Fair Value Hierarchy

Question 1

What qualifies as a Level 1 input? Level 2? Level 3?

Answer 1

Level 1 = observable inputs such as quoted market prices; information for IDENTICAL assets or liabilities; must relate to transactions that were not forced such as selling under duress or announcements made after the market closes for the day such as negative publicity. Must be a an ordinary transaction between willing participants

Level 2 = observable inputs, but for SIMILAR assets or liabilities; can involve with information that is outside of the market such as announcements made after close of business such as a company that lost its only production facility. Still verifiable, but takes more work because have to go beyond just market information such as looking at indexes

Level 3 = unobservable; anything goes; based on whatever management assumes to be its best estimate of the value - need to disclose methodology in footnotes to the financials

Question 2

When does a Level 1 input gets downgraded to Level 2? Do we re-value the asset or liability when there is information in addition to the market following the date of the financial statements?

Answer 2

Yes, we re-value the asset or liability on the financial statements even if we received the information after the date of the financial statements. GAAP requires the best available information to be used and ensure that the level of inputs are properly presented. We have to evaluate whether the input is still Level 1 or 2 and whether to downgrade or not.

For example, we prepared financial statements for ABC Company. On the day of the financial statements, ABC’s investment in XYZ is quoted on the market as $65 per share. At 4:30 PM, after the market closed for the date, it was announced that XYZ lost its only production facility to a flood. The market quoted XYZ’s shares at $25 the next day following the announcement. We have to:

Revalue the XYZ investment to $25 because it is the best and available information and put that on the financial statements.

We also have to DOWNGRADE the level of input from Level 1 to Level 2 because the announcement caused the value to drop, not due to normal observable market transactions. The announcement is information in addition to the market and it takes more effort to verify the announcement. Hence, principle of conservatism kicks in.

FASB ASC 820

Question 3

In-exchange premise

Answer 3

Assumes that the maximum value of an item is from the purchaser’s perspective when the item is used ALONE

Remember: “in-exchAnge” = “A” = Alone”

Question 4

In-use premise

Answer 4

Assumes that the maximum value of an item is from the purchaser’s perspective when the item is used IN CONJUNCTION WITH OTHER ASSETS AS A GROUP.

Remember: “in-Use” = U = groUp