or payments, the adjustment for risk inherent in the cash flows of the asset or liability being measured is included in the discount rate. In some applications of the discount rate adjustment technique to cash flows that are not fixed receipts or payments, an adjustment to the cash flows may be necessary to achieve comparability with the observed asset or liability from which the discount rate is derived.

Expected Present Value Technique

55-13 The expected present value technique uses as a starting point a set of cash flows that represents the probability-weighted average of all possible future cash flows (that is, the expected cash flows). The resulting estimate is identical to expected value, which, in statistical terms, is the weighted average of a discrete random variable’s possible values with the respective probabilities as the weights. Because all possible cash flows are probability-weighted, the resulting expected cash flow is not conditional upon the occurrence of any specified event (unlike the cash flows used in the discount rate adjustment technique).

55-14 In making an investment decision, risk-averse market participants would take into account the risk that the actual cash flows may differ from the expected cash flows. Portfolio theory distinguishes between two types of risk:

Unsystematic (diversifiable) risk
Systematic (nondiversifiable) risk.

55-15 Method 1 of the expected present value technique adjusts the expected cash flows of an asset for systematic (that is, market) risk by subtracting a cash risk premium (that is, risk-adjusted expected cash flows). Those risk-adjusted expected cash flows represent a certainty equivalent cash flow, which is discounted at a risk-free interest rate. A certainty equivalent cash flow refers to an expected cash flow (as defined), adjusted for risk so that a market participant is indifferent to trading a certain cash flow for an expected cash flow. For example, if a market participant was willing to trade an expected cash flow of $1,200 for a certain cash flow of $1,000, the $1,000 is the certainty equivalent of the $1,200 (that is, the $200 would represent the cash risk premium). In that case, the market participant would be indifferent as to the asset held.

55-16 In contrast, Method 2 of the expected present value technique adjusts for systematic (that is, market) risk by applying a risk premium to the risk-free interest rate. Accordingly, the expected cash flows are discounted at a rate that corresponds to an expected rate associated with probability-weighted cash flows (that is, an expected rate of return). Models used for pricing risky assets, such as the capital asset pricing model, can be used to estimate the expected rate of return. Because the discount rate used in the discount rate adjustment technique is a rate of return relating to conditional cash flows, it is likely to be higher than the discount rate used in Method 2 of the expected present value technique, which is an expected rate of return relating to expected or probability-weighted cash flows.

55-17 To illustrate Methods 1 and 2, assume that an asset has expected cash flows of $780 in 1 year determined on the basis of the possible cash flows and probabilities shown below. The applicable risk-free interest rate for cash flows with a 1-year horizon is 5 percent, and the systematic risk premium for an asset with the same risk profile is 3 percent.

55-18 In this simple illustration, the expected cash flows ($780) represent the probability-weighted average of the 3 possible outcomes. In more realistic situations, there could be many possible outcomes. However, to apply the expected present value technique, it is not always necessary to take into account distributions of all possible cash flows using complex models and techniques. Rather, it might be possible to develop a limited number of discrete scenarios and probabilities that capture the array of possible cash flows. For example, a reporting entity might use realized cash flows for some relevant past period, adjusted for changes in circumstances occurring subsequently (for example, changes in external factors, including economic or market conditions, industry trends, and competition as well as changes in internal factors affecting the reporting entity more specifically), taking into account the assumptions of market participants.

55-19 In theory, the present value (that is, the fair value) of the asset’s cash flows is the same whether determined using Method 1 or Method 2, as follows:

Using Method 1, the expected cash flows are adjusted for systematic (that is, market) risk. In the absence of market data directly indicating the amount of the risk adjustment, such adjustment could be derived from an asset pricing model using the concept of certainty equivalents. For example, the risk adjustment (that is, the cash risk premium of $22) could be determined using the systematic risk premium of 3 percent ($780 – [$780 × (1.05/1.08)]), which results in risk-adjusted expected cash flows of $758 ($780 – $22). The $758 is the certainty equivalent of $780 and is discounted at the risk-free interest rate (5 percent). The present value (that is, the fair value) of the asset is $722 ($758/1.05).
Using Method 2, the expected cash flows are not adjusted for systematic (that is, market) risk. Rather, the adjustment for that risk is included in the discount rate. Thus, the expected cash flows are discounted at an expected rate of return of 8 percent (that is, the 5 percent risk-free interest rate plus the 3 percent systematic risk premium). The present value (that is, the fair value) of the asset is $722 ($780/1.08).

55-20 When using an expected present value technique to measure fair value, either Method 1 or Method 2 could be used. The selection of Method 1 or Method 2 will depend on facts and circumstances specific to the asset or liability being measured, the extent to which sufficient data are available, and the judgments applied.

Example 2: Discount Rate Adjustment Technique — The Build-Up Methodology

55-33 To illustrate a build-up methodology (as discussed in paragraph 820-10-55-11), assume that Asset A is a contractual right to receive $800 in 1 year (that is, there is no timing uncertainty). There is an established market for comparable assets, and information about those assets, including price information, is available. Of those comparable assets:

Asset B is a contractual right to receive $1,200 in 1 year and has a market price of $1,083. Thus, the implied annual rate of return (that is, a 1-year market rate of return) is 10.8 percent [($1,200/$1,083) – 1].
Asset C is a contractual right to receive $700 in 2 years and has a market price of $566. Thus, the implied annual rate of return (that is, a 2-year market rate of return) is 11.2 percent [($700/$566)^0.5 – 1].
All three assets are comparable with respect to risk (that is, dispersion of possible payoffs and credit).

55-34 On the basis of the timing of the contractual payments to be received for Asset A relative to the timing for Asset B and Asset C (that is, one year for Asset B versus two years for Asset C), Asset B is deemed more comparable to Asset A. Using the contractual payment to be received for Asset A ($800) and the 1-year market rate derived from Asset B (10.8 percent), the fair value of Asset A is $722 ($800/1.108). Alternatively, in the absence of available market information for Asset B, the one-year market rate could be derived from Asset C using the build-up methodology. In that case, the 2-year market rate indicated by Asset C (11.2 percent) would be adjusted to a 1-year market rate using the term structure of the risk-free yield curve. Additional information and analysis might be required to determine whether the risk premiums for one-year and two-year assets are the same. If it is determined that the risk premiums for one-year and two-year assets are not the same, the two-year market rate of return would be further adjusted for that effect.

ASC 820-10-55-4 through 55-20 contain guidance on the application of present value techniques (i.e., an income approach). An entity should consider such guidance, which is derived from FASB Concepts Statement 7, when measuring the fair value of an asset, liability, or equity instrument on the basis of future cash flows. In addition, ASC 820-10-55-33 and 55-34 contain an example illustrating the application of a discount-rate adjustment technique. See also the examples in Section 10.2.7.5 and Section 10.6.4. For discussion of the valuation technique applied to determine the fair value of a customer-relationship intangible asset, see Section 10.10.4.

10.3.2 Using a Single Technique or Multiple Techniques

ASC 820-10

Valuation Techniques

35-24B In some cases, a single valuation technique will be appropriate (for example, when valuing an asset or a liability using quoted prices in an active market for identical assets or liabilities). In other cases, multiple valuation techniques will be appropriate (for example, that might be the case when valuing a reporting unit). If multiple valuation techniques are used to measure fair value, the results (that is, respective indications of fair value) shall be evaluated considering the reasonableness of the range of values indicated by those results. A fair value measurement is the point within that range that is most representative of fair value in the circumstances.

In some cases, it is appropriate to use more than one valuation technique to determine the fair value of an asset, liability, or instrument classified in stockholders’ equity. An entity that employs multiple valuation techniques should consider both supporting and contradictory evidence in determining the relevancy of the results of the individual techniques. An entity must use judgment to determine the “weighting” to give to each valuation technique used. When evaluating the reasonableness of the range of values arrived at by using multiple techniques, an entity should consider a value to be more reasonable if it is produced by a technique that maximizes the use of observable inputs and minimizes the use of unobservable inputs. For each measurement calculated, the entity must consider the fair value hierarchy and choose the most reliable inputs available. When two or more sources for the same input are in the same level of the fair value hierarchy, the entity chooses the source that reflects the least amount of subjectivity and that provides the most reliable information for the given input.

The FASB did not intend for Statement 157 to require the use of multiple valuation techniques; rather, the Board wanted to suggest that in certain situations, it may be necessary to use multiple techniques to determine fair value, as discussed in paragraphs C54 through C56 of FASB Statement 157:

The Board affirmed that its intent was not to require the use of multiple valuation techniques. To convey its intent more clearly, the Board clariﬁed that, consistent with existing valuation practice, valuation techniques that are appropriate in the circumstances and for which sufficient data are available should be used to measure fair value. This Statement does not specify the valuation technique that should be used in any particular circumstances. Determining the appropriateness of valuation techniques in the circumstances requires judgment.

The Exposure Draft referred to the cost and effort involved in obtaining the information used in a particular valuation technique as a basis for determining whether to use that valuation technique. Some respondents pointed out that the most appropriate valuation technique also might be the most costly valuation technique and that cost and effort should not be a basis for determining whether to use that valuation technique. Moreover, a cost-and-effort criterion likely would not be consistently applied. The Board agreed and removed that cost-and-effort criterion from this Statement.

The Board expects that in some cases, a single valuation technique will be used. In other cases, multiple valuation techniques will be used, and the results of those techniques evaluated and weighted, as appropriate, in determining fair value. The Board acknowledged that valuation techniques will differ, depending on the asset or liability and the availability of data. However, in all cases, the objective is to use the valuation technique (or combination of valuation techniques) that is appropriate in the circumstances and for which there are sufficient data.

The example below illustrates factors to consider in the determination of whether multiple valuation techniques should be used to measure fair value.

Example 10-13

Use of Multiple Valuation Techniques

Entity L, a private equity firm, is required to account for its investments at fair value on a recurring basis in accordance with ASC 946. Entity L holds a number of investments, two of which are in the common stock of:

Company A, a clothing retailer that operates in a niche market of the baby clothing industry. Quoted prices are not available for A’s stock, and most of A’s competitors are either privately held or subsidiaries of larger publicly traded clothing retailers. Company A is similar to two other organizations whose shares are thinly traded in an observable market.
Company B, a retailer that operates in the competitive consumer electronics industry. Although quoted prices are not available for B’s stock, B is considered comparable to many companies whose shares are actively traded.

Entities commonly use the market approach and income approach to value equity investments that are not publicly traded. Under the market approach, entities use prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities, including a business (e.g., market-multiple approach). Under the income approach, entities use valuation techniques to convert future amounts to a single present amount (e.g., discounted cash flows model). Generally, the cost approach is not relevant to the valuation of equity investments.

Entity L should evaluate each investment individually to determine the appropriate valuation technique(s) used to measure fair value. Whether L should use both a market approach and an income approach to calculate the fair value of each investment (as opposed to using only a single valuation technique) depends on the facts and circumstances and could change over time.

Some factors that L should consider in evaluating the appropriateness of valuation techniques, including whether a single technique or multiple techniques should be employed, include the following:

Relevance and applicability of the technique — Since the cost approach is not relevant to the valuation of equity investments, only valuation techniques that reflect market and income approaches should be considered. The appropriateness of each specific valuation technique will depend on the facts and circumstances. While L would assess the appropriateness of each valuation technique individually, it would also compare the techniques to each other.
Availability and reliability of data — If L, for example, does not have sufficient reliable data to support an income approach but does have sufficient reliable data to support a market approach, a single approach (market approach) might be appropriate.
Comparative level of the alternative approaches in the fair value hierarchy — Entity L should determine the level in the ASC 820 fair value hierarchy in which (1) each input to each technique would be classified and (2) each measurement would fall in its entirety. For example, L may conclude that a single approach (market approach) is appropriate if it uses (1) a market approach based entirely on market-observable inputs, which places the fair value measurement in Level 2 in its entirety, and (2) the income approach, which in this example includes an unobservable input that is significant to the entire measurement and causes the measurement to be categorized in Level 3 of the fair value hierarchy. On the other hand, if both measurements are Level 3, L may conclude, after considering other factors, that it could use both approaches. However, to support the unobservable inputs used, it would still evaluate the availability and reliability of data. Even when all inputs are unobservable, L would choose the most reliable data available and the measurement technique or techniques that use the most reliable data available after it considers all inputs significant to the measurement.

As discussed above, when evaluating the reasonableness of the range of values arrived at by using multiple techniques, L should consider a value to be more reasonable if it is produced by a technique that maximizes the use of observable inputs and minimizes the use of unobservable inputs.
Significant decline in volume and level of market activity — If, on the basis of ASC 820-10-35-54C, L concludes that there has been a significant decline in volume and level of market activity relative to normal market activity for the investment being measured, it might be appropriate for L to change its valuation technique (e.g., shift from a market approach to an income approach) or use multiple valuation techniques (e.g., use both an income approach and a market approach) in determining fair value. However, regardless of the technique(s) used, the resulting fair value measurement must reflect market-participant assumptions under current market conditions.
Views of market participants on the relevance of valuation techniques — Market transactions involving the specific investment or similar investments may highlight the use of a single technique or multiple techniques by market participants. Entity L may observe approaches used by market participants to help them determine a bid price for similar investments (i.e., through discussions with other private equity firms or valuation specialists) and to gain an understanding of techniques that are used by market participants in determining the fair value at which they will transact.

Entity L should consider the above factors in identifying an appropriate approach for measuring the fair value of its investment in A. For example, assume that when using a market approach, L estimates that market participants would incorporate significant entity-specific adjustments into the valuation of A’s stock (e.g., risk adjustments for illiquidity/uncertainty of A’s stock relative to that of comparable companies as well as other adjustments to reflect business model differences between A and comparable companies). These adjustments are calculated on the basis of L’s assumptions, rendering the fair value measurement Level 3. Similarly, assume that in using an income approach based on discounted cash flows to measure fair value, L must make significant entity-specific assumptions in forecasting A’s future cash flows. In such a case, the fair value measurement under the income approach is also Level 3.

In addition, because (1) the cost approach would not be relevant and (2) the market and income approaches are common valuation techniques used by prospective buyers to help them bid on acquisitions, L would generally conclude that both valuation techniques are appropriate in this circumstance. Further, it should use both approaches in estimating fair value (even if one approach is only used to corroborate the results of the other) provided that relevant and reliable inputs are available and there are no other factors that would cause L to conclude that one of the approaches is superior.

Likewise, in determining an appropriate approach for measuring the fair value of its investment in B, L should consider the above factors. For example, assume that when using a market approach, L estimates that market participants would not incorporate significant adjustments into the valuation of B’s stock, resulting in a Level 2 measurement (e.g., because of the large number of similar companies and high trading volume of the comparable companies’ stock). Similarly, assume that when measuring fair value by using an income approach based on discounted cash flows, L must use significant entity-specific assumptions in forecasting B’s future cash flows. These assumptions would result in a Level 3 fair value measurement under the income approach.

As a result, L may conclude that using a single valuation technique (e.g., market approach) may be appropriate in this circumstance because it results in a more reliable fair value measurement (Level 2 vs. Level 3). (Note that in practice it would be atypical for an entity not to incorporate significant adjustments into a market approach to value an equity investment; this example is intended to illustrate the concept of maximizing the use of relevant observable inputs in a fair value measurement.)

Entity L should also consider using a valuation specialist, when appropriate, and should document its conclusions and considerations related to the application of valuation techniques (as part of its internal control policies and procedures).

Cases A and B of Example 3 in ASC 820 also illustrate the use of multiple valuation techniques.

ASC 820-10

Example 3: Use of Multiple Valuation Approaches

Case A: Machine Held and Used

55-36 A reporting entity acquires a machine in a business combination. The machine will be held and used in its operations. The machine was originally purchased by the acquired entity from an outside vendor and, before the business combination, was customized by the acquired entity for use in its operations. However, the customization of the machine was not extensive. The acquiring entity determines that the asset would provide maximum value to market participants through its use in combination with other assets or with other assets and liabilities (as installed or otherwise configured for use). There is no evidence to suggest that the current use of the machine is not its highest and best use. Therefore, the highest and best use of the machine is its current use in combination with other assets or with other assets and liabilities.

55-37 The reporting entity determines that sufficient data are available to apply the cost approach and, because the customization of the machine was not extensive, the market approach. The income approach is not used because the machine does not have a separately identifiable income stream from which to develop reliable estimates of future cash flows. Furthermore, information about short-term and intermediate-term lease rates for similar used machinery that otherwise could be used to project an income stream (that is, lease payments over remaining service lives) is not available. The market and cost approaches are applied as follows:

The market approach is applied using quoted prices for similar machines adjusted for differences between the machine (as customized) and the similar machines. The measurement reflects the price that would be received for the machine in its current condition (used) and location (installed and configured for use). The fair value indicated by that approach ranges from $40,000 to $48,000.
The cost approach is applied by estimating the amount that would be required currently to construct a substitute (customized) machine of comparable utility. The estimate takes into account the condition of the machine and the environment in which it operates, including physical wear and tear (that is, physical deterioration), improvements in technology (that is, functional obsolescence), conditions external to the condition of the machine such as a decline in the market demand for similar machines (that is, economic obsolescence), and installation costs. The fair value indicated by that approach ranges from $40,000 to $52,000.

55-38 The reporting entity determines that the higher end of the range indicated by the market approach is most representative of fair value and, therefore, ascribes more weight to the results of the market approach. That determination is made on the basis of the relative subjectivity of the inputs, taking into account the degree of comparability between the machine and the similar machines. In particular:

The inputs used in the market approach (quoted prices for similar machines) require fewer and less subjective adjustments than the inputs used in the cost approach.
The range indicated by the market approach overlaps with, but is narrower than, the range indicated by the cost approach.
There are no known unexplained differences (between the machine and the similar machines) within that range.

Accordingly, the reporting entity determines that the fair value of the machine is $48,000.

55-38A If customization of the machine was extensive or if there were not sufficient data available to apply the market approach (for example, because market data reflect transactions for machines used on a standalone basis, such as, a scrap value for specialized assets, rather than machines used in combination with other assets or with other assets and liabilities), the reporting entity would apply the cost approach. When an asset is used in combination with other assets or with other assets and liabilities, the cost approach assumes the sale of the machine to a market participant buyer with the complementary assets and the associated liabilities. The price received for the sale of the machine (that is, an exit price) would not be more than either of the following:

The cost that a market participant buyer would incur to acquire or construct a substitute machine of comparable utility
The economic benefit that a market participant buyer would derive from the use of the machine.

Case B: Software Asset

55-39 A reporting entity acquires a group of assets. The asset group includes an income-producing software asset internally developed for licensing to customers and its complementary assets (including a related database with which the software asset is used) and the associated liabilities. To allocate the cost of the group to the individual assets acquired, the reporting entity measures the fair value of the software asset. The reporting entity determines that the software asset would provide maximum value to market participants through its use in combination with other assets or with other assets and liabilities (that is, its complementary assets and the associated liabilities). There is no evidence to suggest that the current use of the software asset is not its highest and best use. Therefore, the highest and best use of the software asset is its current use. (In this case, the licensing of the software asset, in and of itself, does not indicate that the fair value of the asset would be maximized through its use by market participants on a standalone basis.)

55-40 The reporting entity determines that, in addition to the income approach, sufficient data might be available to apply the cost approach but not the market approach. Information about market transactions for comparable software assets is not available. The income and cost approaches are applied as follows:

The income approach is applied using a present value technique. The cash flows used in that technique reflect the income stream expected to result from the software asset (license fees from customers) over its economic life. The fair value indicated by that approach is $15 million.
The cost approach is applied by estimating the amount that currently would be required to construct a substitute software asset of comparable utility (that is, taking into account functional and economic obsolescence). The fair value indicated by that approach is $10 million.

55-41 Through its application of the cost approach, the reporting entity determines that market participants would not be able to construct a substitute software asset of comparable utility. Some characteristics of the software asset are unique, having been developed using proprietary information, and cannot be readily replicated. The reporting entity determines that the fair value of the software asset is $15 million, as indicated by the income approach.

10.3.3 Model Calibration

ASC 820-10

Valuation Techniques

35-24C If the transaction price is fair value at initial recognition and a valuation technique that uses unobservable inputs will be used to measure fair value in subsequent periods, the valuation technique shall be calibrated so that at initial recognition the result of the valuation technique equals the transaction price. Calibration ensures that the valuation technique reflects current market conditions, and it helps a reporting entity to determine whether an adjustment to the valuation technique is necessary (for example, there might be a characteristic of the asset or liability that is not captured by the valuation technique). After initial recognition, when measuring fair value using a valuation technique or techniques that use unobservable inputs, a reporting entity shall ensure that those valuation techniques reflect observable market data (for example, the price for a similar asset or liability) at the measurement date.

Section 9.3 discusses the requirement in ASC 820-10-35-24C to calibrate a valuation technique to the transaction price. While that discussion focuses primarily on calibration of a valuation technique to the initial amount recognized for an asset or liability that is subsequently measured at fair value, entities should also calibrate valuation techniques to other relevant transactions, such as:

Observable market transactions (e.g., calibration of a valuation technique used to measure the fair value of mortgage servicing rights to observed market transactions involving the sale of mortgage servicing rights).
An entity’s own sale transactions (e.g., calibration of a valuation technique used to measure fair value of private equity investments to amounts received upon disposition of such investments).

See Section 10.7 for discussion of how an entity considers whether observable transactions represent orderly transactions between market participants. See Section 10.8.2 for discussion of an entity’s use of quotes from brokers or pricing services to calibrate its valuation techniques.

10.3.4 Changes in Valuation Techniques

ASC 820-10

Valuation Techniques

35-25 Valuation techniques used to measure fair value shall be applied consistently. However, a change in a valuation technique or its application (for example, a change in its weighting when multiple valuation techniques are used or a change in an adjustment applied to a valuation technique) is appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances. That might be the case if, for example, any of the following events take place:

New markets develop.
New information becomes available.
Information previously used is no longer available.
Valuation techniques improve.
Market conditions change.

35-26 Revisions resulting from a change in the valuation technique or its application shall be accounted for as a change in accounting estimate. (See paragraph 250-10-45-17. However, paragraph 250-10-50-5 explains that the disclosures in Topic 250 for a change in accounting estimate are not required for revisions resulting from a change in a valuation technique or its application.)

ASC 820 does not preclude an entity from changing its valuation technique or the application thereof. However, before making such a change, the entity must determine that doing so would yield a measurement that is equally or more representative of fair value. ASC 820-10-35-25 gives examples of circumstances in which an entity may need to change its valuation technique or how it applies such a technique.

A change in valuation technique from one in which a quoted price is used would generally not be appropriate when there is a quote from an active market for an identical asset. As discussed in ASC 820-10-35-41, if a quoted price in an active market exists, it “shall be used without adjustment to measure fair value whenever available,” with limited exceptions. Decreased volumes in a market are not necessarily indicative of an inactive market (see Section 10.6.2.1 for more information).

Depending on the circumstances, a change from a valuation technique in which a quoted price (or a direct adjustment to a quoted price) is used to a different valuation technique (e.g., a discounted cash flow technique) may be appropriate in the following cases:

When a quoted price is no longer available.
When a quoted price is available but the market is not active (see ASC 820-10-35-48(b)). ASC 820-10-35-54C states that entities must “evaluate the significance and relevance” of the following factors to determine whether the volume or level of activity for an asset or liability has significantly decreased:
1. There are few recent transactions.
2. Price quotations are not developed using current information.
3. Price quotations vary substantially either over time or among market makers (for example, some brokered markets).
4. Indices that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability.
5. There is a significant increase in implied liquidity risk premiums, yields, or performance indicators . . . for observed transactions or quoted prices when compared with the reporting entity’s estimate of expected cash flows, taking into account all available market data about credit and other nonperformance risk for the asset or liability.
6. There is a wide bid-ask spread or significant increase in the bid-ask spread.
7. There is a significant decline in the activity of, or there is an absence of, a market for new issues . . . for the asset or liability or similar assets or liabilities [or own equity instruments].
8. Little information is publicly available (for example, for transactions that take place in a principal-to-principal market).
Note, however, that an entity must consider prices from relevant observable transactions in determining fair value even if the market is not active. See Chapter 7 and Section 10.6.3 for more information.
The entity is not able to access the price in the market in which it is quoted (see ASC 820-10-35-6B and ASC 820-10-35-41B(b)).
The price is not based on relevant observable market data and does not reflect assumptions that market participants would make in pricing the asset as of the measurement date. (As discussed in Section 10.8, an entity cannot necessarily assume that a price provided by an external source is representative of fair value as of the measurement date.)

When there is no quoted price in an active market, it is sometimes appropriate for an entity to use multiple valuation techniques to measure fair value (as discussed in ASC 820-10-35-24B). Like other changes in valuation technique, a change in the application of multiple valuation techniques (such as a change in how they are weighted) is permitted if it results in a measurement that is equally or more representative of fair value in the circumstances. For instance, if the entity employs both a market approach (e.g., market multiples for comparable assets) and an income approach (e.g., a discounted cash flow model) in determining fair value, the method of weighting the two approaches should be consistent over time unless the conditions for a change in valuation technique are met. Furthermore, an entity would consider the reasonableness of the range of fair value measurements resulting from the approaches. ASC 820-10-35-54F states that “[t]he objective is to determine the point within the range that is most representative of fair value under current market conditions. A wide range of fair value measurements may be an indication that further analysis is needed.”

ASC 820 also requires disclosure of the valuation techniques and inputs used to measure fair value as well as a discussion of changes in valuation techniques (including the justification for making them) during interim and annual periods (see ASC 820-10-50-2(bbb)). See Chapter 11 for more information.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.