The preferred method of determining fair value of transactions is:

While “what” is required or permitted to be measured at fair value and “when” it is required or permitted to be measured at fair value is addressed in separate topics in the accounting guidance, there is a principle-based fair value framework provided in ASC 820 and IFRS 13 that must be applied that increases consistency and comparability of fair value measurements in financial reporting.

Fair value is defined in both frameworks as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  Key concepts to this definition include:

The Transaction: A fair value measurement assumes the transaction to sell the asset or transfer the liability takes place in the principal market. 

The Price:  Fair value is the price that would be received to sell an asset or paid to transfer a liability under current market conditions. In other words, it is an exit price.  

Market Participants: Fair value of an asset or a liability must be measured using the assumptions that market participants would use when pricing the asset or liability, assuming that market participants act in their best economic interest.

Orderly Transaction: An orderly transaction is a transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities.

Determining these components of fair value and applying the principles of the fair value framework are not always straightforward. Significant judgment and assumptions are sometimes needed to estimate  fair value, which can include determining the principal market, establishing an exit price, identifying the type of transaction, and determining the market participant’s perspective. 

Let’s review some of the accounting issues and key principles of the fair value framework.

Principal Market

As we discussed, fair value is the exit price in the principal market. But what is meant by the principal market? And how does one go about determining it?

ASC 820 indicates that the principal market should be determined based on the market with the greatest volume and level of activity for the asset or liability. In the absence of contrary evidence, the market in which an entity would normally enter into a transaction is presumed to be the principal market.

If the principal market is not determinable, then the most advantageous market should be used to determine fair value.

A reporting entity does not need to undertake an exhaustive search of all possible markets to identify the principal market or, in the absence of a principal market, the most advantageous market, but it should take into account all information that is reasonably available.

It is also important to note that different entities may have different principal markets for identical assets or liabilities depending on their activities and which markets they can access.

Valuation Techniques to Determine Fair Value of Financial Assets

Valuation techniques that are appropriate to the circumstances, and for which sufficient data are available, should be used to measure fair value. ASC 820 identifies the following three valuation approaches:

Market Approach – A valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (i.e., similar) assets, liabilities, or a group of assets and liabilities, such as a business.

Income Approach – A valuation technique that converts future amounts (e.g., cash flows, or income and expenses) to a single current (i.e., discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts.

Cost Approach – A valuation technique that reflects the amount that would currently be required to replace the service capacity of an asset (i.e., current replacement cost).

The objective of using a valuation technique is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. Evaluation of the merits of the valuation techniques should be done to determine which one to apply or whether to weight the results of different valuation techniques.

Highest and Best Use Concept

When determining the fair value of a nonfinancial asset, it is important to base the measurement on the asset’s highest and best use.

ASC 820 requires that a fair value measurement of a nonfinancial asset take into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use.

The highest and best use of a nonfinancial asset might provide maximum value to market participants through its use in combination with other assets as a group (as installed or otherwise configured for use) or in combination with other assets and liabilities (for example, as a business).

The highest and best use is determined from the perspective of market participants.

Net Asset Value as a Practical Expedient for Fair Value

Some reporting entities, such as investment companies, frequently invest in funds and other alternative investments. It is not easy to value alternative investments because sales are typically private and not available to the public.

These types of investments usually report Net Asset Value or NAV. NAV is the amount of net assets, recorded at fair value with changes in fair value recorded within profit or loss, attributable to each share, or unit, of the fund.

The FASB permits but does not require the use of NAV as a practical expedient for fair value if certain conditions are met.

IFRS does not contain a practical expedient for estimating fair value of certain investments using NAV.

Under U.S. GAAP, investors may use net asset value (NAV) to estimate the fair value of investments in investment companies that do not have a readily determinable fair value if:

• The investment does not have a readily determinable fair value
• The investment is in an or is an investment in a real estate fund for which it is industry practice to measure investment assets at fair value on a recurring basis and to issue financial statements that are consistent with the measurement principles in ASC 946
• The NAV is calculated consistent with the measurement principles of ASC 946 as of the measurement date

The Fair Value Hierarchy

To increase consistency and comparability in fair value measurements and related disclosures, ASC 820 establishes a fair value hierarchy that categorizes the inputs used in valuation techniques to measure fair value into three broad levels.

Fair value measurements must be categorized in their entirety based on the lowest level input that is significant to the entire measurement.

• Level 1: Quoted prices (unadjusted) in active markets for identical assets and liabilities that the reporting entity can access at the measurement date
• Level 2: Inputs other than quoted prices in active markets for identical assets and liabilities that are observable either directly or indirectly
• Level 3: Unobservable inputs

Unlike a financial liability, which requires only a cash transfer for settlement, satisfying a performance obligation may require the use of other operating assets.

A performance obligation may be contractual or noncontractual, which affects the risk that the obligation is satisfied. These differences affect the variability and magnitude of risks and uncertainties that can influence the settlement or satisfaction of the obligation and its fair value. Therefore, it is important to be aware of these differences when measuring the fair value of performance obligations. This is particularly critical when considering future cash flow estimates and applicable discount rates when using the income method to measure fair value.

Question FV 4-5
How does fair value measurement based on a transfer price differ from a valuation based on settlement of a liability with the counterparty?

PwC response

The value of a liability measured at fair value is the price that would be paid to transfer the liability to a third party. The amount that would be required to pay a third party (of equivalent credit or nonperformance risk) to assume a liability may differ from the amount that a reporting entity would be required to pay its counterparty to extinguish the liability.

For example, a financial institution transferee may be willing to assume non-demand-deposit liabilities for less than the principal amount due to the depositors because of the relatively low funding cost of such liabilities. However, in other instances, an additional risk premium above the expected payout may be required because of uncertainty about the ultimate amount of the liability (e.g., asbestos liabilities or performance guaranties). The risk premium paid to a third party may differ from the settlement amount the direct counterparty would be willing to accept to extinguish the liability. In addition, the party assuming a liability may have to incur certain costs to manage the liability or may require a profit margin.

These factors may cause the transfer amount to differ from the settlement amount. In measuring liabilities at fair value, the reporting entity must assume that the liability is transferred to a credit equivalent entity and that it continues after the transfer (i.e., it is not settled). Accordingly, it follows that the hypothetical transaction used for valuation is based on a transfer to a credit equivalent entity that is in need of funding and willing to take on the terms of the obligation.

In application, there may be significant differences between settlement value and transfer value. Among the differences is the impact of credit risk, which is often not considered in the settlement of a liability, as demonstrated in Example FV 4-4.

EXAMPLE FV 4-4
Transfer value compared to settlement value

A debt obligation is held by a bank with a face value of $100,000 and a market value of $95,000. The interest rate is at market; however, there is a $5,000 discount due to market concerns about the risk of nonperformance.

What is the presumed settlement value and transfer value of the note?

Analysis

Absent exceptional circumstances, the counterparty (Counterparty A) would be required to pay the full face value of the note to settle the obligation, as the bank may not be willing to discount the note by the credit risk adjustment. Therefore, the settlement value would be equal to the face amount of the note.

To calculate the transfer value, Counterparty A must construct a hypothetical transaction in which another party (Counterparty B) with a similar credit profile is seeking financing on terms that are substantially the same as the note. Counterparty B could choose to enter into a new note agreement with the bank or receive the existing note from Counterparty A in a transfer transaction. In this hypothetical transaction, Counterparty B should be indifferent to obtaining financing through a new bank note or assumption of the existing note in transfer for a payment of $95,000. The bank should also be indifferent to Counterparty B’s choice, as both counterparties have similar credit profiles. Therefore, the transfer value would be $95,000, $5,000 less than the settlement amount.

Under ASC 820, reporting entities should adopt an approach to valuing liabilities that incorporates the transfer concept. There is no exemption from or practical expedient for this requirement.

Page 2

Unlike a financial liability, which requires only a cash transfer for settlement, satisfying a performance obligation may require the use of other operating assets.

A performance obligation may be contractual or noncontractual, which affects the risk that the obligation is satisfied. These differences affect the variability and magnitude of risks and uncertainties that can influence the settlement or satisfaction of the obligation and its fair value. Therefore, it is important to be aware of these differences when measuring the fair value of performance obligations. This is particularly critical when considering future cash flow estimates and applicable discount rates when using the income method to measure fair value.

Question FV 4-5
How does fair value measurement based on a transfer price differ from a valuation based on settlement of a liability with the counterparty?

PwC response

The value of a liability measured at fair value is the price that would be paid to transfer the liability to a third party. The amount that would be required to pay a third party (of equivalent credit or nonperformance risk) to assume a liability may differ from the amount that a reporting entity would be required to pay its counterparty to extinguish the liability.

For example, a financial institution transferee may be willing to assume non-demand-deposit liabilities for less than the principal amount due to the depositors because of the relatively low funding cost of such liabilities. However, in other instances, an additional risk premium above the expected payout may be required because of uncertainty about the ultimate amount of the liability (e.g., asbestos liabilities or performance guaranties). The risk premium paid to a third party may differ from the settlement amount the direct counterparty would be willing to accept to extinguish the liability. In addition, the party assuming a liability may have to incur certain costs to manage the liability or may require a profit margin.

These factors may cause the transfer amount to differ from the settlement amount. In measuring liabilities at fair value, the reporting entity must assume that the liability is transferred to a credit equivalent entity and that it continues after the transfer (i.e., it is not settled). Accordingly, it follows that the hypothetical transaction used for valuation is based on a transfer to a credit equivalent entity that is in need of funding and willing to take on the terms of the obligation.

In application, there may be significant differences between settlement value and transfer value. Among the differences is the impact of credit risk, which is often not considered in the settlement of a liability, as demonstrated in Example FV 4-4.

EXAMPLE FV 4-4
Transfer value compared to settlement value

A debt obligation is held by a bank with a face value of $100,000 and a market value of $95,000. The interest rate is at market; however, there is a $5,000 discount due to market concerns about the risk of nonperformance.

What is the presumed settlement value and transfer value of the note?

Analysis

Absent exceptional circumstances, the counterparty (Counterparty A) would be required to pay the full face value of the note to settle the obligation, as the bank may not be willing to discount the note by the credit risk adjustment. Therefore, the settlement value would be equal to the face amount of the note.

To calculate the transfer value, Counterparty A must construct a hypothetical transaction in which another party (Counterparty B) with a similar credit profile is seeking financing on terms that are substantially the same as the note. Counterparty B could choose to enter into a new note agreement with the bank or receive the existing note from Counterparty A in a transfer transaction. In this hypothetical transaction, Counterparty B should be indifferent to obtaining financing through a new bank note or assumption of the existing note in transfer for a payment of $95,000. The bank should also be indifferent to Counterparty B’s choice, as both counterparties have similar credit profiles. Therefore, the transfer value would be $95,000, $5,000 less than the settlement amount.

Under ASC 820, reporting entities should adopt an approach to valuing liabilities that incorporates the transfer concept. There is no exemption from or practical expedient for this requirement.

Page 3

Certain accounting standards require or permit an asset or a liability to be initially recognized at fair value. ASC 820-10-30-3 states that in many cases the transaction price equals fair value, such as when on the transaction date the transaction to buy an asset takes place in the market in which the asset would be sold. In determining whether a transaction price represents the fair value at initial recognition, a reporting entity should take into account factors specific to the transaction and to the asset or the liability. As discussed in ASC 820-10-30-3A, a transaction price may not represent fair value in certain situations:

• a related party transaction;
• a transaction under duress or a forced transaction;
• the unit of account for the transaction price does not represent the unit of account for the asset or liability being measured; or
• the market for the transaction is different from the market for the asset or liability being measured.

Under US GAAP, if the transaction involves one or more of the above factors, a reporting entity may determine that the transaction price does not represent the fair value of the asset or the liability at initial recognition, resulting in recognition of a Day one gain or loss.

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