Fair value hierarchy

What Is Fair Value Hierarchy?

The fair value hierarchy is a classification system used in financial accounting to categorize the inputs used to measure the fair value of assets and liabilities. It is a core component of financial reporting standards, particularly under Generally Accepted Accounting Principles (GAAP) in the United States, designed to enhance the consistency and comparability of fair value measurements. The fair value hierarchy falls under the broader financial category of accounting standards. This hierarchy prioritizes the inputs used in valuation techniques, placing a greater emphasis on observable market data over unobservable inputs.

History and Origin

The concept of the fair value hierarchy gained prominence with the issuance of Statement of Financial Accounting Standards No. 157 (SFAS 157), now codified as ASC 820, by the Financial Accounting Standards Board (FASB) in September 2006.⁵², ⁵³, ⁵⁴ This standard was developed to create a single, comprehensive definition of fair value and to establish a framework for its measurement, addressing inconsistencies that existed in prior guidance.⁵⁰, ⁵¹ Before SFAS 157, various definitions of fair value were scattered across numerous FASB pronouncements, leading to complexities in applying GAAP.⁴⁸, ⁴⁹ The introduction of the fair value hierarchy aimed to improve the transparency of corporate accounting practices by standardizing the framework for valuation.⁴⁷

The role of fair value accounting, including the hierarchy, became a subject of intense debate during the 2008 financial crisis.⁴⁵, ⁴⁶ Critics questioned whether it exacerbated the crisis by increasing volatility and amplifying the effects of the business cycle on financial institutions' net worth.⁴³, ⁴⁴ However, the International Monetary Fund (IMF) concluded in its October 2008 Global Financial Stability Report that fair value accounting, by reflecting current market settings, generally ensures the most accurate assessment of financial condition under most circumstances, while acknowledging potential procyclicality in some applications.⁴²

Key Takeaways

• The fair value hierarchy classifies inputs for fair value measurement into three levels, prioritizing observable market data.
• Level 1 inputs offer the highest reliability, using quoted prices for identical assets or liabilities in active markets.
• Level 2 inputs rely on observable data for similar assets, while Level 3 inputs are unobservable and highly subjective.
• The hierarchy promotes transparency and comparability in financial reporting, particularly for complex financial instruments.
• Increased reliance on Level 3 inputs often indicates greater measurement uncertainty and requires more extensive disclosure.

Formula and Calculation

The fair value hierarchy does not involve a specific formula or calculation in the traditional sense. Instead, it provides a framework for selecting the inputs used within various valuation techniques. The overall concept is that the fair value of an asset or liability is determined 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. This is often referred to as an "exit price."³⁸, ³⁹, ⁴⁰, ⁴¹

The determination of fair value often involves valuation techniques such as the market approach, income approach, or cost approach. The choice of technique and the inputs used within it are guided by the fair value hierarchy. For example, if a company uses a discounted cash flow (DCF) model (an income approach) to value an illiquid asset, the inputs to that model (e.g., projected cash flows, discount rate) would be categorized within the fair value hierarchy. The goal is to maximize the use of observable inputs.³⁷

Interpreting the Fair Value Hierarchy

The fair value hierarchy categorizes inputs into three levels, reflecting the observability of the data:

• Level 1 Inputs: These are the most reliable and are defined as unadjusted quoted prices in active markets for identical assets or liabilities. Examples include publicly traded stocks, bonds, and exchange-traded derivatives.³⁴, ³⁵, ³⁶ When Level 1 inputs are available, they should be used to measure fair value without adjustment.³³
• Level 2 Inputs: These are observable inputs other than Level 1 quoted prices. They include 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, interest rates, and yield curves.³¹, ³² Adjustments to Level 2 inputs may be necessary to reflect specific facts and circumstances of the asset or liability.³⁰
• Level 3 Inputs: These are unobservable inputs for the asset or liability, meaning there is no readily available market data to corroborate them.²⁸, ²⁹ Level 3 inputs are based on a reporting entity's own assumptions about how market participants would price the asset or liability, including assumptions about risk.²⁶, ²⁷ Examples often include private equity investments, complex derivatives, or real estate when market data is scarce.²⁴, ²⁵ The use of Level 3 inputs indicates a higher degree of judgment and estimation uncertainty.²³

The classification within the fair value hierarchy provides insights into the reliability and transparency of the fair value measurement. A measurement based on Level 1 inputs is considered highly reliable, while one heavily reliant on Level 3 inputs involves significant management judgment and carries a higher degree of estimation uncertainty.²¹, ²²

Hypothetical Example

Consider a hypothetical private equity firm, "Horizon Capital," that holds a significant investment in a privately held technology startup, "InnovateTech." Horizon Capital needs to report the fair value of its investment in InnovateTech on its balance sheet.

Since InnovateTech is a private company, there are no active market quotes for its shares. Therefore, Horizon Capital cannot use Level 1 inputs.

Horizon Capital next considers Level 2 inputs. They look for recent transactions of similar private technology startups that have raised funding or been acquired. While they find some comparable companies, the specific business model, stage of development, and geographic market of InnovateTech differ significantly, requiring substantial adjustments to the observable data. These adjustments would likely move the valuation into Level 3.

Ultimately, Horizon Capital determines that the most appropriate approach is to use a discounted cash flow (DCF) model, incorporating internal financial projections for InnovateTech and market-derived discount rates from comparable public companies. However, key inputs like the long-term growth rate and the specific risk premium applied to InnovateTech are unobservable and require significant judgment based on Horizon Capital's expertise. As a result, the fair value measurement of InnovateTech falls under Level 3 of the fair value hierarchy. Horizon Capital would then need to disclose the significant unobservable inputs and the sensitivity of the fair value to changes in these inputs.

Practical Applications

The fair value hierarchy is applied broadly in financial reporting, particularly for entities that hold or issue financial instruments. It is integral to how companies present their assets and liabilities on their financial statements.

• Investment Management: Hedge funds, private equity firms, and mutual funds frequently deal with investments that lack readily observable market prices. The fair value hierarchy dictates how these complex investments, such as illiquid securities or derivative instruments, are valued and reported, providing transparency to investors.¹⁹, ²⁰
• Banking and Financial Services: Banks utilize the fair value hierarchy for valuing their loan portfolios, certain debt securities, and derivatives. The classification helps regulators and analysts understand the inherent risks and subjectivity in a bank's reported asset values.¹⁸
• Mergers and Acquisitions (M&A): In business combinations, acquired assets and assumed liabilities are typically recognized at their fair value. The fair value hierarchy provides the framework for determining these values, particularly for intangible assets that may not have active markets.¹⁷
• Regulatory Oversight: Regulators like the Securities and Exchange Commission (SEC) review and monitor companies' application of the fair value hierarchy to ensure compliance with reporting standards and to assess the quality of fair value disclosures.¹⁴, ¹⁵, ¹⁶ The SEC frequently requests additional information and disclosures regarding fair value measurements.¹², ¹³

Limitations and Criticisms

Despite its aim to enhance transparency, the fair value hierarchy faces several limitations and criticisms, particularly concerning Level 3 measurements.

One significant criticism is the subjectivity inherent in Level 3 inputs. Since these inputs are unobservable and rely on management's own assumptions, they can be less verifiable and potentially subject to manipulation or bias.¹¹ This lack of external validation has led some critics to label Level 3 mark-to-market valuations as "mark-to-make-believe."¹⁰ This issue becomes particularly pronounced during periods of market stress or illiquidity, where observable market data diminishes, forcing more assets into Level 3.⁸, ⁹

Another concern relates to the impact of fair value accounting, especially Level 3 measurements, on financial stability during crises. Critics have argued that mandating fair value measurements for illiquid assets can exacerbate downturns by forcing companies to record significant write-downs based on distressed or non-existent market prices, potentially leading to a "doom loop" of declining asset values and reduced capital.⁶, ⁷ However, some research suggests that fair value accounting, even for Level 3 assets, did not significantly contribute to the severity of the 2008 financial crisis.⁵

The complexity of valuing certain financial instruments can also be a limitation. While the fair value hierarchy provides a framework, the actual process of determining fair value for complex, illiquid assets can be challenging and require significant judgment and specialized expertise.³, ⁴ This can lead to variations in how different entities value similar assets, even when applying the same accounting standards.

Fair Value Hierarchy vs. Historical Cost Accounting

The fair value hierarchy is a key component of fair value accounting, which fundamentally differs from historical cost accounting. While fair value accounting aims to reflect the current market-based "exit price" at which an asset or liability could be sold or settled, historical cost accounting records assets and liabilities at their original purchase price.²

Fair value accounting, with its hierarchy, provides a more real-time reflection of an entity's financial position, as it constantly adjusts asset and liability values to reflect prevailing market conditions. This can result in greater volatility in reported earnings and equity compared to historical cost accounting, which tends to be more stable.¹ The fair value hierarchy, by categorizing inputs, attempts to provide transparency around the degree of observability and subjectivity in these real-time valuations.

In contrast, historical cost accounting is generally seen as more objective and verifiable since it relies on actual transaction prices. However, it may not reflect the true economic value of assets and liabilities, particularly in rapidly changing markets. The choice between, or combination of, these two accounting methods often involves balancing relevance with reliability in financial reporting.