If market prices are not readily available for fair value measurements, management should use

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Publication date: 31 Mar 2022   

us Fair value guide 4.5

To increase consistency and comparability in reporting fair value measurements, ASC 820-10-35-37 establishes the fair value hierarchy to prioritize the inputs used in valuation techniques. There are three levels to the fair value hierarchy (Level 1 is the highest priority and Level 3 is the lowest priority):

• Level 1: observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets
• Level 2: inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or indirectly
• Level 3: unobservable inputs (e.g., a reporting entity’s or other entity’s own data)

The ASC Master Glossary defines a principal market as "the market with the greatest volume and level of activity for the asset or liability." It further states that market participants are buyers and sellers in this market that are independent of each other, knowledgeable, and willing and able to enter into a transaction for the asset or liability. The determination of the reporting entity’s principal market is made from the perspective of the reporting entity; the availability of pricing inputs is not part of that assessment. For example, if the reporting entity is a retail customer and does not have access to the wholesale market, the reporting entity’s principal market is the retail market and quoted prices in the wholesale market will not qualify as fair value for that reporting entity.

If a price for the exact unit of account (i.e., a Level 1 input) is not available in the principal market, then the reporting entity will have to use a valuation technique with one or more inputs from the same or other markets to derive fair value. The availability of pricing inputs from other markets may impact the choice of valuation technique. For example, if Level 1 inputs are available in another market (i.e., a market approach), that approach may provide more objective evidence of fair value than an income approach using Level 2 inputs from the principal market. However, in either case, the resulting fair value measurement would not be considered a Level 1 input.

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 reliability of the fair value measurements.

Disclosure is required by level; as the objectivity of the inputs decrease, disclosure increases. Certain required disclosures are applicable only to those fair value assets and liabilities characterized as Level 3.

Figure FV 4-2 illustrates the steps to differentiate Level 2 and Level 3 in the fair value hierarchy of a fair value measurement. Level 1 fair value measurements have been excluded from the framework as they have a Level 1 price for the entire unit of account.

Figure FV 4-2
Fair value hierarchy framework (for Levels 2 and 3)

Steps 1 through 4 are explained in the following sections. See FSP 20 for the required disclosures.

4.5.1 Step 1: determine all inputs to valuation techniques

Inputs broadly refer to the information that market participants use to make pricing decisions, including assumptions about risk. Inputs may include price information, revenue growth, changes in profitability, volatility factors, specific and broad credit data, liquidity statistics, and all other factors that have more than an insignificant effect on the fair value measurement.

Reporting entities should use observable inputs when available.

4.5.2 Step 2: determine which inputs are significant

In some cases, a valuation technique used to measure fair value may include inputs from multiple levels of the fair value hierarchy. ASC 820-10-35-37A indicates that the asset or liability is categorized in its entirety on the lowest level of a significant input. One significant unobservable input results in the entire asset or liability being classified in Level 3. Therefore, the reporting entity needs to identify all significant inputs when determining the appropriate classification within the hierarchy.

Assessing the significance of a particular input to the fair value measurement requires judgment, and should consider factors specific to the asset or liability. There are no bright lines for determining significance. A reporting entity should develop and consistently apply a policy for assessing significance.

In assessing the significance of unobservable inputs to an asset or liability's fair value, a reporting entity should (1) consider the sensitivity of the asset or liability's overall value to changes in the input and (2) assess the likelihood of variability in the input over the life of the asset or liability. An input could be unobservable and have little impact on the valuation at initial recognition, but the same input could have a significant remeasurement impact if markets and related assumptions change.

Additionally, we believe reporting entities should perform the significance assessment on an individual input level and an aggregate input level, considering aggregation of inputs when more than one item of unobservable data (or more than one parameter) is used to measure the fair value of an asset or liability.

ASC 820-10-55-21(b) provides an example of an interest rate swap with a ten-year life that has an observable yield curve for nine years. In that example, provided that the extrapolation of the yield curve to the tenth year is not significant to the fair value measurement of the swap in its entirety, the fair value measurement is considered Level 2. Had the reporting entity judged the final year of the instrument to be a significant input, it would have been a Level 3 measurement.

4.5.3 Step 3: determine if significant inputs are observable

Observable inputs include both Level 1 and Level 2 inputs. We believe observable inputs include the following.

• Prices or quotes from exchanges or listed markets (e.g., New York Mercantile Exchange, Chicago Board of Trade, London Stock Exchange, Tokyo Stock Exchange, or New York Stock Exchange and Euronext) in which there is sufficient activity
• Proxy observable market data that is proven to be highly correlated and has a logical, economic relationship with the instrument being valued (e.g., electricity prices in two different locations or “zones” that are highly correlated)
• Other direct and indirect market inputs that are observable in the marketplace

Determining what constitutes observable inputs will require significant judgment.

The following list of characteristics, if present, would provide evidence that an input is derived from observable market data. However, inputs need not have all of the following characteristics for it to qualify as observable market data.

• Supported by market transactions

  Although data need not be traced directly to a “live” or “perfectly offsetting” transaction, there should be strong evidence that (1) the data sources draw their information from actual market transactions between other market participants or (2) the information is used by market participants to price actual market transactions. The reporting entity will normally need to perform a degree of review and/or verification of the data supporting the quote.

• Not proprietary

  Observable data incorporated into an input of a valuation technique comes from sources other than within the reporting entity that is making the determination. In addition, the data should be distributed broadly, and not limited in its distribution to only the entity making the determination or to a small group of users. The data should be available to and regularly used by participants in the relevant market/product sector as a basis for pricing transactions or verifying such prices. Even an internally developed assumption may be an observable input if it can be corroborated to an external source.

• Readily available

  Market participants should be able to obtain access to the data, although the supplier of the information could impose a reasonable fee for access.

• Regularly distributed

  The term “regular distribution” means that the data is made available in a manner that is timely enough to allow the data to be meaningful in pricing decisions. Further, there should be procedures in place to verify that changes between intervals have not occurred that would render the data meaningless. In addition, the distributed information should indicate its effective date to ensure that data received is not stale.

• Transparent

  The people/sources providing and/or distributing the data and their role in a particular product/market should be transparent and known to be reliable. In addition, it needs to be clear to the people who provide the data that market participants use this information to price/verify transactions.

• Verifiable

  The data should be verifiable. Further, there should be evidence that users are, in fact, regularly verifying the data. For example, people who are independent of a particular reporting entity should be able to contact the third-party data provider directly in order to verify the data that is obtained and used. It also should be possible for people to verify the data by comparing it with data that is obtained from other reliable sources.

• Reliable

  The data should reflect actual market parameters and be subject to certain levels of periodic testing and monitoring. These controls should exist at the entity providing the data, and at the entity using the data. Reporting entities should test and review the reliability of a source’s data on an ongoing basis before actually using that source as a basis for determining or disclosing a fair value measurement and its level within the fair value hierarchy.

• Based on consensus

  The data or inputs that are provided by multiple sources should be comparable within a reasonably narrow range before a reporting entity can regard the information as demonstrating a market consensus. If particular sources produce price outliers, the reporting entity should understand them and how they impact the data. Due diligence should be performed to confirm that the consensus was derived from different sources.

• Provided by sources actively involved in the relevant market

  The data should originate from a source that is an active participant with respect to the relevant product and within the relevant market. Further, the reporting entity that is using the data should periodically demonstrate that the source of the data provides reliable information on a consistent basis. Although there are instances in which market forces could help ensure that a data source provides reliable information, such assurance may need to be supplemented with other evidence, such as the results of back-testing applied to verify the consistency and reliability of a particular source’s data.

4.5.3.1 Assessing market activity to determine if inputs are observable

The level of activity in the asset or liability’s principal market will contribute to the determination of whether an input is observable or unobservable. Level 1 and Level 2 measurements are based on observable inputs while Level 3 measurements are unobservable.

The ASC Master Glossary defines an active market as “a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.” An observable input that may otherwise be a Level 1 input will be rendered Level 2 if the information relates to a market that is not active.

To determine the level of the inputs within the hierarchy, the reporting entity should consider recent activity supporting the quote and trading volume trends. For example, in assessing market inputs, consider a security for which aggregate broker data is published on occasion, and for which trading does not occur on a regular basis. In this case, the price is quoted only occasionally and the security is not regularly traded. Consequently, the quote is no longer a Level 1 input, and would be Level 2 or 3.

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, a reporting entity may be able to sell a structured security in one day; however, for valuation purposes, they are only able to obtain indicative broker quotes that cannot be corroborated by market observable inputs.

Additionally, there can be a wide spectrum of liquidity associated with instruments in Levels 2 and 3. For example, a residential mortgage-backed security is likely significantly more liquid than an abandoned warehouse and land in tertiary markets, while both may accurately be determined to be Level 3 valuations.

In addition, a US dollar fixed-for-floating interest rate swap is likely to be determined to be a Level 2 instrument by most market participants based upon the observability of the market inputs used to value it. However, it is not easy and likely time consuming, to novate an interest rate swap to another party. By definition, this derivative is less “liquid” than many fixed income securities that are determined to be Level 3. This is another example of why Level 2 versus Level 3 is not a representation of liquidity.

ASC 820-10-35-36A provides examples of markets in which inputs might be observable for some assets and liabilities. Reporting entities should consider the specific facts and circumstances of each input in each market in assessing whether an input in a particular market is observable.

Excerpt from ASC 820-10-35-36A

Examples of markets in which inputs might be observable for some assets and liabilities (for example, financial instruments) include exchange markets, dealer markets, brokered markets, and principal-to-principal markets. [Emphasis added.]

The ASC 820 Glossary provides additional clarification on each market:

• Exchange market
  
  In an active exchange market (e.g., NYSE, London Stock Exchange), closing prices are both readily available and representative of fair value.
• Dealer market

  In a dealer market, dealers stand ready to trade at an executable bid or ask price for their own account, thereby providing market liquidity by using their capital to hold an inventory of the items for which they make a market. Over-the-counter markets are dealer markets. Assets and liabilities, other than securities, also exist in dealer markets, such as financial instruments, commodities, and physical assets.

• Brokered market

  In a brokered market, brokers attempt to match buyers with sellers; they may not stand ready to trade. Instead, they typically provide indicative valuations for their own account, and do not use their own capital to hold an inventory of the items for which they make a market.

  For a broker quote to be observable, a reporting entity may not need transparency into the market data used to develop the quote, but would need knowledge of how the quote is created and whether the broker stands ready to execute. Broker quotes can be derived from models or based on market observable transactions. In many cases, transparency into the specific technique used is not available. However, a reporting entity may be able to determine the implied inputs used (e.g., discount rate/yield). From this analysis, a reporting entity may be able to connect such implied inputs to market observable information (e.g., trade information).

• Principal-to-principal market

  Principal-to-principal transactions (both originations and resales) are negotiated independently, with no intermediary. Often, very little information about these transactions is publicly available, and as such, the markets are generally not considered observable.

4.5.3.2 Pricing services, broker quotes, and dealer quotes

Ultimately, it is management’s responsibility to determine the appropriateness of its fair value measurements and their classification in the fair value hierarchy, including measurements for which pricing services (such as Bloomberg, Interactive Data Corporation, Thomson Reuters, Markit, Standard and Poor’s), broker pricing information, and similar sources are used.

ASC 820-10-35-54K indicates that the use of quoted prices provided by third parties, such as pricing services or brokers, is permitted if the reporting entity has determined that the quoted prices provided by those parties are developed in accordance with the fair value standard. Therefore, reporting entities that use pricing services need to understand how the pricing information is developed and obtain sufficient information to determine where instruments fall within the fair value hierarchy.

For example, a pricing service could provide quoted prices for an actively traded equity security which, if corroborated by the reporting entity, would be considered Level 1 inputs. The same pricing service may also provide a corporate bond price based on matrix pricing, which may constitute a Level 2 or Level 3 input, depending on the information used in the model. The information provided by these sources could result in a financial instrument falling into any level in the fair value hierarchy, depending on the inputs and methods used for a particular financial instrument.

Dealer quotes are observable only if the dealer stands ready and willing to transact at that price. Brokers, on the other hand, report what they see in the market but usually are not ready and willing to transact at that price. In order for broker quotes to be observable, they need to be corroborated by other market events or data.

A broker quote may be a Level 2 input if observable market information exists for comparable assets and/or the dealer is willing and able to transact in the security at that price. In many cases, a single broker quote may be indicative of a Level 3 measure if there are no comparables and the quote is provided with no commitment to actually transact at that price.

A reporting entity should have some higher-level (i.e., observable) data to support classification of an input as Level 2. A broker quote for which the broker does not stand ready to transact cannot be corroborated with an internal model populated with Level 3 information to support a Level 2 classification. Multiple indicative broker quotes or vendor prices based on Level 3 inputs do not raise the categorization of that instrument to Level 2. However, there may be other instances in which pricing information can be corroborated by market evidence, resulting in a Level 2 input.

In some cases, reporting entities may rely on pricing services or published prices that represent a consensus reporting of multiple brokers or "evaluated prices." It may not be clear if the reporting entity can transact at the prices provided or if observable market data was used to develop the indicative price. To support an assertion that a broker quote or information obtained from a pricing service represents a Level 2 input, the reporting entity should perform further review procedures to understand how the price was developed, including understanding the nature and observability of the inputs used to determine that price. As market activity often ebbs and flows, pricing techniques often do as well. Because of this, reporting entities should perform review procedures on an ongoing basis for financial reporting purposes versus at a singular point in time. Additional corroboration could include the following:

• Use of liquidity or transparency information and metrics provided by the vendor which may include the liquidity score and depth of the quotes informing the price
• Review of vendor valuation methodology documentation
• Discussions with pricing services, dealers, or other companies to obtain additional prices of identical or similar assets to corroborate the price
• Back-testing of prices to determine historical accuracy against actual transactions. While this analysis provides more evidence on the accuracy/reliability of historical prices provided, it may also provide an initial indication of whether pricing uses observable data inputs. It is likely that additional corroboration would be necessary to determine the use of observable market data.
• Comparisons to other external or internal valuation model outputs and their corroboration with observable market data

The level of investigation necessary is highly dependent on the facts and circumstances, such as the type and complexity of the asset or liability being measured, and its observability and the level of activity in the marketplace. Generally, the more specialized the asset or liability being measured and the less actively traded it is, the more review procedures will be necessary to corroborate the price to support classification as a Level 2 input.

When performing additional procedures, reporting entities should clearly document the assessment and conclusion. Without additional supporting information, we believe prices obtained from a single or multiple broker sources or a pricing service are indicative values or proxy quotes that generally represent Level 3 inputs.

In another example, a reporting entity may obtain a price from a broker or pricing service for a municipal security. The reporting entity may be fully aware of the depth and activity of the security's trading in the marketplace based on its historical trading experience. In addition, the pricing methodology for the security may be common and well-understood (e.g., matrix pricing) and the reporting entity may be able to perform less due diligence. However, this conclusion may not be appropriate for a reporting entity that obtains a price from a broker or pricing service for a collateralized debt obligation that is not frequently traded and may not be as easily subject to common, well-understood pricing methodologies (e.g., matrix pricing), for example. Therefore, the reporting entity may need to perform more due diligence.

4.5.3.3 Valuation models

Reporting entities commonly use proprietary models to calculate certain fair value measurements (e.g., some long-term derivative contracts, impairments of financial instruments, and illiquid investments such as real estate). However, they determine the level within the fair value hierarchy based on the inputs to the valuation, not on the methodology or complexity of the model. However, certain valuations may require the use of complex models to develop forward curves and other inputs; therefore, the models and inputs are frequently inextricably linked.

The use of a valuation model does not automatically result in a Level 3 fair value measurement. A standard valuation model that uses all observable inputs may result in a measurement classified as Level 2. For example, consider the measurement of a financial asset that is not actively traded. The reporting entity performs the valuation using a proprietary model incorporating inputs provided by brokers. While the financial asset is not actively traded, the entity assumes the broker providing the inputs is standing ready to transact at the quoted price and/or the reporting entity obtains sufficient corroborating data. Provided the model does not include management assumptions used to make adjustments to the data, it may be reasonable to conclude that the inputs are observable, and thus the measurement would be classified as Level 2.

However, if adjustments or interpolations are made to Level 2 inputs in an otherwise standard model, the measurement may fall into Level 3, depending on whether the adjusted inputs are significant to the measurement. Further, if a reporting entity uses a valuation model that is proprietary and relies on significant unobservable inputs, the resulting fair value measurement will be categorized as Level 3.

For example, when Level 2 inputs are not available and the reporting entity is required to develop a forward price curve because the duration of the contract exceeds the length of time that observable inputs are available, or is otherwise required to make adjustments to observable data, the valuation is relying on Level 3 inputs and would be classified as a Level 3 fair value measurement if those inputs are significant to the overall fair value measurement.

4.5.4 Step 4: determine level in the hierarchy of the significant input (or all significant inputs)

The evaluation of the significant inputs determines the classification of the asset or liability in the fair value hierarchy. Some of the key characteristics of each level are included in Figure FV 4-3.

Figure FV 4-3
Characteristics of each level in the fair value hierarchy

A common misconception is that securities that are “less risky” should be categorized in Level 1. For instance, many might perceive US Treasury securities as essentially risk-free, and, therefore, should be considered Level 1 in the fair value hierarchy. However, certain Treasury securities are more appropriately categorized in Level 2 because they do not trade in an active market.

4.5.4.1 Level 1 inputs

Level 1 inputs are quoted prices (unadjusted) for identical assets or liabilities in active markets. A quoted price for an identical asset or liability in an active market (e.g., an equity security traded on a major exchange) provides the most reliable fair value measurement and, if available, should be used to measure fair value in that particular market.

In practical terms, the list of instruments that likely qualify as Level 1 fair value measurements is fairly narrow. It includes:

• Listed equity securities traded in active, deep markets (e.g., NYSE, NASDAQ)
• London Metal Exchange futures contract prices
• On-the-run Treasury bills, notes, and bonds
• Exchange-traded futures and options
• Open-ended mutual funds with published daily NAV at which investors can freely subscribe to or redeem from the fund

  These are investments that do not use NAV as a practical expedient and, therefore, are still required to be leveled in the fair value hierarchy — unlike funds that use NAV as a practical expedient, as discussed in FSP 20.5.

• Closed-ended registered mutual funds (e.g., exchange-traded funds) traded on active markets (the exchange price may represent a Level 1 input)
• Many government-backed to-be-announced securities (TBAs)

Cleared transactions

Certain derivative transactions, such as interest rate and credit default swaps, are executed through clearinghouses.

Each day, the clearinghouse provides a “value mark” that dictates the amount owed by/to the counterparty. Because this value mark is not a value at which a reporting entity could open or close the trade at that particular point in time, the value mark is not a Level 1 fair value input.

Question FV 4-6
Can a single price source or quote be considered a Level 1 valuation?

PwC response

Maybe. Absent the source being transactions on an exchange, in general, a single source would not be a Level 1 input since a single market maker would almost, by definition, suggest an inactive market. However, in some rare cases, a single market maker dominates the market for a particular security such that trading in that security is active but all trades flow through that market maker. In those limited circumstances, a reporting entity may be able to support a determination that the input is Level 1.

Other than in this fact pattern, the reporting entity should determine if the single broker quote represents a Level 2 or Level 3 input. See key considerations in making this assessment in FV 4.5.3.

Question FV 4-7
Should a reporting entity that invests in a fund that invests primarily in exchange-traded equity securities look through the fund to determine the level of the fund in the fair value hierarchy?

PwC response

No. The reporting entity should first determine the appropriate unit of account (i.e., what is being measured). The unit of account is determined based on other applicable US GAAP or IFRS.

We would expect the unit of account for interests in mutual or alternative fund investments to be the interest in the fund itself, rather than the individual assets and liabilities held by the fund. Thus, the reporting entity should assess the categorization within the fair value hierarchy based on the investment in the fund itself and not the securities within the fund.

An investor cannot simply "look through" an interest in an alternative investment to the underlying assets and liabilities to estimate fair value or to determine the classification of the fair value measurement in the fair value hierarchy. Rather, the reporting entity should consider the inputs used to establish fair value of the fund and whether they were observable or unobservable.

The investment could be classified as Level 1 if the fair value measurement of the interest in the fund (not the underlying investments) was based on observable inputs that reflect quoted prices (unadjusted) for identical assets in active markets (i.e., the fund is exchange-traded).

Large number of similar assets and liabilities

ASC 820-10-35-41C(a) provides a practical expedient for the fair value measurement of a large number of similar assets or liabilities (e.g., debt securities) for which quoted prices in active markets are available, but not readily accessible. In accordance with this guidance, a reporting entity may measure fair value by using an alternative pricing method (e.g., matrix pricing) instead of obtaining quoted prices for each individual security, provided that the reporting entity demonstrates that the method replicates actual prices. If an alternative pricing method is used as a practical expedient, the resulting fair value measurement will be Level 2, not Level 1 as it would have been had the quoted prices been used.

Post-market close events

As discussed in ASC 820-10-35-41C(b), in some situations, significant events (e.g., principal-to-principal transactions, brokered trades, or announcements) may occur after the close of a market but before the end of the measurement date. When that is the case, a quoted market price may not be representative of fair value on the measurement date. Reporting entities should establish and consistently apply a policy for identifying and incorporating events that may affect fair value measurements. In addition, if a reporting entity adjusts the quoted price, the resulting measurement will not be classified in Level 1, but will be a lower-level measurement.

In general, the measurement date, as specified in each accounting standard requiring or permitting fair value measurements, is the “effective” valuation date. Accordingly, a valuation should reflect only facts and circumstances that exist on the specified measurement date (these include events occurring before the measurement date or that were reasonably foreseeable on that date) so that the valuation is appropriate for a transaction that would occur on that date.

4.5.4.2 Level 2 inputs

The categorization of an asset/liability as Level 1 requires that it is traded in an active market. If an instrument is not traded in an active market, it may fall to Level 2. Level 2 inputs are inputs that are observable, either directly or indirectly, but do not qualify as Level 1.

Level 2 inputs typically include:

• A dealer quote for a non-liquid security, provided the dealer is standing ready and able to transact
• Posted or published clearing prices, if corroborated with market transactions
• Vendor or broker provided indicative prices, if due diligence by the reporting entity indicates such prices were developed using observable market data 

Examples of instruments that are typically Level 2 measurements include:

• Most US public debt
• Short-term cash instruments
• Certain derivative products 
• Off-the-run Treasury bills, bonds and notes
• Mortgage-backed securities when valued by adjusting the quoted prices of TBAs)

Adjustments to Level 2 inputs

Adjustments to Level 2 inputs should include factors such as the condition and/or location of the asset/liability on the measurement date. An adjustment that is significant to the fair value measurement may place the measurement in Level 3 in the fair value hierarchy.

Extrapolating and interpolating data

ASC 820-10-35-48 indicate that a Level 2 input needs to be observable for substantially the full term of an asset or liability that has a contractual term. However, certain inputs derived through extrapolation or interpolation may be corroborated by observable market data (e.g., interpolating three-year yields using observable one- and five-year interest rate yields) and would be considered a Level 2 input.

For example, assume that the interest rate yield curve for index A has historically been correlated to the interest rate yield curve for index B, and market participants believe the indexes will continue to be correlated. Also, assume that the interest rate yield curve for index A is observable for three years, but the interest rate yield curve for index B is only observable for two years. A reporting entity could extrapolate the third year of the interest rate yield curve for index B based on years one and two and the correlation of the third year of interest rate yield curve for index A. In this example, the interest rate yield for index B for year three would be considered a Level 2 input.

However, extrapolating short-term data to measure longer-term inputs may require assumptions and judgments that cannot be corroborated by observable market data and, therefore, represent a Level 3 input. Then, the reporting entity would need to evaluate the significance of the input to determine if the resulting fair value measurement in its entirety is a Level 3 measurement.

Question FV 4-8
How would the fair value measurement of a foreign exchange (FX) contract that is based on interpolated information be classified in the fair value hierarchy?

PwC response

Generally, a fair value measurement that can be interpolated using observable market data (i.e., externally-quoted sources) would be a Level 2 valuation.

Assume there are quoted forward prices available for 30-day and 60-day FX contracts, and the reporting entity is valuing a 50-day contract. If the price can be derived through simple interpolation, the resulting measurement is a Level 2 valuation.

However, if the contract length is three years, FX rates are only quoted for the next two years, and there is no other observable market information to corroborate the rates in the third year, the input for year 3 would be a Level 3 input. If it is considered a significant input, the resulting fair value measurement would be Level 3.

4.5.4.3 Level 3 inputs

Reporting entities may use unobservable inputs to measure fair value if relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. These unobservable inputs are considered Level 3.

Even when Level 3 inputs are used, the fair value measurement objective remains the same—that is, to reflect an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs should reflect the assumptions that market participants would use when pricing the asset or liability (including assumptions about risk).

Level 3 inputs may include information derived through extrapolation or interpolation that cannot be directly corroborated by observable market data. In developing Level 3 inputs, a reporting entity need not undertake exhaustive efforts to obtain information about market participant assumptions; however, it should take into account all information that is reasonably available. Therefore, if a reporting entity uses its own data to develop Level 3 inputs, it should adjust that data if information is reasonably available that indicates market participants would use different assumptions.

Inputs that are typically unobservable and considered Level 3 include:

• Inputs obtained from broker quotes that are indicative (i.e., not firm and able to be transacted upon) or not corroborated with market transactions
• Management assumptions that cannot be corroborated with observable market data
• Vendor-provided prices, not corroborated by market transactions

Examples of instruments that are typically Level 3 measurements include:

• Complex instruments, such as longer-dated interest rate and currency swaps and structured derivatives
• Fixed income asset-backed securities, depending on the specific asset owned (i.e., the specific tranche), the nature of the valuation model used, and whether the inputs are observable
• Impairment testing of goodwill or indefinite-lived intangible assets
• Contingent consideration

4.5.5 Step 5: Assess disclosure required by the fair value standard

The disclosure requirements of the fair value standard can be divided into two areas: those explaining (1) the fair value of the entire asset or liability, and (2) the significant input(s) to the fair value measurement.

4.5.6 Step 6: Reassess

The categorization of a particular instrument in the fair value hierarchy may change over time. As markets evolve, certain ones may become more or less liquid, inputs may become more or less observable, and therefore, the level in the fair value hierarchy could change. Therefore, it is important to evaluate the continued appropriateness of the levels in which fair value measurements are categorized at each reporting date.

PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

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