of the asset and future outflows of the liability. A fair value measurement incorporates the attributes of the particular asset or liability (e.g., location, condition). In formulating fair value, consideration is given to the exchange price, which refers to the market price at the measurement date in an orderly transaction between the parties to sell the asset or transfer the liability. The focus is on the price that would be received to sell the asset or paid to transfer the liability (exit price), not the price that would be paid to buy the asset or received to assume the liability (entry price).
The asset or liability may be by itself (e.g., financial security, operating asset) or a group of assets or liabilities (e.g., asset group, reporting unit).
The Fair Value Hierarchy
A hierarchy list of fair value distinguishes between (1) assumptions based on market data from independent outside sources (observable inputs) and (2) assumptions by the company itself (unobservable inputs). The use of unobservable inputs allows for situations in which there is minimal or no market activity for the asset or liability at the measurement date. Valuation methods used to measure fair value shall maximize the use of observable inputs and minimize the use of unobservable ones.
Risk and Restrictions
An adjustment for risk should be made in a fair value measurement when market participants would include risk in the pricing of the asset or liability. Nonperformance risk of the obligation and the entity’s credit risk should be noted. Further, consideration should be given to the effect of a restriction on the sale or use of an asset that impacts its price.
The Difference between the Principal Market and the Most Advantageous Market
In a fair value measurement, we assume that the transaction occurs in the principal (main) market for the asset or liability. This is the market in which the company would sell the asset or transfer the liability with the greatest volume. If a principal market is nonexistent, then the most advantageous market should be used. This is the market in which the business 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 after taking into account any transaction costs. The fair value measurement should incorporate transportation costs for the asset or liability.
Valuation Approaches
In fair value measurement, valuation techniques based on the market, income, and cost approaches may be used. The market approach uses prices for market transactions for identical or comparable assets or liabilities. The income approach uses valuation techniques to discount future cash flows to a present value amount. The cost approach is based on the current replacement cost such as the cost to buy or build a substitute comparable asset after adjusting for obsolescence. Input availability and reliability related to the asset or liability may impact the choice of the most suitable valuation method.
A single or multiple valuation technique may be needed, depending on the situation. For example, a single valuation method would be used for an asset having quoted market prices in an active market for identical assets. A multiple valuation method would be used to value a reporting unit.
The Three Levels of Fair Value Hierarchy
The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. Level 1, the highest priority, assigns quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 3, the lowest priority, is assigned for unobservable inputs for the assets or liabilities.
Level 2 inputs are those except quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include:
In the case of Level 3, unobservable inputs are used to measure fair value to the degree that observable inputs are not available. Unobservable inputs reflect the reporting company’s own assumptions about what market participants consider (e.g., risk) in pricing the asset or liability.
Financial Applications
In addition to accounting and business applications, compound interest, annuity, and present value concepts apply to personal finance and investment decisions. In purchasing a home or car, planning for retirement, and evaluating alternative investments, you will need to understand time value of money concepts. Other financial applications include determination of sinking funds--the contributions necessary to accumulate a fund for debt retirements and installment contracts--periodic payments on long-term purchase contracts or leases, periodic payments of an amortized loan, and valuations of businesses, stocks, bonds, real estate, and other financial securities.
Time Value Fundamentals
The following four variables are fundamental to all time value problems (Exhibit 1).
Exhibit 1: Fundamental Variables*
1. Rate of interest. This rate, unless otherwise stated, is an annual rate that must be adjusted to reflect the length of the compounding period if less than a year.
2. Number of time periods. This is the number of compounding periods. (A period may be equal to or less than a year.)
3. Future value. The value at a future date of a given sum or sums invested assuming compound interest.
4. Present value. The present worth of a future sum or sums discounted assuming compound interest.
* Given any two variables of 1,2,3, or 1,2,4, one can determine the third variable. Many situations will be illustrated later in the book.
Exhibit 2 depicts the relationship of these four fundamental variables in a time diagram.
Exhibit 2: The relationship of four fundamental variables
Exhibit 3 shows all the tables we will be using throughout this book.
Exhibit 3: Summary of time value tables*
* Future and present value table values are truncated to three decimal digits for simplicity. In practice, you are
