8.1 Introduction

8.1.1 General

ASC 820-10

Fair Value Hierarchy

35-37 To increase consistency and comparability in fair value measurements and related disclosures, this Topic establishes a fair value hierarchy that categorizes into three levels (see paragraphs 820-10-35-40 through 35-41, 820-10-35-41B through 35-41C, 820-10-35-44, 820-10-35-46 through 35-51, and 820-10-35-52 through 35-54A) the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs).

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

Level 1 Inputs

Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.

Level 2 Inputs

Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

Level 3 Inputs

Unobservable inputs for the asset or liability.

The FASB established the fair value hierarchy in FASB Statement 157 (codified in ASC 820) to increase the consistency and comparability of fair value measurements and disclosures about such measurements. The hierarchy is divided into three categories on the basis of the relative observability and reliability of the inputs used in a fair value measurement. The categorization of inputs is important both to estimating fair value and to providing disclosures about such measurements.

With respect to measuring fair value, the fair value hierarchy focuses on inputs rather than valuation techniques. However, ASC 820-10-35-38 indicates that the availability of inputs and their relative subjectivity might affect the selection of the valuation technique. For example, a valuation technique in which an entity uses relevant inputs classified within Level 2 of the fair value hierarchy takes precedence over a valuation technique containing significant unobservable inputs (i.e., Level 3 inputs). In addition, with limited exceptions, an entity is precluded from using a valuation technique that employs Level 2 or Level 3 inputs if a Level 1 quoted market price in an active market is available for an asset, liability, or equity instrument subject to fair value measurement.

As discussed in Chapter 11, for recurring and nonrecurring fair value measurements, all entities are required to disclose the level of the fair value hierarchy within which the measurements are categorized in their entirety (i.e., Level 1, 2, or 3). Such disclosures are provided on the basis of the inputs used in the fair value measurements. As a result, it is critical that entities apply the guidance appropriately in assessing the appropriate level of the fair value hierarchy within which an item is measured or disclosed at fair value.

8.1.2 Determining the Classification of a Fair Value Measurement

ASC 820-10

Fair Value Hierarchy

35-37A In some cases, the inputs used to measure the fair value of an asset or a liability might be categorized within different levels of the fair value hierarchy. In those cases, the fair value measurement is categorized in its entirety in the same level of the fair value hierarchy as the lowest level input that is significant to the entire measurement. Assessing the significance of a particular input to the entire measurement requires judgment, taking into account factors specific to the asset or liability. Adjustments to arrive at measurements based on fair value, such as costs to sell when measuring fair value less costs to sell, shall not be taken into account when determining the level of the fair value hierarchy within which a fair value measurement is categorized.

35-38A If an observable input requires an adjustment using an unobservable input and that adjustment results in a significantly higher or lower fair value measurement, the resulting measurement would be categorized within Level 3 of the fair value hierarchy. For example, if a market participant would take into account the effect of a restriction on the sale of an asset when estimating the price for the asset, a reporting entity would adjust the quoted price to reflect the effect of that restriction. If that quoted price is a Level 2 input and the adjustment is an unobservable input that is significant to the entire measurement, the measurement would be categorized within Level 3 of the fair value hierarchy.

As noted in ASC 820-10-35-37A, inputs used in a fair value measurement “might be categorized within different levels of the fair value hierarchy.” As a result, the asset, liability, or equity instrument will be categorized in its entirety within a level of the fair value hierarchy on the basis of the lowest-level input that is significant to the fair value measurement.

To assess the level of the fair value hierarchy in which an asset, liability, or equity instrument should be categorized, an entity should first determine the inputs that it will use as part of its valuation technique for that instrument. The entity should then assess the level of the fair value hierarchy in which each input would be categorized in accordance with ASC 820-10-35-37 through 35-54A. See Sections 8.2, 8.3, and 8.4 for more information about Level 1, Level 2, and Level 3 inputs.

After assessing the level of the fair value hierarchy in which each input should be categorized, the entity should determine the lowest level of the fair value hierarchy in which an input that is significant to the fair value measurement is categorized. The entity should classify the entire asset, liability, or equity instrument in that level of the fair value hierarchy. For example, a fair value measurement that includes significant Level 2 inputs and significant Level 3 inputs would be classified in its entirety within Level 3.

ASC 820-10 does not establish a bright line for significance or mandate that significance be determined quantitatively. Rather, as noted in ASC 820-10-35-37A, an entity must use judgment in making this determination, “taking into account factors specific to the asset or liability.” Therefore, an entity should establish a method for determining whether an input is significant to a fair value measurement in its entirety and should apply this method consistently. The method might include a threshold or percentage of the overall measurement amount as a benchmark for significance. The threshold should represent a percentage of the overall measurement and not a percentage of a particular component of the measurement or the income statement effect of the measurement (i.e., the threshold should be based on a balance sheet approach). In determining significance for particularly complex valuations, an entity may need to consider how a particular input or inputs behave within a reasonable range of expected outcomes (i.e., a sensitivity analysis). The three examples below illustrate how an entity might determine whether an unobservable input is significant to a fair value measurement.

Example 8-1

Evaluation of Unobservable Volatility Input

Entity A is evaluating whether the unobservable volatility input to a valuation technique used to measure the fair value of a hybrid financial instrument that contains an embedded option is significant to the overall fair value measurement. Entity A should consider the significance of the unobservable volatility relative to the hybrid financial instrument in its entirety and not solely the embedded option. Depending on the nature of the inputs to the hybrid financial instrument, A may need to perform a sensitivity analysis of the unobservable volatility input to determine its significance. Such an analysis might include considering how the unobservable volatility input affects the fair value of the hybrid financial instrument within a range of reasonable expected outcomes.

Example 8-2

Evaluation of Adjustment Made to an Observable Transaction Price

Recent transactions between independent third parties or between the entity and third parties (e.g., quoted prices in an inactive market, privately negotiated acquisitions, or dispositions of the entity’s equity or debt) may be considered Level 2 inputs. This is the case if the transaction price meets the definition of fair value (i.e., the price represents an exit price for the item as of the date of the transaction, the transaction is not executed under duress, and the transaction is executed at terms that are consistent with how other market participants would transact).

In addition, an investor’s recent acquisition or disposition of interests in the entity may be considered a Level 2 input if it meets the criteria above. For example, an investor may own a 25 percent equity investment in an entity that it recognizes at fair value. If the investor acquires another 10 percent equity investment in the entity and the acquisition meets the definition of fair value, the investor may use the price at which it acquired the additional 10 percent interest as a basis for valuing its entire 35 percent equity investment as of the next reporting date.

The investor must adjust the transaction price, if necessary, to appropriately measure the investment at fair value as of the reporting date. For example, the investor would adjust the transaction price for changes in the entity’s financial position or for events that have occurred since the date of the transaction that would affect the fair value of the entity’s shares. Unobservable adjustments that are significant to the measurement would render the fair value measurement of the investment a Level 3 measurement.

Example 8-3

Evaluation of Adjustment Made to a Level 2 Input

ASC 820-10-55-21(h) indicates that a “Level 2 input would be a valuation multiple (for example, a multiple of earnings or revenue or a similar performance measure) derived from observable market data, for example, multiples derived from prices in observed transactions involving comparable (that is, similar) businesses, taking into account operational, market, financial, and nonfinancial factors.” The market-derived multiple may be considered a Level 2 input; however, the historical financial measure (i.e., earnings or EBITDA) and any adjustments needed to reflect differences between the entity and comparable entities would most likely be Level 3 inputs because these factors are entity-specific and are not considered market-observable data. Therefore, the fair value measurement of the investment would most likely be classified within Level 3 of the fair value hierarchy.

Connecting the Dots

As discussed in Section 2.3.3, under ASC 810, a reporting entity that consolidates an eligible CFE may elect to measure the less observable of the fair value of the CFE’s financial assets or the fair value of the CFE’s financial liabilities by using the more observable of the two measurements (the “CFE fair value measurement alternative”). See ASC 810-10-15-17D for discussion of the eligibility requirements related to this fair value measurement alternative. In addition, ASC 810-10-30-10 through 30-16 and ASC 810-10-35-6 through 35-9 provide guidance on applying the CFE fair value measurement alternative to initial and subsequent fair value measurements, respectively.

When applying the CFE fair value measurement alternative, a reporting entity must disclose, for the financial assets and the financial liabilities of the CFE, the information required by ASC 820 on fair value measurement and by ASC 825 on financial instruments. Accordingly, the required disclosures apply to both the less observable and the more observable of the two measurements (although disclosures are not required for certain assets and liabilities that are incidental to the operations of the CFE and have carrying values that approximate fair value). In providing such disclosures, an entity must categorize the fair value measurement by level within the fair value hierarchy. ASC 810-10-50-21 states that for the less observable fair value measurement, the reporting entity must “disclose that the amount was measured on the basis of the more observable of the fair value of the financial liabilities and the fair value of the financial assets.”

To determine the level of the fair value hierarchy in which an entity should categorize the less observable fair value measurement, the reporting entity must first identify the inputs to the more observable fair value measurement. Such inputs include all of those used to calculate the fair value of the more observable measurement, which is described in the guidance in ASC 810-10-30-10 through 30-16 and ASC 810-10-35-6 through 35-9 on applying the CFE fair value measurement alternative.

For example, if the fair value of the CFE’s financial assets is more observable than the fair value of the CFE’s financial liabilities, the reporting entity should treat all of the following as inputs to the less observable fair value measurement (if applicable) in a manner consistent with ASC 810-10-30-12:

The fair value of the financial assets, including (1) loans, (2) derivatives, and (3) the carrying values of any financial assets that are incidental to the CFE’s operations because the financial assets’ carrying values approximate their fair values.
The carrying value of any nonfinancial assets held temporarily (e.g., real estate measured at historical cost less impairment).
The fair value of any beneficial interests retained by the reporting entity (other than those that represent compensation for services).
The reporting entity’s carrying value of any beneficial interests that represent compensation for services.

Next, the reporting entity must assess the observability of these inputs and determine whether the unobservable inputs are significant to the less observable fair value measurement. In performing this assessment, the entity must also consider any method used to allocate the amounts to the less observable fair value measurement, since such allocation is considered an input to the fair value measurement. The allocation may be performed on the basis of significant unobservable inputs, which would render the fair value measurement of the less observable measurement as a Level 3 measurement even if the fair value measurement of the more observable measurement is not categorized within Level 3.

The less observable fair value measurement cannot be categorized within Level 1 because the fair value measurement does not apply to the identical asset or liability.

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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.