Fair value measurements are crucial in accounting for mergers and acquisitions. They provide a standardized way to value assets and liabilities, ensuring accurate financial reporting and informed decision-making during complex transactions.

Understanding fair value hierarchy, valuation techniques, and disclosures is essential for accountants and financial professionals. These concepts help in assessing the reliability of fair value measurements and their impact on financial statements, particularly in M&A scenarios.

Fair value definition

• Fair value 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
• Represents an exit price from the perspective of a market participant holding the asset or owing the liability
• Determined based on assumptions market participants would use in pricing the asset or liability, including risk assumptions

Quoted prices in active markets

• The most reliable evidence of fair value comes from quoted prices in active markets for identical assets or liabilities
• An active market has sufficient frequency and volume of transactions to provide pricing information on an ongoing basis
• Examples include major stock exchanges (NYSE, NASDAQ) for publicly traded securities

Valuation techniques

• Used to estimate fair value when quoted prices in active markets are not available
• Techniques should maximize the use of relevant observable inputs and minimize the use of unobservable inputs
• Common valuation techniques include the market approach, income approach, and cost approach

Inputs to valuation techniques

• Inputs are assumptions market participants would use in pricing the asset or liability
• Inputs can be observable (based on market data) or unobservable (company's own data)
• Observable inputs include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar items in markets that are not active
• Unobservable inputs reflect the reporting entity's own assumptions about the assumptions market participants would use

Fair value hierarchy

• Categorizes fair value measurements into three levels based on the observability and significance of the inputs used
• Helps users assess the relative reliability of the fair value measurements
• Level 1 inputs are the most reliable, while Level 3 inputs are the least reliable

Level 1 inputs

• Unadjusted quoted prices in active markets for identical assets or liabilities accessible to the entity at the measurement date
• Provides the most reliable evidence of fair value and should be used without adjustment whenever available
• Example: Quoted stock prices on major exchanges for actively traded securities

Level 2 inputs

• Inputs other than Level 1 quoted prices that are observable for the asset or liability, either directly or indirectly
• Includes quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar items in markets that are not active
• Also includes inputs derived principally from or corroborated by observable market data through correlation or other means
• Example: Interest rate swaps valued using observable yield curves

Level 3 inputs

• Unobservable inputs for the asset or liability
• Used when observable inputs are not available
• Reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing the asset or liability
• Example: Private equity investments valued using discounted cash flow analysis with company-specific growth and discount rate assumptions

Present value techniques

• Used to estimate fair value by discounting future cash flows or costs
• Capture all the elements that market participants would consider in setting a price
• Can be applied to both assets and liabilities

Elements of present value measurement

• Estimate of future cash flows for the asset or liability being measured
• Expectations about possible variations in the amount and timing of the cash flows
• Time value of money, represented by the risk-free rate
• Price for bearing the uncertainty inherent in the cash flows (risk premium)
• Other factors market participants would consider (liquidity, credit risk)

Application to assets vs liabilities

• For assets, present value techniques consider the cash inflows expected to be generated by the asset over its life and the proceeds from its ultimate disposal
• For liabilities, present value techniques consider the cash outflows expected to be required to settle the liability in the normal course of business

Discount rate adjustment technique

• Uses a single set of cash flows and a discount rate that incorporates all the expectations about future cash flows and risk premiums
• Discount rate is derived from observed rates of return for comparable assets or liabilities traded in the market
• Most commonly used for debt securities with contractual cash flows

Expected cash flow technique

• Uses multiple cash flow scenarios to capture the range of possible outcomes and assigns probability weights to each scenario
• Resulting probability-weighted cash flows are then discounted at a risk-free rate
• More complex but provides a better representation of uncertainty when cash flows are not contractual

Highest and best use

• Considers the use of a non-financial asset by market participants that would maximize its value
• May be different from the asset's current use by the reporting entity
• Provides a basis for measuring fair value even if the entity intends a different use

Valuation premise for non-financial assets

• In-use valuation assumes the asset is used in combination with other assets as a group (as installed or configured for use)
• In-exchange valuation assumes the asset is used on a standalone basis

In-use vs in-exchange valuation

• If an asset's highest and best use is in-use, fair value considers the asset's use in combination with other assets (even if the entity intends to use it on a standalone basis)
• If an asset's highest and best use is in-exchange, fair value considers the asset's use on a standalone basis (even if the entity intends to use it in combination with other assets)
• Highest and best use is determined from the perspective of market participants, even if the entity intends a different use

Liabilities and credit risk

• Fair value of a liability reflects the effect of nonperformance risk (the risk the entity will not fulfill the obligation)
• Nonperformance risk includes the reporting entity's own credit risk
• Fair value of a liability is not adjusted for restrictions preventing its transfer

Nonperformance risk

• Encompasses both the entity's own credit risk and any other risks that might affect the likelihood the obligation will not be fulfilled (asset-specific risk)
• Should be the same before and after the transfer of the liability
• Can be measured using the credit spreads of the entity's own traded debt or credit default swap prices

Restrictions preventing transfer

• The fair value of a liability is not adjusted to reflect restrictions that prevent its transfer
• Transfer restrictions are specific to the liability and would not transfer to the market participant
• Example: Debt covenants that restrict transfer to another party do not affect the fair value of the debt

Measuring fair value of investments

• Applies to investments in subsidiaries, associates, and joint ventures as well as debt and equity securities
• Specific considerations for investment companies and entities that qualify for the practical expedient

In investment companies

• Investment companies measure their investments at fair value, including controlling interests in investees
• Fair value provides the most relevant information to investors in an investment company
• Investments are measured at fair value even if the investment company has the ability to exercise significant influence or control over the investee

Practical expedient

• Entities are permitted to measure fair value of certain investments using net asset value per share (or its equivalent) as a practical expedient
• Applies to investments that do not have readily determinable fair values and are in entities that calculate net asset value per share
• Examples include certain hedge funds, private equity funds, and real estate funds
• Disclosures are required about the nature and risks of investments measured using the practical expedient

Fair value at initial recognition

• Generally, the transaction price (the price paid or received) represents the fair value of an asset or liability at initial recognition
• In some cases, the transaction price may not represent fair value (e.g., related party transactions, transactions under duress)

Transaction price vs fair value

• If the transaction price differs from fair value at initial recognition, the resulting gain or loss is recognized in profit or loss unless otherwise specified by the applicable accounting standard
• Gains or losses may be deferred if the fair value measurement uses significant unobservable inputs (Level 3)

Day 1 gains or losses

• Arise when the transaction price differs from the fair value measured using a valuation technique with unobservable inputs
• Recognized in profit or loss only to the extent they relate to a change in a factor market participants would consider in setting a price
• Unrecognized gains or losses are deferred and amortized over the life of the asset or liability

Disclosures about fair value

• Entities are required to provide disclosures about their fair value measurements to help users assess the valuation techniques and inputs used
• Disclosures vary based on the level of the fair value hierarchy and the significance of the measurements to the entity's financial position and performance

Valuation techniques and inputs

• Entities must disclose the valuation techniques and inputs used for each class of assets and liabilities measured at fair value
• Changes in valuation techniques and the reasons for those changes must also be disclosed
• Quantitative information about significant unobservable inputs used in Level 3 measurements is required

Transfers between hierarchy levels

• Entities must disclose the amounts of any transfers between levels of the fair value hierarchy and the reasons for those transfers
• Transfers are recognized as of the beginning of the reporting period
• Separate disclosures are required for transfers into and out of each level

Level 3 fair value measurements

• Entities must provide a reconciliation of the opening and closing balances for Level 3 measurements, showing total gains or losses, purchases, sales, issues, settlements, and transfers
• Unrealized gains or losses recognized in profit or loss for assets and liabilities still held at the end of the period must be separately disclosed
• Narrative description of the sensitivity of Level 3 measurements to changes in unobservable inputs is required if those changes would result in a significantly different fair value