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The purpose of this memo is to evaluate the issues surrounding the relevance and reliability tradeoffs between the three levels of the fair value hierarchy.
The fair value of an asset or liability is the amount at which that instrument could be bought, sold, or settled in a current transaction between willing parties, other than in liquidation.
The fair value of an asset or a liability should be obtained initially from quoted prices in an active market. In the absence of these quoted prices, an estimate fair value should be used based on the best and most accurate information available. In many cases quoted market prices are unavailable which results in difficulties when making estimates of fair value, and raise the issues of relevance and reliability of the fair value measurements.
In today's active markets, users, investors or bankers are more interested in what the asset is worth today rather than the various prices involved historically. Fair value measurements that have impacted on financial statements, have allowed entity's to reflect current market prices in their balance sheets, whether it is through the recognition of a profit or a loss.
Previously, financial accounting statements displayed a historical cost method, where the acquisition of an asset was recorded at the historical cost and did not reflect inflation, or any other changes within the given period of the specified asset or liability. As of recently the International Accounting Standards Board (IASB) has amended the International Financial Reporting Standards (IFRS) and introduced a three level fair value hierarchy.
The fair value hierarchy consists of three levels of measurements to help obtain a fair value for an instrument wether it has an active market or not. Level one of the hierarchy is intended for instruments (asset or liability) that have an active market. A price or a quote can be obtained readily and regularly from a past transaction, a dealer or an agency for instruments of an identical nature. This level of the hierarchy is only used for purchases or sales of an item that have an active market and can be purchased at anytime. It also has proven to be a reliable and relevant method of determining the value of an asset or liability as it uses past transactions (historical cost) to determine the value of the instrument to the entity. A definite example of a level one measurement within an active market is in the trading of stock within the New York Stock Exchange. This is because quoted prices are given, the market is active and the fair value is reliably represented within this measurement. The new value in the balance sheet from the tradeoffs within the stock exchange will reflect a relevant and reliable value for an investor or other users.
Level two of the fair value hierarchy is aimed at measuring the fair value of instruments within active or non-active markets, other than those that have been exhausted in level one. This tier within the hierarchy consists of quoted prices for those assets and liabilities which are not identical but have similarities. This technique is not as reliable as tier one as the instrument is restricted in having no identical forms. Therefore tier two of the hierarchy develops its most efficient form in which to obtain the fair value, developing the one most faithfully represented. An example representing tier two is given in the valuation of a piece of land that is owned by an entity. Fair value measurement for the given land will be based on the similar surrounding lands and their quoted/market prices, which will be used to derive an estimate price for the land at hand. Tier two gives a less reliable outcome than tier one as various estimates based on comparability of instruments develops a result with less certainty that tier one for the user.
Tier three of the fair value hierarchy outlines a technique in which is used when there are no active markets for the given instrument. It also displays a measurement in which is completely unobservable, where the instrument in which the reporting entity attempts to retrieve the fair value for cannot be physically observed like in tier one and two of the hierarchy. For the users of this measurement it displays the least amount of reliability in the outcome within the three tiers. This is because of the unobservable characteristic within the measurement, and is based on only assumptions given by the reporting entity, displaying little relevance, and no reliability. Although with this being said the reliability can be displayed with great use to the users with the fair value that is given, only when they are retrieved in a legitimate way, with the utmost precision being carried out during the measurement within the reporting entity. Therefore level three if carried out correctly can display great information for the decision-usefulness of the users. An example of level three is outlined within listed securities, in markets which are completely inactive and no quoted prices can be obtained. Limited information is available to the users, where the price changes constantly.
Preparing financial statements under the new amended fair value hierarchy disclosure, may increase the relevance of the information in the balance sheet while at the same time decrease its reliability. The balance sheet under the fair value measurement reflects current market value where this information will be more relevant to current investors and creditors as opposed to historical cost which is considered more reliable. If the balance sheet can be easily liquidated, fair value accounting will have less issues in relation to reliability. In conclusion, relevance in the current economy is of more importance than reliability, as the end user is more interested in the current market price reflected in the balance sheet, than that of the previous historical cost method. Overall for the investors, level one of the hierarchy is considered to be the most relevant and reliable level compared to level two and three, which has less reliability and more uncertainty in their fair values.