For the purpose of fair value measurements, “inputs” are the assumptions that market participants would use in pricing an asset or liability, including assumptions regarding risk. In measuring fair value of asset or liability, valuators (and other readers of companies’ financial statements) would need to understand with means of prioritizing of those assumptions used as to their level of objectivity and verifiability in the marker place. It needs a framework. For serving the purpose GAAP’s Accounting Standard Codificiation (ASC) provides the “Fair Value Inputs Hierarchy.” What is in the hierarchy that helps valuators and financial statements’ readers? How inputs (assumptions) are classified?
This post concludes and describes the “Fair Value Inputs Hierarchy” used in the fair value measurements.
Before that, let’s recall that fair value is 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 (ASC 820). It’s also worth mentioning that an “orderly transaction”:
- is a hypothetical transaction assumed to take place on the measurement date with the item being valued having been exposed to the market for the usual and customary period of time for transactions involving such assets or liabilities in order to provide sufficient time for marketing activities.
- isn’t a sale where the seller is under duress (e.g., a forced liquidation or distress sale). Fair value measurements are to be considered from the perspective of a market participant that holds the asset or owes the liability.
Thus, the objective of measuring fair value is to determine an exit price: the price that would be received to sell an asset or the price that would be paid to transfer the liability.
Fair Value Inputs Hierarchy (Diagram and Explanations)
An input is either observable or unobservable. Observable inputs are either directly observable or indirectly observable. ASC 820 requires the evaluator to maximize the use of observable inputs and minimize the use of unobservable inputs.
An observable input is based on market data obtainable from sources independent of the reporting entity. An unobservable input reflects assumptions made by management of the reporting entity with respect to assumptions it believes market participants would use to price an asset or liability based on the best information available under the circumstances.
ASC 820 provides a fair value input hierarchy (see diagram below) to serve as a framework for classifying inputs based on the extent to which they are based on observable data.
Here they are explained:
Level 1 Inputs
Level 1 inputs are considered the most reliable evidence of fair value and are to be used whenever they are available. These inputs consist of quoted prices in active markets for identical assets or liabilities.
The active market must be one in which the reporting entity has the ability to access the quoted price at the measurement date. To be considered an active market, transactions for the asset or liability being measured must occur frequently enough and in sufficient volume to provide pricing information on an ongoing basis.
If a market price at the exact measurement date is not readily available, or is available but not representative of fair value because the market is not active or because events occurring after the last available quoted price would have affected fair value at the measurement date, the quoted price is to be adjusted to more accurately reflect fair value.
Examples of such events that could occur after the close of a market but prior to the measurement date would include principal-to-principal transactions or brokered trades about which the evaluator has access to reliable information, or announcements made in press conferences, shareholders meetings, or in regulatory filings.
In order for a market to be considered active, it must have a sufficient volume of transactions to provide quoted market prices that are the most reliable measure of fair value.
Markets experiencing reduced transaction volumes are still considered active if transactions are occurring frequently enough on an ongoing basis to provide reliable pricing information.
ASC 820 requires that quoted prices from active markets (Level 1 inputs) be used whenever they are available. The use of Level 2 or Level 3 inputs is generally prohibited when Level 1 inputs are available.
Even if management were to conclude that a reduction in transaction volume in a particular market rendered that market inactive (i.e., the market is unable to provide reliable pricing information) the observable transactions that were occurring in that market would still be considered Level 2 inputs which need to be taken into account by management in its measurements of fair value. Management is required to establish and consistently apply a policy for identifying events that potentially affect its fair value measurements.
If the reporting entity holds a large number of similar assets and liabilities (such as a pool of debt securities), and quoted prices are not accessible with respect to each individual asset and/or liability in a cost-effective manner to enable timely financial reporting, management may choose to substitute, as a practical expedient, an alternative pricing model that does not rely exclusively on quoted prices such as using a matrix pricing model for debt securities.
The use of a pricing model as an alternative to directly pricing each asset or liability in the group will require management to characterize the measurement in its entirety as a level lower than Level 1 in the hierarchy.
Under no circumstances, however, is management to adjust the quoted price for blockage factors. Blockage adjustments arise when an entity holds a position in a single financial instrument that is traded on an active market that is relatively large in relation to the market’s daily trading volume.
While there is no common agreement as to how large a position would constitute a “block” of a particular instrument, FASB unconditionally prohibits any adjustment as a result of blockage, even if the market’s normal daily trading volume is insufficient to absorb the quantity held by the reporting entity and irrespective of whether the placing of an order to sell the position in a single transaction might affect the quoted price.
Level 2 Inputs
Level 2 inputs are quoted prices for the asset or liability (other than those included in Level 1) that are either directly or indirectly observable. Level 2 inputs are to be considered when quoted prices for the identical asset or liability are not available. If the asset or liability being measured has a contractual term, a Level 2 input must be observable for substantially the entire term. These inputs include:
1. Quoted prices for similar assets or liabilities in active markets.
2. Quoted prices for identical or similar assets or liabilities in markets that are not active. These markets may not be considered active because of:
- They have an insufficient volume or frequency of transactions for the asset or liability
- Prices are not current
- Quotations vary substantially over time
- Quotations vary substantially among market makers (e.g., in some brokered markets)
- Insufficient information is released publicly (e.g., a principal-to-principal market)
3. Inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates and yield curves observable at commonly quoted intervals; volatilities; prepayment speeds; loss severities; credit risks; and default rates.)
4. Inputs that are derived principally from or corroborated by observable market data that, through correlation or other means, are determined to be relevant to the asset or liability being measured (market-corroborated inputs)
Adjustments made to Level 2 inputs necessary to reflect fair value, if any, will vary depending on an analysis of specific factors associated with the asset or liability being measured. These factors include:
- Extent to which the inputs relate to items comparable to the asset or liability
- Volume and level of activity in the markets in which the inputs are observed
Depending on the level of the fair value input hierarchy in which the inputs used to measure the adjustment are classified, an adjustment that is significant to the fair value measurement in its entirety could render the measurement a Level 3 measurement.
During the turmoil experienced in credit markets beginning in early 2008, a holder of collateralized mortgage obligations (CMOs) backed by a pool of subprime mortgages might determine that no active market exists for the CMOs. Management might use an appropriate ABX credit default swap index for subprime mortgage bonds to provide a Level 2 fair value measurement input in measuring the fair value of the CMOs.
Note: ABX indices are disseminated by Markit Group Limited, a London-based consortium of 6 large banks and four hedge funds that provides credit derivative pricing data, valuations, and trade processing services.
Level 3 Inputs
Level 3 inputs are unobservable inputs. These are necessary when little, if any, market activity occurs for the asset or liability. Level 3 inputs are to reflect management’s own assumptions about the assumptions regarding an exit price that a market participant holding the asset or owing the liability would make including assumptions about risk.
The best information available in the circumstances is to be used to develop the Level 3 inputs. This information might include internal data of the reporting entity. Cost-benefit considerations apply in that management is not required to “undertake all possible efforts” to obtain information about the assumptions that would be made by market participants. Attention is to be paid, however, to information available to management without undue cost and effort and, consequently, management’s internal assumptions used to develop unobservable inputs are to be adjusted if such information contradicts those assumptions.
Classifying Inputs Used in Fair Value Measurements
Classification of inputs as to the “level of the hierarchy” in which they fall serves two purposes:
- It provides the evaluator with a means of prioritizing assumptions used as to their level of objectivity and verifiability in the marketplace.
- It provides a framework to provide informative disclosures that enable readers to assess the reliability and market observability of the fair value estimates embedded in the financial statements.
In making a particular measurement of fair value, the inputs used may be classifiable in more than one of the levels of the hierarchy. When this is the case, the inputs used in the fair value measurement in its entirety are to be classified in the level of the hierarchy in which the lowest level input that is significant to the measurement is classified.
It is important to assess available inputs and their relative classification in the hierarchy prior to selecting the valuation technique or techniques to be applied to measure fair value for a particular asset or liability. The objective, in selecting from among alternative calculation techniques, would be to select the technique or combination of techniques that maximizes the use of observable inputs.
FASB clarifies, however, that the intended use of the hierarchy is to prioritize the inputs themselves, not the valuation techniques in which they are used.
Inputs Based on Bid and Ask prices
Quoted bid prices represent the maximum price at which market participants are willing to buy an asset; quoted ask prices represent the minimum price at which market participants are willing to sell an asset.
If available market prices are expressed in terms of bid and ask prices, management is to use the price within the bid-ask spread (the range of values between bid and ask prices) that is most representative of fair value irrespective of where in the fair value hierarchy the input would be classified.
ASC 820 permits the use of pricing conventions such as midmarket pricing as a practical alternative for determining fair value measurements within a bid-ask spread.