Fair Value Measurement in Financial Reporting

Graziano Stefanelli
Jul 14
3 min read

Fair value measurement has become a cornerstone of modern financial reporting, affecting asset and liability valuation, earnings volatility, and transparency. Accurately determining and disclosing fair value is critical for presenting an entity’s financial position and performance in a manner that reflects current market realities. US GAAP (ASC 820) and IFRS (IFRS 13) provide a robust, principles-based framework for measuring and disclosing fair value in financial statements.

Definition of Fair Value

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This is an exit price—not an entry price—emphasizing the perspective of market participants rather than the entity’s own intentions.

The Fair Value Hierarchy

ASC 820 and IFRS 13 require entities to maximize the use of observable inputs and minimize unobservable inputs when measuring fair value. The fair value hierarchy classifies inputs into three levels:

Level 1: Quoted prices in active markets for identical assets or liabilities.
Level 2: Observable inputs, either directly or indirectly, such as quoted prices for similar assets in active or inactive markets, or market-corroborated inputs.
Level 3: Unobservable inputs reflecting the entity’s own assumptions about what market participants would use.

This hierarchy must be disclosed for each class of assets and liabilities measured at fair value.

Valuation Techniques

Entities should use valuation techniques appropriate for the circumstances and for which sufficient data are available, maximizing relevant observable inputs. The three most common approaches are:

Market approach: Uses prices and other relevant information generated by market transactions.
Income approach: Converts future amounts (cash flows or income/expenses) to a single present value using current market expectations.
Cost approach: Reflects the amount required to replace the service capacity of an asset.

Selection depends on the nature of the asset or liability and the availability of market data.

Application to Financial and Nonfinancial Items

Fair value measurement is widely applied to:

Financial instruments: Investments, derivatives, certain receivables and payables.
Nonfinancial items: Investment property, biological assets, asset retirement obligations, and some business combinations.

Not all items are required or permitted to be measured at fair value; the accounting standards specify when and how it is applied.

Disclosures and Sensitivity Analysis

Entities must disclose:

The level within the fair value hierarchy for each class of assets and liabilities
Valuation techniques and inputs used
Reconciliation of beginning and ending balances for Level 3 items
Sensitivity of Level 3 measurements to changes in assumptions

These disclosures provide financial statement users with insight into valuation uncertainty and subjectivity.

Practical Considerations and Challenges

Inactive markets: In times of market stress, entities may need to adjust quoted prices or rely on Level 2 or Level 3 inputs.
Model risk: Use of unobservable inputs increases estimation risk and the need for robust controls and governance.
Audit and regulatory scrutiny: Fair value measurements, especially Level 3, are subject to rigorous review.

Relevant Accounting Standards

US GAAP: ASC 820 – Fair Value Measurement
IFRS: IFRS 13 – Fair Value Measurement

Both frameworks are substantially converged and require consistent, transparent measurement and disclosure.

Summary Table: Fair Value Hierarchy and Key Concepts

Level	Description	Example
1	Quoted prices in active markets for identical items	Listed shares, government bonds
2	Observable inputs for similar items	Corporate bonds, interest rate swaps
3	Unobservable inputs, entity’s own assumptions	Private equity, complex derivatives

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