Two appraisers value the same private equity stake. One pulls quoted prices from a thinly traded private market and reports $14M as Level 2. The other builds a discounted cash flow model with a 12% internal discount rate and reports $11M as Level 3. Same asset, different hierarchy levels, $3M swing on the balance sheet. The classification is not a label; it drives disclosure burden and audit scrutiny.
ASC 820 defines fair value and the framework used to measure it. Other standards trigger when fair value is required (impairments, financial instruments, business combinations, asset retirement obligations). ASC 820 supplies the how.
HIGH-FREQUENCY: Fair value is the price you would receive to sell an asset, or pay to transfer a liability, in an orderly transaction between market participants at the measurement date. Three pieces matter:
- Exit price, not entry price. What you paid is irrelevant after acquisition.
- Orderly transaction, not a forced sale or liquidation. Distress prices do not qualify.
- Market participants, not the holder. Their assumptions, their motivations, their data.
Common mistakes
- Confusing entry price with exit price. Carlton paid $40 per share for a stock now quoted at $42.10. Fair value is $42.10, the exit price. Selecting $40 (entry) gives the wrong answer. The exam will plant the historical cost as a trap choice.
- Misclassifying hierarchy level by the technique used. A DCF model alone does not make a measurement Level 3. If the DCF inputs are observable yield curves and market credit spreads, the measurement is Level 2. Level depends on input significance, not on technique name. Trap answer: Level 3 for any DCF.
- Recording a blockage discount on a large Level 1 position. A 50,000-share position priced at $42.10 fair-values to $2,105,000. Discounting for the size of the holding ("if we tried to sell it all, the market would dip") is prohibited at Level 1. The trap: $2,000,000 with a 5% blockage haircut.
Bottom line
- Fair value = exit price (what you would receive to sell), not entry price (what you paid), measured at the measurement date
- Hierarchy level is set by the lowest-level significant input, not the valuation technique
- Three approaches: market (comparables), income (DCF), cost (replacement); the chosen approach does not control the hierarchy level
- Level 1 = identical assets, active market. Level 2 = observable inputs. Level 3 = unobservable inputs
Exam shortcut
When given a measurement scenario, test inputs in this order: (1) is there a quoted price for the identical asset in an active market? Level 1. (2) Are all significant inputs observable in the market? Level 2. (3) Otherwise, Level 3. The technique name (DCF, market multiples, replacement cost) is a distractor; the input significance controls the level. Memory aids: Exit, not entry. Inputs, not technique. Lowest level wins.
The full lesson (about 2,534 words, 17 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- III.E1
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