F2 M6 Fair Value Measurement Flashcards
What is the fair value of an asset or liability that trades in multiple markets if there is no principal market?
The price in the most advantageous market, which is the market with the best price after considering transaction costs.
Example: Acme owns XYZ stock, which trades on the NYSE and the London Stock Exchange. Neither exchange is the principal market. The price and transaction cost on NYSE are $103 and $1, respectively. The price and transaction cost on LSE are $106 and $5, respectively. Therefore the fair value of the stock is $103 (because $103 - $1 > $106 - $5).
Define fair value.
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the principal market at the measurement date under current market conditions.
What assumptions should fair value include?
All assumptions that a market participant would make, including assumptions about risk and restrictions.
Once a company has elected the fair value measurement option for certain financial instruments, how must it apply the measurement method?
Once chosen, fair value must be applied until the instruments are disposed.
Example: Acme chooses to apply fair value to two of the 12 corporate bonds in its portfolio. Once it chooses, it continues to apply fair value to the two bonds until it sells them or they reach maturity.
If a company chooses the fair value measurement option for a financial instrument, must it apply fair value to all other financial instruments of the same type?
No. Fair value is applied on an instrument-by instrument-basis.
What determines whether a market is the principal market for an asset or liability?
The principal market is the market with the greatest volume or level of activity for the asset or liability and determines fair value (even if there is a more advantageous price in a different market).
Note that if there is no principal market, the market with the most advantageous price determines fair value.
Which should be used first to determine fair value: principal market or most advantageous market?
Principal market.
If principal market is not available, most advantageous market may be used.
Are transaction costs used in the determination of fair value?
No
However, transaction costs are used to determine the most advantageous market in the absence of a principal market.
Example: Acme owns XYZ stock, which trades on the NYSE and the London Stock Exchange. Neither exchange is the principal market. The price and transaction cost on NYSE are $103 and $1, respectively. The price and transaction cost on LSE are $106 and $5, respectively. Therefore the fair value of the stock is $103 (because $103 - $1 > $106 - $5). Note that although transaction costs are used to determine the most advantageous market, they are not included in the fair value of the stock.
In determining fair value, what makes an entity a market participant?
Market participants are buyers and sellers acting in their economic best interests who are independent (not related parties), knowledgeable about an asset or liability, and willing and able to transact for that asset or liability.
What is the market approach for determining fair value?
The market approach uses prices and other relevant information from market transactions involving identical or comparable assets/liabilities to measure fair value.
Example: To determine the fair value of its private placement securities, Acme uses a matrix of current pricing spreads on similar private placement securities.
What is the cost approach for determining fair value?
The cost approach uses current replacement cost to measure the fair value of assets.
Example: To determine the fair value of its inventory, Acme uses the current cost to replace the inventory it has in stock, including inbound transportation costs.
What is the income approach for determining fair value?
The income approach converts future amounts, including cash flows or earnings, to a single discounted amount to measure fair value.
Example: To determine the fair value of its subsidiary, Acme discounts the subsidiary’s estimated future cash flows to present value using a discount rate that incorporates assumptions about risk.
In determing fair value, what is the highest and best use concept?
The fair value of an asset is based on the price at which the asset could theoretically be put to its highest and best use, which may or may not be its current use.
Example: Acme owns a factory and the land under it. With the factory on it, the land is valued at $150,000. But based on recent sales of similar land nearby, the value of the land with housing on it would be $180,000. Therefore, the fair value of the land is $180,000.
What is a Level 1 input to a valuation method used to measure fair value?
A quoted price in an active market for the identical asset or liability.
Example: Acme determines the fair value of its XYZ stock by looking up the quoted price of XYZ stock on a stock exchange.
What is a Level 2 input to a valuation method used to measure fair value?
An input other than a quoted market price that is either observable or unobservable.
Example: To measure the fair value of its factory, Acme uses the the fair value of a similar neighboring factory. Applying fair value based on a similar asset’s value is a Level 2 valuation.
What is a Level 3 input to a valuation method used to measure fair value?
Unobservable inputs for the asset or liability, reflecting the company’s judgment about the assumptions that a market participant would use.
Example: Acme determines the fair value of shares of a privately held startup based on projected cash flows.
Under GAAP, what method is used to measure the value of land held as an investment?
Historical cost
Historical cost is used to value land regardless of its intended use (part of PP&E or an investment).
Under GAAP, what method is used to measure the value of bonds that a company intends to hold to maturity?
Amortized cost (initial investment +/− amortization of discount or premium)
If bonds are sold at par with no discount or premium, then amortized cost = par value.
