Last Wednesday, I enjoyed our most recent FASRI Round Table.  Ben Couch discussed the new guidance for making Fair Value Measurements (hereafter, FVM) as well as the new disclosures about FVM.  Part of the discussion centered distinguishing between level 2 and 3 measurements.  For a FVM that uses some market information, how does the accountant decide that the measurement is predominantly based on observable inputs (level 2) versus the FVM is based on significant use of unobservable inputs (level 3)?  Further, is classification into level 2 versus level 3 important?

The answer to the latter is a clear “yes” because the new guidance requires substantially more disclosures for level 3 than for level 2.  This led to some very interesting discussion, which unfortunately was not archived.  In particularly, if you look at the first slide deck that Phil posted, slides 6 and 7 discuss the additional disclosures.  The reporting entity will group assets into categories, and for each category, the company must disclose the type of valuation technique used and the unobservable inputs.  Ben mentioned a few of FVM approaches currently used by companies:

non-binding brokers quotes:  The reporting entity gets an estimated price from a broker.  Since the broker is not offering to buy at the quoted price (hence the term “non-binding”), the broker might spend very little time preparing the FVM.  Another problem is that the reporting entity must ascertain details underlying the broker’s methodology in order to comply with the new disclosure requirements, but brokers are hesitant to provide information about their proprietary pricing models.

in house valuation experts:  For some reporting entities, executing the company’s business model requires frequent FVM’s.  These companies may hire valuation experts for other reasons, and as a result, will generate its own FVM for financial reporting.

binding broker quotes:  The broker promises to buy the asset for the quoted price (quote expires after a few days).  This almost sounds like level 1 FVM to me.

Some other FVM approaches were mentioned briefly, but I do not recall what they were.

Academic accounting researchers have shown great interest in companies’ accounting choices.  At first, the new FVM guidance that Ben discussed appears to mandate accounting policy, which makes it a poor venue for studying accounting choice.  But what seems unique is that firms can choose how to comply with the mandate (measure FVM using non-binding broker quotes, in house estimates, binding broker quotes, or multiple methods), and the firms are asked to make fairly transparent disclosures about these choices.

I asked Ben what factors are expected to drive the choice of FVM method.  One factor is whether in house valuation expertise is available, because if this expertise does not already exist, he doubted entities would develop it just for complying with the new guidance.  Second, he expected market pressure over time might influence the choice; the hypothesis (although he did not label it this way) went as follows – companies initially disclose a methodology that is pretty weak and subject to significant errors (e.g., non-binding broker quotes or FVM’s prepared by in house experts using questionable inputs), the market applies a larger cost of capital to those companies, the companies improve their FVM methods and disclosures, and the cost of capital falls.

Obviously an archival test of this hypothesis will have to wait until we have a long enough time-series of disclosures.  But I expect some academics will be looking closely at the new disclosures, either as preparation for future research or for interesting class discussions about accounting disclosure choices.