Latest / VoraPrep Audio — Professional Licensure & Certification Exam Prep / [CPA] FAR: Mastering Fair Value Measurement: Applying ASC 820
Transcript
- Hey, welcome to VoraPrep Audio. Glad you could join me. So, picture this. You're looking at a company's balance sheet, and you see a line item: "Investment in private company, fifty million dollars." And you just have to wonder… is that number real? Is it solid? Or is it just wishful thinking? Valuing a share of Apple stock is simple. You just look it up. But how do you put a reliable number on things that don't trade every day? That's the whole reason we have ASC 820 on fair value measurement. It gives everyone a common playbook, so we can trust the numbers, even for the tricky stuff. This comes up all the time on the FAR exam, so let's walk through it. The whole framework is built around one core idea: the exit price. ASC 820 defines fair value as the price you'd get to sell an asset. Or, it's what you'd have to pay to transfer a liability. Think about it like selling your car. It doesn't matter that you paid thirty thousand dollars for it three years ago. Its fair value today is what someone would actually pay you for it. It's an exit price, not an entry price. The definition also specifies a few key conditions. The transaction must be "orderly." That means it's not a fire sale where you're desperate. It assumes a normal amount of time to find a buyer. The parties involved are called "market participants." These are people who are knowledgeable and independent. So, not your cousin giving you a special deal. And the valuation is for a specific "measurement date," like December 31st. It’s a snapshot in time. Okay, so to get that exit price, you need to figure out the right market. ASC 820 gives you a clear rule for this. First, you look for the principal market. This is simply the market with the most volume and the most activity for that specific asset. If a principal market exists, you have to use the price from that market. Period. Even if you think you could get a slightly better price somewhere else. The principal market rules. But what if there isn't one? What if there's no single, dominant market? Then, and only then, you look for the most advantageous market. This is the market that gives you the best net price—the one that maximizes what you pocket after costs. This is a tricky point, and it's important for the exam. When you're figuring out which market is most advantageous, you do consider transaction costs. But when you actually record the fair value? You back those transaction costs out. Let me make that real with an example. Let's say you have an asset you can sell in two places: Market A and Market B. And there’s no principal market. In Market A, the price is one hundred dollars. You'd have to pay five dollars in transaction costs, like a broker's fee. And it would cost two dollars to ship it there. Now, in Market B, the price is higher—one hundred two dollars. But the transaction costs are also higher at eight dollars, and shipping is three dollars. First, let's find the net price for each market. For Market A, you start with the one-hundred-dollar price. Then you subtract the five-dollar transaction cost and the two-dollar transportation cost. That leaves you with ninety-three dollars. Now for Market B. You start with the one-hundred-two-dollar price. Subtract the eight-dollar transaction cost and the three-dollar transportation cost. That nets you ninety-one dollars. So, which one is most advantageous? Market A. Because ninety-three dollars is more than ninety-one dollars. Now for the critical part. What is the fair value you actually record on the books? It’s the price in that most advantageous market, which is Market A. But here's the key: you only adjust for transportation costs. You ignore the transaction costs for the final measurement. So, you take the one-hundred-dollar price from Market A. Then you subtract the two dollars for transportation. The fair value is ninety-eight dollars. That five-dollar transaction fee helped you pick the market. But it doesn't reduce the final fair value number itself. This is a subtle but really important distinction. Once you know the market, you need a way to actually calculate the value. ASC 820 lays out three broad valuation techniques. There's the Market Approach, the Income Approach, and the Cost Approach. The Market Approach is the most intuitive. You're just looking at what identical or similar things are selling for. It's like valuing a house by looking at recent sales of similar houses in the neighborhood. It's perfect for actively traded stocks or real estate. The Income Approach is all about the future. It converts future cash flows or earnings into a single present value. This is what you'd use to value a whole business or an intangible asset like a patent. The classic example is a Discounted Cash Flow, or DCF, model. And finally, there's the Cost Approach. This one asks, what would it cost to replace the asset today? It's often called "current replacement cost." This is for unique, tangible things, like a custom-built piece of factory equipment that you can't just buy off the shelf. You figure out what it would cost to build another one just like it. Now, the inputs you use for these techniques aren't all created equal. This brings us to the most heavily tested part of ASC 820: the Fair Value Hierarchy. It's a three-level system that ranks the reliability of your inputs. The whole point is to push companies to use observable, market-based data whenever they can. Level 1 is the best of the best. The gold standard. These are quoted prices in active markets for identical assets. Think of a share of Microsoft trading on the nahz-dak. There is no ambiguity. It’s the most reliable input you can get. Level 2 is a step down, but still pretty solid. These are inputs that are observable, either directly or indirectly. But they aren't that perfect, quoted Level 1 price. For example, it could be a quoted price for a similar asset in an active market. Or, it could be the price for an identical asset, but in a market that isn't very active. Things like interest rates or yield curves also fall in here. They're all observable market data. And then you have Level 3. This is the lowest rung on the ladder. Level 3 inputs are unobservable. They’re based on the company's own assumptions and internal data. Think about projecting a startup’s future revenue for a DCF model. That’s a Level 3 input because it’s coming from inside the house, not from the external market. Let's make this concrete with an example. Imagine a company, Apex Holdings, with three investments. First, they have ten thousand shares of an S and P 500 company. That's easy. It's a quoted price for an identical asset in an active market. Textbook Level 1. Next, they hold a corporate bond. This bond doesn't trade very often, so there's no active market price for it. But its value is calculated using other observable data. Things like the company's credit spread and treasury yield curves. The key inputs are observable, but it's not a Level 1 quoted price. So, this is a Level 2 measurement. Finally, Apex has a stake in a private startup. They value it using their own DCF model, with their own internal projections for growth. Those projections are unobservable inputs. And they're significant to the whole valuation. That makes this a Level 3 measurement. This brings us to a critical rule. The classification for the entire asset is determined by the lowest-level input that is significant to the valuation. So, imagine a complex derivative. It might use a bunch of Level 2 inputs, like interest rates. But let's say it also uses one significant Level 3 input, maybe a volatility assumption you came up with yourself. In that case, the whole thing gets classified as Level 3. Just one subjective input can pull the entire valuation down to the bottom of the hierarchy. If you need a quick way to remember the levels on exam day, just think of the letters A, O, U. The "A" is for Active markets, which is Level 1. The "O" is for other Observable data, which is Level 2. And the "U" is for Unobservable inputs, which is Level 3. So remember, A, O, U. One last tip for the exam. Pay close attention to the disclosures. The test loves to ask about them. For any asset measured at fair value, you have to disclose which level of the hierarchy it falls into. Now, for Level 3 assets, the disclosure requirements are way more intense. You have to provide a full reconciliation from the beginning of the year to the end. This reconciliation shows all the purchases, sales, and any gains or losses. And it makes sense. Regulators want more transparency when a valuation is based on a company's own subjective assumptions. So, let's recap the key points. Remember that fair value is an exit price. You find that price using the principal market. Or, if there isn't a principal one, you use the most advantageous market. The valuation itself uses one of three techniques: Market, Income, or Cost. And finally, you classify the inputs using the three-level hierarchy. Level 1 is the most reliable, and Level 3 is the least. VoraPrep is a full exam-prep app — lessons, practice questions, and an AI tutor in one place. Get started at Vora Prep dot com.