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In September 2006, the Financial Accounting Standards Board (FASB) of the United States issued Statement of Financial Accounting Standards 157: Fair Value Measurements), which “defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements.”
Paragraph 5 of SFAS No. 157 (also known as ASC 820 in the updated FASB Codification) defines fair value as “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.” Of note, this Statement requires consideration of the exit price paid (if liability) or received (if asset) in a hypothetical transaction in an orderly market (i.e., not a forced liquidation or sold under duress).
This Statement also introduces two more concepts to the definition of fair value – the Principal (or Most Advantageous) Market and Highest and Best Use.
Principal (or Most advantageous) Market – Fair Value Measurement assumes the hypothetical transaction occurs in a principal market, the “the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability.” In the absence of a principal market, the asset or liability is assumed to be transferred in the most advantageous market, “the market in which the reporting entity would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability, considering transaction costs in the respective market(s).”
Highest and Best Use – Fair Value Measurement assumes the asset is being utilized in a manner that will maximize its value. For example, where a company owns a factory, but the property would have a higher value as a residential lot, the asset should be fair valued as a residential lot.
Intended to increase consistency and comparability in and expand disclosures about fair value measurements, the Statement establishes a fair value hierarchy that prioritizes inputs to valuation techniques used to measure fair value into three broad levels:
Level 1 – quoted prices in active markets for identical assets and liabilities;
Level 2 – inputs other than quoted market prices that are directly or indirectly observable for the asset or liability, including quoted prices in an active market for similar assets or liabilities; quoted prices in a market that is not active for same or similar assets or liabilities; inputs other than quoted market prices that are observable for the asset or liability; and inputs derived from observable market data by correlation or other means; and
Level 3 – unobservable inputs reflecting the company’s assumptions about the inputs that a market participant would use to price the asset or liability.