Fair Value Framework

Question 1

What are the objectives of ASC 820?

Answer 1

ASC 820 provides a fair value framework by defining the term, providing a method for determining fair value measurement, and identifying required disclosures when fair value is used.

Question 2

What is the definition of fair value?

Answer 2

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.

Question 3

Are there differences between U.S. GAAP and IFRS regarding the definition of fair value?

Answer 3

No, as a result of the joint efforts of the IASB and the FASB, there are no significant differences between U.S. GAAP and IFRS related to the meaning of fair value, its measurement or required disclosures.

Question 4

What is the definition of principal market?

Answer 4

The principal market is the one with the greatest volume and level of activity for the asset or liability within which the reporting entity could sell the asset or transfer the liability.

Question 5

What is the definition of most advantageous market?

Answer 5

The most advantageous market is the one in which the reporting entity could sell the asset at a price that maximizes the amount that would be received for the asset or that minimizes the amount that would be paid to transfer the liability.

Question 6

What are transaction costs?

Answer 6

Transaction costs are incremental direct costs to sell the asset or transfer the liability.

Question 7

How are transaction costs factored into a fair market value?

Answer 7

Transaction costs are taken into account in determining the most advantageous market, but they are not used in determining the fair value of an asset or liability. In other words, they are not deducted from the asset market price or added to the liability transfer cost.

Question 8

How are transportation costs factored into a fair market value?

Answer 8

Transportation costs incurred to transport the asset or liability to its principal or most advantageous market would be used to adjust fair value for measurement purposes.

Question 9

What is an entry price?

Answer 9

When an asset is acquired or a liability is assumed in an actual transaction, the price paid to acquire the asset or the price received to assume the liability (the transaction price) is an entry price. In other words, the price paid when an asset or liability is initially recognized, which may or may not be fair value.

Question 10

What is an exit price?

Answer 10

Fair value of an asset or a liability is the price that would be received to sell an asset or paid to transfer a liability.

Question 11

When will the exit price (fair value) not be equal to the entry price (transaction price)?

Answer 11

In many cases, the entry price and the exit price will be the same at the date of initial recognition of an asset or liability. In some cases, however, the entry price may not be the exit price. For example, when the transaction is between related parties, the transaction takes place when the seller is under duress, the unit of account for the transaction price is different from the unit of account that would be used to measure the asset or liability at fair value (the quoted price includes transaction costs), or the market in which the transaction price takes place is different from the principal market.

Question 12

What happens when the transaction price is different than the fair value price at initial recognition?

Answer 12

A gain or loss is recognized in earnings at initial recognition of the asset or liability. The asset or liability would be recorded at fair value. The difference between the transaction price and the recorded fair value price would be recognized as a loss or gain in the period of initial recognition.

Question 13

What are the three valuation techniques?

Answer 13

Market Approach - This approach uses prices and other relevant information generated by market transactions involving assets or liabilities that are identical or comparable to those being valued.

Income Approach - This approach converts future amounts to a single present amount. Discounting future cash flows would be an income approach to determining fair value.

Cost Approach - This approach uses the amount that currently would be required to replace the service capacity of an asset (i.e., current replacement cost), adjusting for obsolescence.

Question 14

How are changes in fair value valuation techniques accounted for?

Answer 14

Changes in fair value resulting from changes in valuation techniques or applications are treated as changes in accounting estimates.

Question 15

What are the five election events (when an entity can apply the fair value option to an eligible item)?

Answer 15

1 - When the item is first recognized
2 - When an eligible firm commitment is established
3 - Specialized accounting for an item ceases to exist (ex. - An item no longer qualifies for fair value treatment)
4 - An investment becomes subject to equity method accounting (but is not consolidated) or to a VIE that is no longer consolidated
5 - An event that requires the item to be measured at fair value, such as a business combination or significant modifications to debt instruments

Question 16

What financial assets and financial liabilities may not be measured with fair value?

Answer 16

1 - An investment in a subsidiary that is to be consolidated (the asset “Investment in subsidiary” is eliminated in the consolidation process and is replaced by the subsidiary’s assets and liabilities on the consolidated balance sheet).
2 - An interest in a variable interest entity that is to be consolidated
3 - Employers’ and plans’ obligations (or assets) for pension benefits, other post retirement benefits, post-employment benefits, and other employee- oriented plans
4 - Financial assets and liabilities recognized under lease accounting
5 - Demand deposit liabilities of financial institutions
6 - Financial instruments that are classified by the issuer as a component of shareholders’ equity

Question 17

How is the fair value option measured with held-to-maturity securities?

Answer 17

If the fair value option is elected for held-to-maturity securities, those securities will be treated and reported as trading securities. Gains and losses resulting from change in fair value will not be reported in other comprehensive income. Gains and losses resulting rom changes in fair value will be reported in current income.

Question 18

What are inputs?

Answer 18

Inputs refer to the various assumptions that market participants would use in determining fair value, including assumptions about the risk inherent in using a particular valuation technique, as well as the risk inherent in using various inputs (data, assumptions, etc.) with each valuation technique.

Question 19

What are the differences between observable and unobservable inputs?

Answer 19

Observable - Inputs used in pricing an asset, liability, or equity item that are developed based on market data obtained from sources independent of the reporting entity.

Unobservable - Inputs that reflect the reporting entity’s own assumptions used in pricing the asset, liability, or equity item that are developed based on the best information available in the circumstances.

Question 20

What are Level 1 valuation techniques?

Answer 20

Level 1 inputs are unadjusted quoted prices in active markets for assets or liabilities (or equity items) identical to those being valued that the entity can obtain at the measurement date.

Question 21

What are Level 2 valuation techniques?

Answer 21

Level 2 inputs are observable for assets or liabilities (or equity items) either directly or indirectly, other than quoted prices described in Level 1 above. This level includes quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active- markets in which there are few relevant transactions, prices are not current or vary substantially, or for which little information is publicly available. Inputs, other than quoted prices, that are observable for the assets or liabilities being valued, including, for example, interest rates, yield curves, implied volatilities and credit spreads, and market-corroborated inputs.

Question 22

What are Level 3 valuation techniques?

Answer 22

Level 3 inputs are unobservable for the assets or liabilities (or equity items) being valued and should be used to determine fair value only to the extent observable inputs are not available.

Question 23

What are the disclosure requirements for assets and liabilities that are measured at fair value on a recurring basis, meaning adjusted to or measured at period after period (ex. : Investments in trading securities).

Answer 23

The reporting entity must disclose the following information in the statement of financial position (balance sheet) for each interim and annual period for each major category of asset and liability (investments held-for-training, investments available-for-sale, derivatives, etc.):
1 - The fair value measurements a the reporting date
2 - Segregated into each of the three levels within the fair value hierarchy
3 - Transfers into each level and transfers out of each level disclosed and discussed separately
4 - For Levels 2 and 3, a description of the valuation and inputs used to measure fair value and a discussion of changes in valuation techniques during the period, if any
5 - Significant additional disclosure requirements for Level 3

Question 24

What are the disclosure requirements for assets and liabilities that are measured at fair value on a nonrecurring basis, meaning adjusted to fair value only when certain conditions are met? (ex. Asset impairment)

Answer 24

The fair value at the reporting date and the reasons for the measurement, segregated into each of the three levels of the fair value hierarchy, for Levels 2 and 3 a description of the valuation techniques and inputs used to measure fair value and a discussion of changes in valuation techniques during the period, if any.

Question 25

How is an investment in another company reported in net income when using the fair value option?

Answer 25

Company A should recognize its share of cash dividends received during the period and the increase/decrease in the fair value of its investment. For example, Company A purchases an investment in Company B for $400,000, which represents 30% of Company B’s outstanding stock. At year end the investment in Company B is worth $410,000. For year 1, Company B reports $60,000 in net income and pays dividends of $20,000. Company A should report the following in net income related to its investment in Company B:
.30 x $20,000 = $6,000 plus increase in FMV of $10,000 for a total of $16,000

Question 26

The guidance of ASC 820 does not apply to:

Answer 26

1 - Accounting principles that address share-based payment transactions (ex. - Determination of the fair value of legal services received in exchange for an entity’s common stock).
2 - ASCs that require or permit measurements that are similar to fair value but that are not intended to measure fair value (ex. - Inventory reported at lower of cost or market).
3 - Accounting principles that address fair value measurements for purposes of lease classification or measurement.

Question 27

What is the fair value of a non-financial asset based on?

Answer 27

The determination of a non-financial asset should be based on the highest and best use of the asset by market participants, not based on the intended use by the reporting entity.

Question 28

What items may an entity elect to report at fair value?

Answer 28

1 - Recognized financial assets or liabilities (some exceptions)
2 - Firm commitments
3 - Written loan commitments
4 - Rights and obligations under insurance contracts and warranties
5 - Other financial instruments embedded in non-financial derivatives

Question 29

How is a change in fair value valuation techniques accounted for?

Answer 29

As a change in accounting estimate.

Question 30

True/False

A subsidiary that is to be consolidated with its parent may elect the fair value option for eligible assets and liabilities on its books.

Answer 30

True

Question 31

What is the intended purpose of financial statement disclosures required of a firm that elects to use fair value measurement?

Answer 31

To facilitate comparisons both across firms and for differently measured financial assets and liabilities of a single firm.