Making Informed Judgments Part 10 Statistics, Measurement, and the Fair Value Hierarchy Navigating Accounting,® G. Peter & Carolyn R. Wilson, © 1991-2009 NavAcc LLC. Modified by [Your Name]. 1 Menu  Fair value hierarchy  Statistics, measurement, and the hierarchy  Closing thoughts 2 View in Slide Show Mode > click hyperlink. Fair Value Hierarchy Things You Need to Know  Fair values are hypothetical prices “that would be received or paid” on the reporting dates and thus they must be estimated.  Under U.S. GAAP, the fair value hierarchy classifies fair value measures as based on attributes of the inputs used in valuation techniques used to determine fair values as either:  Level 1  Level 2  Level 3 Return to menu 3 Fair Value Hierarchy Things You Need to Know  Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date (FASB 820-10-35-40).  An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis (FASB 820-10-35-24). Return to menu 4 Fair Value Hierarchy Things You Need to Know  Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.  They include quoted prices for similar assets and liabilities in active markets, quoted prices for identical assets or liabilities in inactive markets, other observable inputs such as interest rates. (FASB 820-10-35-47-48) Return to menu 5 Fair Value Hierarchy Things You Need to Know  Level 3 inputs are unobservable inputs for the asset or liability. (FASB 820-10-35-47-52)  Unobservable inputs are inputs that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. (FASB 820-10-35-41) Return to menu 6 Statistics , Measurement, and Hierarchy Question  How do statistical concepts relate to the FASB’s fair-value hierarchy?  Would you generally expect the dispersion of experts’ estimates of fair values to be aligned with the hierarchy?  For example, would you expect the dispersion to be smaller for level 1 measures, wider for level 2 measures, and even wider for level 3 measures?  Would this alignment necessarily hold in all situations?  For example, can you think of situations where the dispersion could be less for level 3 estimates than for levels 1 and 2? Return to menu 7 Statistics, Measurement, and Hierarchy Take Aways  When fair values are relevant to investors’ decisions, the fair value hierarchy and related disclosures can help them gauge the dispersion of related measures, which we have seen helps them make more informed decisions and assess the confidence they should have in these decisions.  The controversy regarding fair values was heightened by the financial crisis because fair value estimates became highly unreliable, regardless of whether they were measured using market prices for comparable assets or the discounted cash flow (DCF) model. Return to menu 8 Closing Thoughts  Fair values were controversial before the financial crisis because of disagreement about their relevance to investors compared to the relevance of historical cost measures and value-in-use measures.  Thus, the earlier arguments centered on measurement objectives and the later on measurement reliability.  Proponents and opponents of fair value accounting often:  Muddle measurement objective arguments, which should center on what is being measured, with measurement reliability arguments, which should center on the availability and reliability of measurement techniques and benchmark data.  Are not contextual and, in particular, do not depend on users’ decisions and the measurement context. Return to menu 9