1.5 Fair Value Measurements & Disclosures

Question 1

Which of the following statements is correct regarding fair value measurement?

a. Fair value is a market-based measurement.

b. Fair value is an entity-specific measurement.

c. Fair value measurement does not consider risk.

d. Fair value measurement does not consider restrictions.

Answer 1

The correct answer is (a).

Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly arm’s length transaction between market participants at the measurement date (at exit price)”. Following are the steps to determine the fair value of an asset / liability:

Determine the principal market with the greatest volume and maximum level of activity where the asset / liability can be sold.
Determine valuation premises (“in-use” or “in-exchange”).
Determine appropriate valuation technique (market, income or cost approach).
Obtain inputs for fair valuation.
Calculate the fair value.

Thus, fair value measurement is a market-based measurement as the fair value is measured based on the principle market.

Option (b) is incorrect because fair value is a market-based measurement and not an entity-specific measurement.

Option (c) is incorrect because fair value measurement considers the non-performance risk for a liability. Non-performance risk includes credit risk i.e. the risk of the liability obligation not being met.

Option (d) is incorrect because fair value measurement considers the restrictions that exist on the sale or use of an asset. While determining the fair value of any asset its various characteristics are considered like its location, condition and restrictions if any, that exist on the sale or use an asset.

Question 2

Which of the following items would best enable Driver Co. to determine whether the fair value of its investment in Favre Corp. is properly stated in the balance sheet?

a. Discounted cash flow of Favre’s operations.

b. Quoted market prices available from a business broker for a similar asset.

c. Quoted market prices on a stock exchange for an identical asset.

d. Historical performance and return on Driver’s investment in Favre.

Answer 2

The correct answer is (c).
The Level 1 input for fair valuation is the quoted prices from active markets for identical assets/liabilities.
Quoted market prices on a stock exchange for an identical asset is the Level 1 input and should be used to determine the fair value of the asset.

Options (a), (b) and (d) are incorrect because they are not Level 1 inputs.

Question 3

Which of the following phrases best describes a Level 1 input for measuring the fair value of an asset or liability?

a. Inputs for the asset or liability based on the reporting entity’s internal data.

b. Quoted prices for similar assets or liabilities in active markets.

c. Inputs that are principally derived from or corroborated by observable market data.

d. Unadjusted quoted prices for identical assets or liabilities in active markets.

Answer 3

The correct answer is (d).
A hierarchy of inputs must be used to prioritize the inputs to valuation techniques. Level1 inputs are quoted prices from active markets for identical assets/liabilities.

Options (a), (b) and (c) are incorrect because they are Level 2 inputs.

Question 4

Giaconda, Inc. acquires an asset for which it will measure the fair value by discounting future cash flows of the asset. Which of the following terms best describes this fair value measurement approach?

a. Market.

b. Income.

c. Cost.

d. Observable inputs.

Answer 4

The correct answer is (b).
Using present value techniques to discount the cash flows or earnings is called the income approach.

Option (a) is incorrect because market approach uses prices and relevant information from market transactions for identical or comparable assets/liabilities.

Option (c) is incorrect because cost approach uses current replacement cost.

Option (d) is incorrect because observable inputs are the inputs for FV valuation and not a valuation technique.

Question 5

Each of the following would be considered a Level 2 observable input that could be used to determine an asset or liability’s fair value, except:

a. Quoted prices for identical assets and liabilities in markets that are not active.

b. Quoted prices for similar assets and liabilities in markets that are active.

c. Internally generated cash flow projections for a related asset or liability.

d. Interest rates that are observable at commonly quoted intervals.

Answer 5

The correct answer is (c).
Level 2 inputs are directly or indirectly observable inputs; it includes:

Quoted prices from active markets for similar assets/liabilities
Quoted prices from limited activity markets for similar/identical assets
Other observable inputs like yield curves, bank prime rates, interest rates, credit risks, default rates on loans.

Options (a), (b) and (d) are incorrect because all of the above fall in the level 2 input category.

Question 6

Which of the following is a level three input to valuation techniques used to measure the fair value of an asset?

a. Quoted prices in active markets for identical assets.

b. Quoted prices for similar assets in active markets.

c. Unobservable inputs for the asset.

d. Inputs other than quoted prices that are observable for the asset.

Answer 6

The correct answer is (c).

In the hierarchy of inputs for measuring fair value of an asset / liability unobservable inputs are prioritized at level three. Unobservable inputs (which may reflect the reporting entity’s own assumption about the market, based on the best information available) like financial forecasts or expected cash flow estimates are used when level one and level two inputs are not available.

Option (a) is incorrect because quoted prices in active markets for identical assets is prioritized at level one in the hierarchy of inputs for measuring fair value of an asset / liability.

Option (b) is incorrect because quoted prices for similar assets in active markets, is a directly or indirectly observable input for measuring fair value of an asset / liability and is prioritized at level two in the hierarchy of inputs.

Option (d) is incorrect because inputs other than quoted prices that are observable for the asset like yield curves, bank prime rates, interest rates, credit risks and default rates on loans are directly or indirectly observable inputs for measuring fair value of an asset / liability and is prioritized at level two in the hierarchy of inputs.