The idea of the fair value hierarchy is twofold: 1) valuation, to maximize use of the most observable inputs, and for 2) disclosure, to increase consistency and comparability in reporting fair values. Hear Pwc’s Maria Constantinou discuss the basics of the fair value hierarchy, some thoughts on where you apply judgement, and examples in each level.
This video is part of The quarter close publication and video perspectives series.
Hi, I’m Maria Constantinou.
In an earlier video, I talked about the basics of fair value measurement. Today, I’d like to talk about the fair value hierarchy, which is important both for valuation and for disclosure. It’s something financial statement users see in the financial statements very clearly, and it’s important to understand what it means and what it does not mean.
The fair value guidance includes a fair value hierarchy that prioritizes the inputs used in valuation techniques. Inputs broadly refer to the information that market participants use to make pricing decisions. Examples are interest rates, credit ratings, market rents, or any factor that impacts the valuation. The idea of the fair value hierarchy is twofold: For valuation, to maximize use of the most observable inputs and for disclosure, to increase consistency and comparability in reporting fair values.
There are three levels to the fair value hierarchy:
Level 1: Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Think of say, a price of a share of a security quoted on the NYSE.
Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or indirectly. Level 2 is not a direct price quote for the exact instrument, but it is still considered observable.
Level 3: Unobservable inputs (a reporting entity’s or other entity’s own data).
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 estimation reliability of the fair value measurements.
So that’s what the hierarchy tells us, how observable the measurements are. What it does not tell us is the relative risk of the assets or liabilities. A Level 2 instrument has inputs that are more observable than a Level 3, but the Level 2 instrument may not necessarily be less risky. This is a common misconception.
Another common misconception is that the hierarchy represents liquidity. 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, you may be able to sell a structured security in one day; however, for valuation purposes, you may only be able to obtain indicative broker quotes that can’t be corroborated by market observable inputs. So that instrument is liquid, but its fair value is not observable.
As I said, Level 1 instruments are those with a quoted price, so that’s pretty straightforward. But determining whether an instrument is Level 2 or Level 3 can be more challenging. In practice, it can be quite difficult to distinguish between a Level 2 and a Level 3 instrument, a lot of judgment may be required. And the distinction does matter because Level 2 instruments are still considered observable while Level 3 are considered unobservable. And because they’re unobservable, there are a lot more footnote disclosures for Level 3 measurements.
Let me share some thoughts on applying this judgment. First, you determine the inputs to the valuation technique. If given a choice of inputs, for example, if different pieces of data are available for valuing a given asset or liability, you need to choose the inputs that are most observable, in other words, closer to Level 1 than Level 3. If any of the inputs are not observable, they are Level 3.
So how do you know if an input is observable? Here are some things to think about:
Is it supported by actual market transactions?
Is it provided by actual market participants, or just observers of the market?
Is it proprietary, or does it come from outside the company?
Is it readily available? Can market participants access the data?
Is it regularly distributed? Is the data made available regularly enough so you have it when you need it to make pricing decisions?
As you can see, these questions and others in the assessment of whether an input is observable or unobservable (that is, level 2 or Level 3) require judgment and a deep understanding of the information you are given.
What are some examples of assets and liabilities in each level?
Level 1: Securities listed on national exchanges (like the example that I used earlier of a security traded on the NYSE), treasury bills, and certain treasury bonds
Level 2: Most U.S. public debt, short-term cash instruments, and certain derivatives
Level 3: On the financial side, complex derivatives and certain fixed income asset-backed securities. On the nonfinancial side, real estate that is measured at fair value is commonly Level 3
Sometimes, the valuation includes inputs that fall within multiple levels of the hierarchy. The level that the asset or liability falls in the fair value hierarchy is based on the lowest level of an input that is considered significant to the valuation. For example, if a fair value measurement of an asset or liability uses just one significant input that is Level 3, then the whole instrument is considered Level 3, even though every other input may be level 2. The result is that the measurement is considered unobservable even though it includes both unobservable and observable inputs.
So, now that we understand the level, the next question is what do you do next? Well, you go to the fair value guidance and provide the required disclosures for the instruments that fall in each level. As you can see, you need to know the correct level in the hierarchy to get the disclosures right.
For more information on this topic, we have 2 guides that include the fair value hierarchy: The Fair value guide, which explains how the inputs are used in valuation, and the Financial statement presentation guide, which includes the impact on disclosure. Both are available on CFOdirect.com.