The standards on fair value measurements and disclosures can prove challenging to understand and implement.
It would be wise at this point to focus on some common issues or shortcomings related to complying with the standards on fair value disclosures.
Fair Value Hierarchy and Reconciliation
In many cases, financial statements fail to disclose the fair value hierarchy and the level at which fair value items are valued (inputs). According to FASB Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures, and more specifically FASB ASC 820-10-50-2b, for recurring and nonrecurring fair value measurements, an entity is required to disclose the level of the fair value hierarchy within which the fair value measurements are categorized in their entirety (Level 1, 2 or 3). And under FASB ASC 820-10-50-8, the reporting entity should present the quantitative disclosures in a tabular format.
Level 3 Reconciliation
Many entities fail to provide a reconciliation from the opening balances to the closing balances of their Level 3 investments as required by FASB ASC 820. But according to FASB ASC 820-10-50-2c, for recurring fair value measurements categorized within Level 3, a reconciliation from the opening balances to the closing balances is required.
Entities must disclose separately the changes during the period attributable to the following:
- Total gains or losses for the period recognized in earnings (or changes in net assets) and the line item(s) in the statement of income (or activities) in which those gains or losses are recognized.
- Total gains or losses for the period recognized in other comprehensive income and the line item(s) in other comprehensive income in which those gains or losses are recognized.
- Purchases, sales, issues and settlements (with each of those types of changes disclosed separately).
- The amount of any transfers into or out of Level 3 of the fair value hierarchy, the reasons for those transfers and the reporting entity’s policy for determining when transfers between levels are deemed to have occurred. Transfers into Level 3 should be disclosed and discussed separately from transfers out of Level 3.
Marketable Securities
Some entities with only marketable securities on their balance sheet that are either trading securities or available-for-sale-securities fail to recognize that, since these securities are required to be measured at fair value under FASB ASC 320, Investments – Debt and Equity Securities, the additional disclosure requirements of FASB ASC 820-10-50 also apply. In addition, any entity that has marketable securities that are subject to fair value measurement should include in their summary of significant accounting policies note their policy on fair value measurements.
Additional Disclosures for Levels 2 and 3 Measurements
When recurring and nonrecurring fair value measurements are categorized within Level 2 and Level 3 of the fair value hierarchy, a description of the valuation technique(s) and the inputs used in the fair value measurement are required to be disclosed per FASB ASC 820-10-50-2. If there has been a change in valuation technique, the entity should disclose that change and the reason(s) for making it.
For fair value measurements categorized within Level 3, a reporting entity should provide quantitative information about the significant unobservable inputs used in the fair value measurement. A reporting entity is not required to create quantitative information to comply with this disclosure requirement if quantitative unobservable inputs are not developed by the reporting entity when measuring fair value (for example, when a reporting entity uses prices from prior transactions or third-party pricing information without adjustment).
However, when providing this disclosure, a reporting entity cannot ignore quantitative unobservable inputs that are significant to the fair value measurement and are reasonably available to the reporting entity.
When an entity holds only Level 1 investments, it still is required to disclose this fact in the notes to the financial statements. Otherwise, financial statement users are left wondering at what level of the fair value hierarchy those investments fall.
In some cases, there is a question as to whether certain investments should have been categorized as Level 3 rather than Level 2 in the financial statements. According to the FASB ASC Master Glossary, the three categories of inputs are defined as follows:
- Level 1 Inputs – Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date
- Level 2 Inputs – Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly
- Level 3 Inputs – Unobservable inputs for the asset or liability
Preparers of financial statements often find the requirements of FASB ASC 820 complicated to understand and implement. The matters discussed above are common areas of difficulty and noncompliance with FASB ASC 820. An awareness of these matters will help financial statement preparers better comply with the fair value standards. – Bob Durak, CPA, CGMA, Director of AICPA Center for Plain English Accounting