Fair Value Hierarchy Level 1, Level 2, Level 3. Fair Value Accounting

Описание: In this video, I explain fair value hierarchy level 1, 2 and 3 when it comes to fair value accounting.
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0:00 Introduction
This video explains fair value accounting and its three-level hierarchy for determining an asset's or liability's current worth (0:05).

Here's a breakdown:

What is Fair Value? It's the price at which an asset could be sold or a liability transferred in an orderly transaction between independent market participants (0:20, 4:37). It's a move away from historical cost accounting (1:00).
Historical Context: Before 2006, there were no clear guidelines, leading to inconsistencies. Now, IFRS and GAAP provide specific rules (3:46).
Market Concepts: The video introduces the principal market (most volume and activity, 5:57) and the most advantageous market (maximizes received amount for assets or minimizes paid amount for liabilities, 8:01), which is used if a principal market doesn't exist or isn't accessible. Transaction costs are considered in the advantageous market, but not the principal market (7:20, 8:34).
Financial vs. Non-Financial Assets: The valuation approach differs. For non-financial assets (like property, plant, equipment), the concept of "highest and best use" comes into play (9:51).
The Fair Value Hierarchy:
Level 1: Uses quoted prices from active markets for identical assets/liabilities. This is the most reliable (11:05). Think publicly traded stocks (11:51).
Level 2: Uses observable inputs other than Level 1 quoted prices, like prices for similar assets in active markets or identical assets in inactive markets (12:10). An example is valuing a private company based on similar publicly traded ones (13:38).
Level 3: Uses unobservable inputs and requires management estimates and valuation models, often involving discounted cash flows. This is the least reliable and requires the most disclosure (14:59).

In the context of fair value measurement, Level I, Level II, and Level III refer to the hierarchy of inputs used to determine the fair value of assets and liabilities. This hierarchy prioritizes the use of observable inputs by requiring that the most reliable and relevant inputs be used when available.

Level I Inputs:

These are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.
Examples include stock prices from a public exchange (like the NYSE or NASDAQ) where the stock is frequently traded.
These are considered the most reliable and transparent valuations since they are directly observable.
Level II Inputs:

These are inputs other than quoted prices included within Level I that are observable for the asset or liability, either directly or indirectly.
They often include:
Quoted prices for similar assets or liabilities in active markets.
Quoted prices for identical or similar assets or liabilities in markets that are not active.
Inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates, yield curves, volatility measures, etc.)
These are used when Level I inputs are not available.
Level III Inputs:

These are unobservable inputs for the asset or liability.
They reflect an entity's own assumptions about what market participants would use to price the asset or liability.
These might be used when there's little to no market activity for the asset or liability at the measurement date.
Examples include certain private equity investments, complex derivatives, or real estate assets in illiquid markets.
Since Level III inputs are based on unobservable data, they are considered the least reliable and involve the most judgment.
In practice, when determining the fair value of an asset or liability, an entity would ideally use Level I inputs when available. If Level I inputs are not available, the entity would then consider Level II inputs. Level III inputs would be used when neither Level I nor Level II inputs can be used. The goal is to achieve the most accurate and objective fair value measurement possible, so the hierarchy is designed to prioritize more observable and less subjective inputs.

In the context of fair value accounting, the "principal market" refers to the market with the greatest volume and level of activity for an asset or liability. When determining the fair value of an asset or liability, the price in the principal market is prioritized because it's considered to represent the most accurate and reliable valuation.

Here's a breakdown:

Principal Market: This is the market with the most volume and activity for the asset or liability in question. It's the first place entities look when determining fair value. If an entity can access the principal market, the price in that market is the fair value, regardless of prices in any other market.