3 Levels of Fair Value Accounting in US GAAP
Under US GAAP, there are 3 levels applicable to this given standard FAS 157:
- Only level 1 can be determined directly by “Mark to market”.
- Level 2 and 3 are only modeled (mark to market-model) based on observations etc.
The following article is an extract from article "Fair Value Accounting – Fact Or Fancy?" written by Andrew Wagner, California State University, Stanislaus, USA and Don Garner, California State University, Stanislaus, USA in Journal of Business & Economics Research – November, 2010.
Fair Value Accounting is intended to represent value rather than historical cash flows and so, presumably, would be preferable to the investor who is primarily concerned with this question. However, the investor is also concerned with risk and transparency and is therefore looking for financial statements with verifiable numbers.
This is not a problem with level 1 FVA because everyone agrees on what the price of a given security was at a given time if that security had a quoted price in an active market at that time, but for levels 2 and 3 FVA the numbers are not verifiable.
For the financial statement to be useful to those using it to make business and investment decisions, the financial position of the firm must be verifiably disclosed with accuracy. Particularly with levels 2 and 3 FVA, the use of mark to market accounting, instead of historical cost accounting, relies on assumed inputs to pricing models (such as prevailing discount rates for similar securities) and has placed emphasis on future cash flows, while considerably less emphasis has been placed on the reliability and integrity of information. Thus, it provides misrepresentation of asset valuation especially at the moment we deal with intangible assets (as it is hard to get its valuation based on market approach). We can quote the example of patents valuation.