Scope

ASC 820 establishes a single framework for measuring fair value across all topics that require or permit fair value measurement, and the related disclosure requirements. It does not require new fair value measurements — other Topics determine when fair value applies; ASC 820 governs how to measure it.

The framework applies to fair value measurements throughout US GAAP, including:

ASC 805 — Business combinations (acquired assets and liabilities)
ASC 815 — Derivatives
ASC 320 / 326 — Investment securities
ASC 350 / 360 — Impairment testing
ASC 718 — Stock-based compensation
ASC 825 — Fair value option
ASC 842 — Leases (initial measurement of certain components)

Definition

Fair value is 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. This is an exit price, not an entry price.

Key elements:

Orderly transaction — exposure to the market for a period before the measurement date sufficient to allow for usual and customary marketing activities. Not a forced or distressed sale.
Market participants — buyers and sellers in the principal market (or most advantageous market) that are independent, knowledgeable, able to transact, and willing to transact.
Measurement date — the reporting date for the asset or liability.
Exit price — what would be received in a sale, not what was paid in the purchase.

The exit price orientation matters for instruments where bid-ask spreads exist. The exit price is generally the bid price for assets and the ask price for liabilities (for an entity that owns the asset and would sell it, or owes the liability and would settle it).

The three-level fair value hierarchy

ASC 820 establishes a hierarchy that prioritizes the inputs to valuation techniques:

Level 1 — Quoted prices in active markets for identical assets or liabilities. Highest priority. Examples: publicly-traded common stock, exchange-traded Treasury bonds, exchange-traded options.

Level 2 — Observable inputs other than Level 1 quoted prices. Includes:

Quoted prices for similar assets or liabilities in active markets
Quoted prices for identical or similar assets/liabilities in markets that are not active
Observable inputs other than quoted prices (interest rates, yield curves, credit spreads, implied volatilities)
Inputs derived principally from or corroborated by observable market data

Examples: corporate bonds with broker quotes, interest rate swaps, FX forwards.

Level 3 — Unobservable inputs. Inputs developed using the best information available, which may include the entity's own data, adjusted as necessary if reasonably available information indicates that other market participants would use different data.

Examples: private equity investments, long-dated derivatives in inactive markets, complex structured products, restricted stock, intangibles in business combinations.

The hierarchy applies to the lowest-level input that is significant to the measurement. A measurement that uses both Level 2 and Level 3 inputs, where the Level 3 inputs are significant, is classified as Level 3 in its entirety.

Valuation techniques

ASC 820-10-35-24 identifies three valuation approaches:

Market approach — uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. Examples: market multiples (revenue, EBITDA), guideline public company analysis, guideline transaction analysis.
Cost approach — reflects the amount that would be required to replace the service capacity of an asset (current replacement cost). Most relevant for assets with limited resale markets (specialized equipment, internally-developed software).
Income approach — converts future amounts (cash flows or earnings) to a single present amount (discounted). Examples: DCF, present value of expected cash flows, option pricing models, multi-period excess earnings method (MPEEM) for customer relationships.

The entity selects the technique(s) that are appropriate in the circumstances and for which sufficient data are available. Multiple techniques can be used and their results weighted; consistency in technique selection is important across reporting periods unless changes in circumstances warrant a switch.

Disclosure requirements (ASC 820-10-50)

Fair value measurements for each class of assets and liabilities
Level in the hierarchy (1, 2, or 3)
Transfers between levels and the reasons for transfers
For recurring Level 3 measurements: reconciliation of beginning to ending balances (purchases, sales, transfers, gains/losses recognized in earnings vs. OCI)
For Level 3 measurements: quantitative information about significant unobservable inputs and a description of the valuation processes used
Sensitivity analysis for Level 3 recurring measurements
Highest and best use for non-financial assets (if different from current use)

The Level 3 disclosures are the most analytically dense. Disclosed unobservable inputs include things like discount rates, credit spreads, prepayment speeds, default rates, recovery rates, and growth rates. Analysts use these disclosures to assess management's valuation judgment.

Highest and best use (non-financial assets)

For non-financial assets, the fair value is determined assuming the asset's highest and best use by market participants — the use that would maximize the value of the asset (or the group of assets and liabilities within which the asset would be used).

The current use is presumed to be the highest and best use unless market or other factors suggest otherwise. A different highest-and-best-use assumption requires evidence that market participants would actually use the asset differently.

Liabilities — non-performance risk

Fair value of a liability reflects the entity's own credit risk (non-performance risk). When an entity's credit deteriorates, the fair value of its liabilities declines (because a market participant would require a higher yield to assume them). This produces the counter-intuitive accounting outcome where deteriorating credit produces a gain on fair-valued liabilities.

The fair value option election under ASC 825 brings this issue into play for non-derivative liabilities. ASU 2016-01 required that changes in fair value attributable to changes in own credit risk be presented in OCI rather than earnings, reducing the P&L noise.

Common pitfalls

Misclassifying within the hierarchy. A bond with a broker quote where the broker is the only market maker may look like Level 2 but is often Level 3 if the broker quote isn't corroborated by transaction data. Classification matters for disclosure and for the appropriate audit procedures.
Stale Level 3 inputs. Discount rates, growth rates, and other Level 3 inputs need to be updated each reporting date. Carrying forward last year's assumptions is a common audit finding.
Inconsistent valuation technique application. Switching between DCF and market multiples between periods without a documented reason for the change creates earnings volatility that isn't economically driven.
Treating current use as automatic highest and best use. Auditors will ask for evidence that market participants would use the asset as the entity does. Property held for investment vs. operating use is a common challenge.
Ignoring blockage discounts and control premiums where they apply (or applying them where they don't). ASC 820 generally prohibits blockage discounts (for assets held in large quantities relative to trading volume) for Level 1 instruments. Control premiums are appropriate for non-controlling interest valuations in business combinations.

Operator note

Fair value measurement is the discipline where the auditors push hardest. At Intersil during the M&A run, the ASC 820 framework applied to every purchase price allocation — fair value of acquired tangible assets, fair value of identifiable intangibles, fair value of contingent consideration, fair value of any non-controlling interest. Each of those measurements lived in Level 3, with significant unobservable inputs.

The valuation reports (typically from a Big 4 or specialized valuation firm) carried the technical detail, but the in-house finance team owned the defense of the assumptions. I spent a lot of audit hours walking through why customer attrition rates were what they were, why the royalty rate for trade name was what it was, why the contributory asset charges in the MPEEM were calibrated as they were. Each assumption had to be supportable to a market-participant standard, not an entity-specific standard.

The lesson that applied across all of those engagements: the audit is going to test the unobservable inputs, period. Build the support file at the time of the valuation, not at audit time. The valuation firm produces the report; the company owns the defense. If the firm engagement ended six months before the audit and the lead appraiser has moved on, the company is the only party who can defend the assumptions.

For consulting clients, the most common ASC 820 issue I see is on contingent consideration. A simple earn-out with one threshold gets valued at the threshold probability times the payment — which is wrong because it ignores the option value below the threshold and the payment cap above it. Proper valuation requires Monte Carlo simulation or a closed-form option model. Companies that don't engage a valuation firm for these measurements often under-state or over-state the liability at close, then drive material P&L volatility when reality diverges.

Related references

ASC 805 — Business Combinations (PPA fair value measurements)
ASC 350 / 360 — Impairment testing
ASC 326 — Credit losses (uses fair value for AFS)
ASC 825 — Fair Value Option
IFRS 13 — Fair Value Measurement (substantively converged international counterpart)