3.2 Fair Value Application Framework | DART – Deloitte Accounting Research Tool

3.2.1 Step-by-Step Application Framework

An entity may apply the following step-by-step approach to measure and disclose fair value when other Codification topics require (or permit) the initial or subsequent measurement of an asset, liability, or equity instrument at fair value.

Certain of the steps described above may be interrelated; therefore, these steps do not necessarily have to be performed in the order shown.

3.2.2 Step 1 — Identify the Unit of Account

ASC 820-10

The Asset or Liability

35-2D The asset or liability measured at fair value might be either of the following:

A standalone asset or liability (for example, a financial instrument or a nonfinancial asset)
A group of assets, a group of liabilities, or a group of assets and liabilities (for example, a reporting unit or a business).

35-2E Whether the asset or liability is a standalone asset or liability, a group of assets, a group of liabilities, or a group of assets and liabilities for recognition or disclosure purposes depends on its unit of account. The unit of account for the asset or liability shall be determined in accordance with the Topic that requires or permits the fair value measurement, except as provided in this Topic.

An asset, liability, or instrument classified in stockholders’ equity that is measured at fair value should be identified on the basis of its unit of account. Although ASC 820 defines fair value and establishes a framework for measuring it, the standard does not specify when items should be recognized at fair value in an entity’s financial statements. With one exception, ASC 820 also does not specify the unit of account that applies to a particular fair value measurement.1 Therefore, entities must consult other Codification topics to determine (1) when an entity is required (or permitted) to initially or subsequently measure an asset, liability, or equity instrument at fair value and (2) the unit of account that applies to such a fair value measurement.

As discussed in Chapter 4, the unit of account represents the level of aggregation or disaggregation of individual assets, liabilities, or equity instruments for recognition in the financial statements and, with one exception, is determined on the basis of the guidance in other Codification topics.2 As discussed in Chapter 5, the unit of valuation is the grouping of assets, liabilities, or equity instruments for fair value measurement purposes. ASC 820 provides guidance on determining the unit of valuation (see Section 3.2.3 and Chapter 5 for more information). The unit of account may differ from the unit of valuation. In addition, entities may need to allocate fair value measurements even when the unit of account and unit of valuation are the same.

Example 3-1

Impairment of Long-Lived Assets

Under ASC 360, the unit of account for impairment testing is the asset group. However, the asset group is not the unit of account for recognition purposes. Rather, each of the individual long-lived assets represents a single unit of account. Therefore, in accordance with ASC 360-10-35-28, an entity must allocate the difference between the fair value of the asset group and the carrying amount of the asset group (i.e., the amount of impairment) to individual long-lived assets within the asset group. This allocation is required even if the unit of valuation for purposes of the fair value measurement is the asset group.

Example 3-2

Groups of Financial Assets and Financial Liabilities With Offsetting Risk Positions

An entity may have the option of grouping financial assets, financial liabilities, and nonfinancial items accounted for as derivatives under ASC 815, or a combination of those items, and measuring the portfolio’s fair value on the basis of its net risk position. In this case, the portfolio is the unit of valuation (see ASC 820-10-35-18D through 35-18L). However, each individual item in the portfolio represents a single unit of account. As a result, the portfolio-based fair value measurement must be allocated to the individual units of account within the portfolio.

See Chapter 4 for more information about the unit of account.

3.2.2.1 Liabilities With Third-Party Credit Enhancements

The unit of account for a liability issued with an inseparable third-party credit enhancement is the liability, excluding the credit enhancement. See Section 4.3.2.2 for further discussion.

3.2.3 Step 2 — Identify the Unit of Valuation

3.2.3.1 Financial Assets, Nonfinancial Derivative Assets, Liabilities, and Equity Instruments

As discussed in Section 4.3.2, the unit of valuation for financial assets, nonfinancial derivative assets, liabilities, and equity instruments is the individual asset, liability, or equity instrument, which is generally also its unit of account under other GAAP. The concept of the “highest and best use” does not apply to fair value measurements of financial assets, nonfinancial derivative assets, liabilities, or instruments classified in stockholders’ equity.

Note that for liabilities and instruments classified in stockholders’ equity, an entity performing a fair value measurement assumes that the liabilities or equity instruments are transferred to a market participant on the measurement date. That is, ASC 820 requires entities measuring the fair value of a liability to assume that the liability remains outstanding and is transferred to a market-participant transferee that would be required to fulfill the obligation. Similarly, entities must assume that an instrument classified in stockholders’ equity would remain outstanding and that a market-participant transferee would take on the rights and responsibilities associated with the instrument. A liability being measured at fair value would not be assumed to be settled, and an instrument classified in shareholders’ equity would not be assumed to be canceled or otherwise extinguished. However, when a quoted price for the transfer of an identical or similar liability or an entity’s own equity instrument is not available and the identical item is held by another party as an asset, the entity must measure the fair value of the liability or its own equity instrument from the perspective of a market participant that holds the identical item as an asset. See Section 10.2.7 for more information.

3.2.3.1.1 Portfolio Valuation Exception for Certain Groups of Assets and Liabilities With Offsetting Risk Positions

ASC 820-10

Application to Financial Assets and Financial Liabilities With Offsetting Positions in Market Risks or Counterparty Credit Risk

35-18D A reporting entity that holds a group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items is exposed to market risks (that is, interest rate risk, currency risk, or other price risk) and to the credit risk of each of the counterparties. If the reporting entity manages that group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items on the basis of its net exposure to either market risks or credit risk, the reporting entity is permitted to apply an exception to this Topic for measuring fair value. That exception permits a reporting entity to measure the fair value of a group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items on the basis of the price that would be received to sell a net long position (that is, an asset) for a particular risk exposure or paid to transfer a net short position (that is, a liability) for a particular risk exposure in an orderly transaction between market participants at the measurement date under current market conditions. Accordingly, a reporting entity shall measure the fair value of the group of financial assets, financial liabilities, nonfinancial items accounted for as derivatives in accordance with Topic 815, or combinations of these items consistently with how market participants would price the net risk exposure at the measurement date.

An exception to ASC 820’s general principles related to the unit of valuation is available for groups of financial assets, financial liabilities, and nonfinancial items accounted for as derivatives in accordance with ASC 815 if an entity (1) manages the group of assets and liabilities on the basis of net exposure to a market risk (or risks) or counterparty credit risk, (2) provides information on that basis to management, and (3) measures those assets and liabilities at fair value in the statement of financial position. To use the exception, an entity must make an accounting policy decision. Once the policy is established, the entity must consistently apply the policy from period to period for a particular portfolio. See Sections 4.3.2.1 and 5.3 for more information.

3.2.3.2 Nonfinancial Assets Other Than Nonfinancial Derivative Assets

ASC 820-10

Highest and Best Use for Nonfinancial Assets

35-10A A fair value measurement of a nonfinancial asset takes 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 unit of valuation (also referred to as the “valuation premise”) for nonfinancial assets (other than nonfinancial derivative assets) is the asset’s highest and best use. ASC 820-10-20 defines the highest and best use as the “use of a nonfinancial asset by market participants that would maximize the value of the asset or the group of assets and liabilities (for example, a business) within which the asset would be used.” The highest and best use must be determined from the market participant’s perspective, regardless of the reporting entity’s current use. However, an entity is not required to perform an exhaustive search to identify the highest and best use and may presume that its current use is the highest and best use unless market or other factors suggest otherwise. The highest and best use of an asset might provide maximum value through its use either (1) in combination with other assets or other assets and liabilities or (2) on a stand-alone basis. See Section 5.2 for more information.

3.2.4 Step 3 — Identify the Principal or Most Advantageous Market

ASC 820-10

Definition of Fair Value

35-5 A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place either:

In the principal market for the asset or liability
In the absence of a principal market, in the most advantageous market for the asset or liability.

Underlying the fair value measurement objective in ASC 820 is the concept of an entity transacting in the principal market for the asset or liability (or equity instrument), or in the absence of a principal market, the most advantageous market. ASC 820-10-20 defines the principal market as the “market with the greatest volume and level of activity for the asset or liability” and the most advantageous market as the “market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability, after taking into account transaction costs and transportation costs.” The determination of the principal (or most advantageous) market for an asset, liability, or equity instrument can affect the fair value measurement since the exit price may differ from market to market. The concept of a most advantageous market is relevant only if there is no principal market for the asset, liability, or equity instrument subject to the fair value measurement.

An entity identifies the principal (or most advantageous) market for the asset or liability (or equity instrument) by first identifying all markets that it can access to sell the asset or transfer the liability. ASC 820-10-35-6A requires that an entity have access to the principal (or most advantageous) market. Then, the entity determines, from the perspective of market participants, which market has the greatest volume or level of activity (or in the absence of a principal market, which market maximizes the fair value of the asset or minimizes the fair value of the liability). If there is a principal market, the fair value measurement should represent the price in that market, even if the price in a different market is potentially more advantageous. ASC 820-10-35-5A clarifies that an entity is not required to perform an exhaustive search to identify all markets. In fact, unless contradictory evidence exists, it is generally presumed that the market in which the reporting entity normally transacts is the principal (or most advantageous) market. See Chapter 6 for more information.

3.2.5 Step 4 — Develop Assumptions That Market Participants Would Use to Measure Fair Value

ASC 820-10

Market Participants

35-9 A reporting entity shall measure the fair value of an asset or a liability using the assumptions that market participants would use in pricing the asset or liability, assuming that market participants act in their economic best interest. In developing those assumptions, a reporting entity need not identify specific market participants. Rather, the reporting entity shall identify characteristics that distinguish market participants generally, considering factors specific to all of the following:

The asset or liability
The principal (or most advantageous) market for the asset or liability
Market participants with whom the reporting entity would enter into a transaction in that market.

To meet the “exit price” measurement objective, an entity is required to develop assumptions that market participants would use to determine the price of an asset, liability, or equity instrument in an orderly transaction as of the measurement date. ASC 820-10-20 defines market participants as “[b]uyers and sellers in the [entity’s] principal (or most advantageous) market for the asset or liability” that are (1) ”independent of each other,” (2) knowledgeable, (3) ”able to enter into a transaction for the asset or liability,” and (4) ”willing to enter into a transaction for the asset or liability.” As noted in ASC 820-10-35-9, an entity “need not identify specific market participants” but should “identify characteristics that distinguish market participants generally.” The assumptions that market participants would use when measuring the fair value of the asset, liability, or equity instrument are relevant in the determination of the inputs to the fair value measurement. An entity may not substitute the assumptions of market participants with its own assumptions that differ from those of market participants. See Chapter 7 for more information.

3.2.6 Step 5 — Measure Fair Value on the Basis of Available Inputs and Appropriate Valuation Techniques

ASC 820-10

30-2 When an asset is acquired or a liability is assumed in an exchange transaction for that asset or liability, the transaction price is the price paid to acquire the asset or received to assume the liability (an entry price). In contrast, the fair value of the asset or liability is the price that would be received to sell the asset or paid to transfer the liability (an exit price). Entities do not necessarily sell assets at the prices paid to acquire them. Similarly, entities do not necessarily transfer liabilities at the prices received to assume them.

30-3 In many cases, the transaction price will equal the fair value (for example, that might be the case when on the transaction date the transaction to buy an asset takes place in the market in which the asset would be sold). . . .

30-3A When determining whether fair value at initial recognition equals the transaction price, a reporting entity shall take into account factors specific to the transaction and to the asset or liability. For example, the transaction price might not represent the fair value of an asset or a liability at initial recognition if any of the following conditions exist:

The transaction is between related parties, although the price in a related party transaction may be used as an input into a fair value measurement if the reporting entity has evidence that the transaction was entered into at market terms.
The transaction takes place under duress or the seller is forced to accept the price in the transaction. For example, that might be the case if the seller is experiencing financial difficulty.
The unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value. For example, that might be the case if the asset or liability measured at fair value is only one of the elements in the transaction (for example, in a business combination), the transaction includes unstated rights and privileges that are measured separately, in accordance with another Topic, or the transaction price includes transaction costs.
The market in which the transaction takes place is different from the principal market (or most advantageous market). For example, those markets might be different if the reporting entity is a dealer that enters into transactions with customers in the retail market, but the principal (or most advantageous) market for the exit transaction is with other dealers in the dealer market.

35-16AA In all cases, a reporting entity shall maximize the use of relevant observable inputs and minimize the use of unobservable inputs to meet the objective of a fair value measurement, which is to estimate the price at which an orderly transaction to transfer the liability or instrument classified in shareholders’ equity would take place between market participants at the measurement date under current market conditions.

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.

ASC 820 applies at both initial recognition and subsequent measurement if fair value is required or permitted by other Codification topics. On initial recognition, the transaction price, which is an entry price, will often equal fair value, which is an exit price. However, as discussed in ASC 820-10-30-3A, the transaction price may not equal fair value at initial recognition in certain situations. In such cases, an inception gain or loss may arise upon initial recognition of an asset or liability. See Chapter 9 for more information about the initial measurement of an item at fair value.

Since a fair value measurement is an exit price, a quoted market price for the identical asset, liability, or equity instrument (i.e., a Level 1 input) constitutes the most reliable evidence of fair value and, when available, must be used to measure fair value without being adjusted, except in limited circumstances. When a Level 1 input is not available to measure the fair value of an asset, liability, or equity instrument in its entirety, an entity will need to measure fair value by using one or more appropriate valuation techniques that incorporate available inputs. An entity must maximize relevant observable inputs (i.e., Level 1 and Level 2 inputs) and use unobservable inputs (i.e., Level 3 inputs) only when relevant observable inputs are not available. See Chapter 8 for more information about the fair value hierarchy.

An entity measures fair value on the basis of one or more of the three valuation approaches outlined in ASC 820-10-35-24A: (1) the market approach, (2) the income approach, or (3) the cost approach. Further, the entity selects one or more techniques “that are appropriate in the circumstances and for which sufficient data are available” to maximize the use of observable inputs while minimizing the use of unobservable inputs. If multiple techniques are used, the entity should evaluate the resultant range and should select a point within the range that is most representative of fair value.

The entity should evaluate the factors listed in ASC 820-10-35-54C to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability in relation to normal market activity. This determination will affect the entity’s selection of techniques or inputs and the weight placed on quoted prices. If the volume and level of activity for the asset or liability have significantly decreased, the entity may need to significantly adjust the transaction or quoted price. Regardless, the entity’s objective is to select an estimate that is most representative of fair value.

See Chapter 10 for more information about the measurement of fair value on the basis of available inputs and appropriate valuation techniques.

3.2.7 Step 6 — Allocate Fair Value Measurement to Individual Units of Account (if Necessary)

As discussed in step 1, the unit of account may differ from the unit of valuation. In addition, an entity may need to perform allocations of fair value measurements even when the unit of account and unit of valuation are the same. In these circumstances, once the fair value is calculated at the level of the unit of valuation (see step 5), the entity must allocate the fair value measurement to the individual units of account that are subject to the fair value measurement. Since ASC 820 does not specify how to perform this allocation, the entity must consider the individual facts and circumstances, along with other relevant Codification topics, in such cases. See Section 4.3 for more information.

3.2.8 Step 7 — Classify the Fair Value Measurement Under the Fair Value Hierarchy and Prepare Disclosures

ASC 820 categorizes inputs used in fair value measurements into a three-level fair value hierarchy. An unadjusted quoted price in an active market is the most reliable measure of fair value and is categorized as Level 1. Fair value measurements that incorporate observable inputs (i.e., quoted market prices in active markets for similar assets or liabilities, quoted prices in inactive markets for identical or similar assets or liabilities, or other inputs that are observable or that can be corroborated through observable market data or in other ways for substantially the entire term of the assets or liabilities) represent Level 2 fair value measurements. Fair value measurements that incorporate unobservable inputs represent Level 3 fair value measurements. A fair value measurement that includes multiple inputs is categorized in its entirety on the basis of the lowest-level input that is significant to the entire measurement. In addition to requiring entities to classify fair value measurements within the fair value hierarchy, ASC 820 requires entities to provide various disclosures on the basis of such classification. See Chapters 8 and 11 for more information.