To increase consistency and comparability in reporting fair value measurements, ASC 820-10-35-37 establishes the fair value hierarchy to prioritize the inputs used in valuation techniques. There are three levels to the fair value hierarchy (Level 1 is the highest priority and Level 3 is the lowest priority):
The ASC Master Glossary defines a principal market as "the market with the greatest volume and level of activity for the asset or liability." It further states that market participants are buyers and sellers in this market that are independent of each other, knowledgeable, and willing and able to enter into a transaction for the asset or liability. The determination of the reporting entity’s principal market is made from the perspective of the reporting entity; the availability of pricing inputs is not part of that assessment. For example, if the reporting entity is a retail customer and does not have access to the wholesale market, the reporting entity’s principal market is the retail market and quoted prices in the wholesale market will not qualify as fair value for that reporting entity.
If a price for the exact unit of account (i.e., a Level 1 input) is not available in the principal market, then the reporting entity will have to use a valuation technique with one or more inputs from the same or other markets to derive fair value. The availability of pricing inputs from other markets may impact the choice of valuation technique. For example, if Level 1 inputs are available in another market (i.e., a market approach), that approach may provide more objective evidence of fair value than an income approach using Level 2 inputs from the principal market. However, in either case, the resulting fair value measurement would not be considered a Level 1 input.
By distinguishing between inputs that are observable in the marketplace, and therefore more objective, and those that are unobservable and therefore more subjective, the hierarchy is designed to indicate the relative subjectivity and reliability of the fair value measurements.
Disclosure is required by level; as the objectivity of the inputs decrease, disclosure increases. Certain required disclosures are applicable only to those fair value assets and liabilities characterized as Level 3.
Figure FV 4-2 illustrates the steps to differentiate Level 2 and Level 3 in the fair value hierarchy of a fair value measurement. Level 1 fair value measurements have been excluded from the framework as they have a Level 1 price for the entire unit of account.
Figure FV 4-2Inputs broadly refer to the information that market participants use to make pricing decisions, including assumptions about risk. Inputs may include price information, revenue growth, changes in profitability, volatility factors, specific and broad credit data, liquidity statistics, and all other factors that have more than an insignificant effect on the fair value measurement.
Reporting entities should use observable inputs when available.In some cases, a valuation technique used to measure fair value may include inputs from multiple levels of the fair value hierarchy. ASC 820-10-35-37A indicates that the asset or liability is categorized in its entirety on the lowest level of a significant input. One significant unobservable input results in the entire asset or liability being classified in Level 3. Therefore, the reporting entity needs to identify all significant inputs when determining the appropriate classification within the hierarchy.
Assessing the significance of a particular input to the fair value measurement requires judgment, and should consider factors specific to the asset or liability. There are no bright lines for determining significance. A reporting entity should develop and consistently apply a policy for assessing significance.
In assessing the significance of unobservable inputs to an asset or liability's fair value, a reporting entity should (1) consider the sensitivity of the asset or liability's overall value to changes in the input and (2) assess the likelihood of variability in the input over the life of the asset or liability. An input could be unobservable and have little impact on the valuation at initial recognition, but the same input could have a significant remeasurement impact if markets and related assumptions change.
Additionally, we believe reporting entities should perform the significance assessment on an individual input level and an aggregate input level, considering aggregation of inputs when more than one item of unobservable data (or more than one parameter) is used to measure the fair value of an asset or liability.
ASC 820-10-55-21(b) provides an example of an interest rate swap with a ten-year life that has an observable yield curve for nine years. In that example, provided that the extrapolation of the yield curve to the tenth year is not significant to the fair value measurement of the swap in its entirety, the fair value measurement is considered Level 2. Had the reporting entity judged the final year of the instrument to be a significant input, it would have been a Level 3 measurement.
Observable inputs include both Level 1 and Level 2 inputs. We believe observable inputs include the following.
The following list of characteristics, if present, would provide evidence that an input is derived from observable market data. However, inputs need not have all of the following characteristics for it to qualify as observable market data.
The level of activity in the asset or liability’s principal market will contribute to the determination of whether an input is observable or unobservable. Level 1 and Level 2 measurements are based on observable inputs while Level 3 measurements are unobservable.
The ASC Master Glossary defines an active market as “a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.” An observable input that may otherwise be a Level 1 input will be rendered Level 2 if the information relates to a market that is not active.
To determine the level of the inputs within the hierarchy, the reporting entity should consider recent activity supporting the quote and trading volume trends. For example, in assessing market inputs, consider a security for which aggregate broker data is published on occasion, and for which trading does not occur on a regular basis. In this case, the price is quoted only occasionally and the security is not regularly traded. Consequently, the quote is no longer a Level 1 input, and would be Level 2 or 3.
Although observability could have an indirect relationship with liquidity, only the observability of significant inputs serves to distinguish between Levels 2 and 3. Liquidity is not a differentiating factor. For example, a reporting entity may be able to sell a structured security in one day; however, for valuation purposes, they are only able to obtain indicative broker quotes that cannot be corroborated by market observable inputs.
Additionally, there can be a wide spectrum of liquidity associated with instruments in Levels 2 and 3. For example, a residential mortgage-backed security is likely significantly more liquid than an abandoned warehouse and land in tertiary markets, while both may accurately be determined to be Level 3 valuations.
In addition, a US dollar fixed-for-floating interest rate swap is likely to be determined to be a Level 2 instrument by most market participants based upon the observability of the market inputs used to value it. However, it is not easy and likely time consuming, to novate an interest rate swap to another party. By definition, this derivative is less “liquid” than many fixed income securities that are determined to be Level 3. This is another example of why Level 2 versus Level 3 is not a representation of liquidity.
ASC 820-10-35-36A provides examples of markets in which inputs might be observable for some assets and liabilities. Reporting entities should consider the specific facts and circumstances of each input in each market in assessing whether an input in a particular market is observable.
Excerpt from ASC 820-10-35-36A
Examples of markets in which inputs might be observable for some assets and liabilities (for example, financial instruments) include exchange markets, dealer markets, brokered markets, and principal-to-principal markets. [Emphasis added.]
The ASC 820 Glossary provides additional clarification on each market:In a brokered market, brokers attempt to match buyers with sellers; they may not stand ready to trade. Instead, they typically provide indicative valuations for their own account, and do not use their own capital to hold an inventory of the items for which they make a market.
Ultimately, it is management’s responsibility to determine the appropriateness of its fair value measurements and their classification in the fair value hierarchy, including measurements for which pricing services (such as Bloomberg, Interactive Data Corporation, Thomson Reuters, Markit, Standard and Poor’s), broker pricing information, and similar sources are used.
ASC 820-10-35-54K indicates that the use of quoted prices provided by third parties, such as pricing services or brokers, is permitted if the reporting entity has determined that the quoted prices provided by those parties are developed in accordance with the fair value standard. Therefore, reporting entities that use pricing services need to understand how the pricing information is developed and obtain sufficient information to determine where instruments fall within the fair value hierarchy.
For example, a pricing service could provide quoted prices for an actively traded equity security which, if corroborated by the reporting entity, would be considered Level 1 inputs. The same pricing service may also provide a corporate bond price based on matrix pricing, which may constitute a Level 2 or Level 3 input, depending on the information used in the model. The information provided by these sources could result in a financial instrument falling into any level in the fair value hierarchy, depending on the inputs and methods used for a particular financial instrument.
Dealer quotes are observable only if the dealer stands ready and willing to transact at that price. Brokers, on the other hand, report what they see in the market but usually are not ready and willing to transact at that price. In order for broker quotes to be observable, they need to be corroborated by other market events or data.
A broker quote may be a Level 2 input if observable market information exists for comparable assets and/or the dealer is willing and able to transact in the security at that price. In many cases, a single broker quote may be indicative of a Level 3 measure if there are no comparables and the quote is provided with no commitment to actually transact at that price.
A reporting entity should have some higher-level (i.e., observable) data to support classification of an input as Level 2. A broker quote for which the broker does not stand ready to transact cannot be corroborated with an internal model populated with Level 3 information to support a Level 2 classification. Multiple indicative broker quotes or vendor prices based on Level 3 inputs do not raise the categorization of that instrument to Level 2. However, there may be other instances in which pricing information can be corroborated by market evidence, resulting in a Level 2 input.
In some cases, reporting entities may rely on pricing services or published prices that represent a consensus reporting of multiple brokers or "evaluated prices." It may not be clear if the reporting entity can transact at the prices provided or if observable market data was used to develop the indicative price. To support an assertion that a broker quote or information obtained from a pricing service represents a Level 2 input, the reporting entity should perform further review procedures to understand how the price was developed, including understanding the nature and observability of the inputs used to determine that price. As market activity often ebbs and flows, pricing techniques often do as well. Because of this, reporting entities should perform review procedures on an ongoing basis for financial reporting purposes versus at a singular point in time. Additional corroboration could include the following:
The level of investigation necessary is highly dependent on the facts and circumstances, such as the type and complexity of the asset or liability being measured, and its observability and the level of activity in the marketplace. Generally, the more specialized the asset or liability being measured and the less actively traded it is, the more review procedures will be necessary to corroborate the price to support classification as a Level 2 input.
When performing additional procedures, reporting entities should clearly document the assessment and conclusion. Without additional supporting information, we believe prices obtained from a single or multiple broker sources or a pricing service are indicative values or proxy quotes that generally represent Level 3 inputs.
In another example, a reporting entity may obtain a price from a broker or pricing service for a municipal security. The reporting entity may be fully aware of the depth and activity of the security's trading in the marketplace based on its historical trading experience. In addition, the pricing methodology for the security may be common and well-understood (e.g., matrix pricing) and the reporting entity may be able to perform less due diligence. However, this conclusion may not be appropriate for a reporting entity that obtains a price from a broker or pricing service for a collateralized debt obligation that is not frequently traded and may not be as easily subject to common, well-understood pricing methodologies (e.g., matrix pricing), for example. Therefore, the reporting entity may need to perform more due diligence.
Reporting entities commonly use proprietary models to calculate certain fair value measurements (e.g., some long-term derivative contracts, impairments of financial instruments, and illiquid investments such as real estate). However, they determine the level within the fair value hierarchy based on the inputs to the valuation, not on the methodology or complexity of the model. However, certain valuations may require the use of complex models to develop forward curves and other inputs; therefore, the models and inputs are frequently inextricably linked.
The use of a valuation model does not automatically result in a Level 3 fair value measurement. A standard valuation model that uses all observable inputs may result in a measurement classified as Level 2. For example, consider the measurement of a financial asset that is not actively traded. The reporting entity performs the valuation using a proprietary model incorporating inputs provided by brokers. While the financial asset is not actively traded, the entity assumes the broker providing the inputs is standing ready to transact at the quoted price and/or the reporting entity obtains sufficient corroborating data. Provided the model does not include management assumptions used to make adjustments to the data, it may be reasonable to conclude that the inputs are observable, and thus the measurement would be classified as Level 2.
However, if adjustments or interpolations are made to Level 2 inputs in an otherwise standard model, the measurement may fall into Level 3, depending on whether the adjusted inputs are significant to the measurement. Further, if a reporting entity uses a valuation model that is proprietary and relies on significant unobservable inputs, the resulting fair value measurement will be categorized as Level 3.
For example, when Level 2 inputs are not available and the reporting entity is required to develop a forward price curve because the duration of the contract exceeds the length of time that observable inputs are available, or is otherwise required to make adjustments to observable data, the valuation is relying on Level 3 inputs and would be classified as a Level 3 fair value measurement if those inputs are significant to the overall fair value measurement.