ASC 820, Fair Value Measurement, does not tell an entity when to measure something at fair value. Other topics do that: investments, business combinations, impairment, derivatives and more. ASC 820 tells the entity how to measure fair value once another topic requires or permits it, and what to disclose about those measurements.
For private companies, fair value measurements are less frequent than at a fund or bank, but those that arise can be Level 3 and material. This guide covers the definition, the hierarchy, valuation techniques, private company considerations and how auditors approach Level 3 measurements under AU-C 540. It paraphrases the Codification and is not a substitute for it.
The definition of fair value
Fair value is 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. Four ideas sit inside that definition.
- Exit price. Fair value is what the entity would receive to sell, not what it paid or would pay to buy.
- Orderly transaction. It assumes normal exposure to the market before the measurement date, not a forced liquidation or distressed sale.
- Market participants. It reflects the assumptions that buyers and sellers in the market would use, not the entity's own intentions. An entity's plan to hold an asset does not change its fair value.
- Principal or most advantageous market. The measurement uses the principal market for the asset or liability, meaning the market with the greatest volume and level of activity. If there is no principal market, it uses the most advantageous market.
For nonfinancial assets, fair value assumes the highest and best use by market participants, which may differ from the entity's current use. For liabilities, the measurement assumes the liability is transferred to a market participant and reflects nonperformance risk, including the entity's own credit risk.
The fair value hierarchy
ASC 820 ranks the inputs to valuation techniques into three levels. The hierarchy ranks inputs, not techniques.
Level 1
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. A publicly traded stock held in a brokerage account is the textbook example. When a Level 1 input is available, it generally must be used without adjustment.
Level 2
Level 2 inputs are inputs other than Level 1 quoted prices that are observable for the asset or liability, either directly or indirectly. Examples:
- quoted prices for similar assets in active markets
- quoted prices for identical or similar assets in markets that are not active
- observable inputs such as interest rate curves, credit spreads and foreign exchange rates
- inputs derived from or corroborated by observable market data
An interest rate swap valued from an observable yield curve, or a corporate bond priced from recent trades in similar bonds, is usually Level 2.
Level 3
Level 3 inputs are unobservable. They reflect the entity's own assumptions about what market participants would use, developed from the best information available. Projected cash flows of a private business, discount rates built up from judgmental premiums, and contingent consideration probabilities are Level 3 inputs.
Categorizing a measurement
A fair value measurement is categorized in its entirety at the level of the lowest-level input that is significant to the entire measurement. A valuation that relies mostly on observable data but uses one significant unobservable input is Level 3. Deciding what is significant is a judgment and should be documented.
Investments measured at NAV
As a practical expedient, an entity may measure certain investments in investment companies, such as private equity or hedge funds, at net asset value per share. Investments measured this way are not categorized in the hierarchy, but they are disclosed so the amounts reconcile to the balance sheet.
Valuation techniques
ASC 820 describes three approaches. An entity uses techniques that are appropriate in the circumstances, maximize the use of relevant observable inputs and minimize the use of unobservable inputs.
- Market approach: uses prices and other information from market transactions involving identical or comparable assets, liabilities or businesses. Guideline public company multiples and comparable transaction multiples are market approach techniques.
- Income approach: converts future amounts, such as cash flows or earnings, into a single discounted present amount. Discounted cash flow models, option-pricing models and multi-period excess earnings methods fall here.
- Cost approach: reflects the amount currently required to replace the service capacity of an asset, often called current replacement cost, adjusted for obsolescence. It is common for specialized equipment.
Using more than one technique and weighting the results is common, and the weighting should be explained. Once a technique is selected, it is applied consistently unless a change produces a measurement that is equally or more representative.
Where fair value shows up in private companies
- Investments in equity securities with readily determinable fair values (ASC 321), and debt securities classified as trading or available for sale (ASC 320). Equity securities without readily determinable fair values may use the measurement alternative in ASC 321.
- Business combinations (ASC 805): assets acquired, liabilities assumed and contingent consideration are measured at fair value at the acquisition date. Contingent consideration classified as a liability is remeasured each period.
- Impairment testing of long-lived assets, goodwill and indefinite-lived intangibles, where the impairment loss is measured by reference to fair value. See ASC 360 and ASC 350 impairment.
- Derivatives under ASC 815, such as interest rate swaps on variable-rate bank debt.
- Assets held for sale, measured at the lower of carrying amount or fair value less cost to sell.
- Not-for-profit entities: contributed nonfinancial assets, beneficial interests in trusts and endowment investments.
Some measurements look like fair value but are scoped out of ASC 820. Share-based payments under ASC 718 use a fair-value-based measure under that topic, and lease classification and measurement under ASC 842 are also excluded. See ASC 718 stock compensation.
Private company considerations
Disclosure relief
Disclosures differ by entity type and by whether the measurement is recurring or nonrecurring. ASU 2018-13 modified the requirements for nonpublic entities: among other changes, instead of a full reconciliation (rollforward) of Level 3 balances, a nonpublic entity discloses transfers into and out of Level 3 and purchases and issues of Level 3 assets and liabilities. ASC 820-10-50 sets out the disclosures that apply.
Thin internal expertise
Private companies may not have an internal valuation function. They engage a valuation firm, rely on statements from brokers or fund administrators, or have the controller build a spreadsheet. Each source creates different audit questions. Management is still responsible for the measurement, even when an outside party prepares it.
Data quality
Level 3 models for private companies may rest on budgets that were prepared for other purposes. The forecast used for a contingent consideration liability should be consistent with the forecast used for goodwill impairment, going concern and the deferred tax valuation allowance.
Auditing fair value: AU-C 540
Fair value measurements are accounting estimates, and AU-C 540, as revised by SAS No. 143, governs how they are audited. The auditor assesses inherent risk separately from control risk for estimates and considers the inherent risk factors: estimation uncertainty, complexity and subjectivity, along with other factors such as change and susceptibility to management bias. A Level 3 measurement usually sits high on that spectrum, and some are significant risks.
The three testing approaches
AU-C 540 requires the auditor's further procedures to include one or more of these approaches:
- Obtain evidence from events occurring up to the date of the auditor's report. A sale of the investment after year end at a known price is strong evidence of its year-end fair value, adjusted for changes in conditions.
- Test how management made the estimate. Evaluate the method, the significant assumptions and the data. Check that the method is appropriate under ASC 820, that assumptions are consistent with market participant views and with each other, and that data is relevant, reliable and accurate.
- Develop an auditor's point estimate or range. Build an independent expectation, alone or with an auditor's specialist, and compare it with management's estimate. A range should include only amounts supported by audit evidence.
Level 3 procedures in practice
- Understand the valuation process. Who prepares it, what review happens, and what changed from last year.
- Read the valuation report. Evaluate the competence, capabilities and objectivity of a management's specialist under AU-C 501, and of any auditor's specialist under AU-C 620.
- Test key inputs. Agree historical financial data to the audited trial balance. Compare forecasts with actual results achieved in prior years. Benchmark discount rates and multiples to market data.
- Perform sensitivity analysis. Identify which assumptions move the result most, and focus testing there.
- Look for bias. Consider whether judgments, individually reasonable, all lean in the same direction. AU-C 540 requires the auditor to evaluate indicators of possible management bias.
- Review hierarchy categorization and disclosures. A Level 3 measurement labeled Level 2 is a disclosure misstatement even if the number is right.
- Retrospective review. Compare prior-year estimates with how they actually resolved, as part of risk assessment under AU-C 540.
Pricing services and broker quotes
For Level 1 and Level 2 investments, auditors often rely on third-party pricing sources. Understand how the source derives prices, whether the price reflects actual trades or a model, and whether a broker quote is binding or indicative. An indicative quote for an illiquid security may itself make the measurement Level 3.
Document your risk assessment for these accounts under AU-C 315, and record judgments clearly enough for a reviewer to follow them, as AU-C 230 requires.
Frequently asked questions
What is the difference between Level 2 and Level 3 fair value?
Level 2 measurements rely on inputs that are observable in the market, directly or indirectly. A measurement is Level 3 when an unobservable input, such as a projected cash flow or a judgmental discount rate, is significant to the entire measurement.
Does ASC 820 require assets to be carried at fair value?
No. ASC 820 defines fair value and sets the framework and disclosures. Other topics, such as ASC 320, ASC 321, ASC 805 and ASC 815, determine when an item is measured at fair value.
Which valuation approach is best?
None is preferred in the abstract. ASC 820 requires techniques that are appropriate in the circumstances and that maximize relevant observable inputs, and the market, income and cost approaches may be used alone or in combination.
How does an auditor test a Level 3 fair value?
Under AU-C 540 the auditor uses one or more approaches: evidence from events up to the report date, testing management's method, assumptions and data, or developing an independent point estimate or range. Sensitivity analysis and a review for management bias are central.
Are investments measured at NAV included in Level 3?
No. Investments measured using the NAV practical expedient are excluded from the hierarchy table but disclosed so the total reconciles to the balance sheet.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- FASB ASC 820, Fair Value Measurement (820-10-35 hierarchy and techniques, 820-10-50 disclosures)
- FASB ASU 2018-13, Disclosure Framework: Changes to the Disclosure Requirements for Fair Value Measurement
- FASB ASU 2015-07 (investments measured using net asset value per share)
- FASB ASC 320, 321, 805, 815, 718 and 842 (scope and measurement topics referenced)
- AICPA, AU-C Section 540, Auditing Accounting Estimates and Related Disclosures (as revised by SAS No. 143)
- AICPA, AU-C Section 501 (management's specialist, as revised by SAS No. 142), AU-C 620, AU-C 315 and AU-C 230
Part of CORAA University · US GAAP for private companies: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error