COVID-19 – The Fair Value Hierarchy and Disclosures under Topic 820, Fair Value Measurements
Today, we’ll explore possible accounting effects of the coronavirus on fair value measurements under Topic 820, Fair Value Measurement. In particular, we’ll focus on the fair value hierarchy and disclosures about fair value measurements.
If you haven’t seen it, please check out our related post which discusses the definition of fair value and valuation approaches, techniques, and inputs in light of the coronavirus.
The Fair Value Hierarchy
The coronavirus disease 2019 (COVID-19) may have a significant impact on how you measure the fair value of assets and liabilities under Topic 820. In turn, this affects the classification of your fair value measurements in the fair value hierarchy.
Fair value measurements are classified into one of three levels, based on the inputs used to determine the measurement:
- Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities.
- Level 2 inputs are observable inputs not included in Level 1 (such as quoted prices in active markets for similar assets or liabilities).
- Level 3 inputs are unobservable inputs.
Due to the fallout from the coronavirus, you may need to use different inputs or the source of those inputs may change. Consequently, you may have to reclassify a fair value measurement. For instance, consider:
- Do you still have quoted prices available?
- Do you need to make an adjustment to an observable input to reflect facts and circumstances?
- Do you have to replace an observable input with an unobservable input?
Topic 820 describes some situations in which an adjustment to a Level 2 input may be necessary. Depending on the facts and circumstances, the adjustment may result in reclassifying the fair value measurement to Level 3.
In general, an entity must not make an adjustment to a Level 1 input. However, in limited circumstances, an adjustment may be required. One of those circumstances is: a quoted price in an active market does not represent fair value as of the measurement date. For instance, this can happen if major events occur after a market closes but before the measurement date. Those events might include transactions in another market (such as a principal-to-principal or brokered market) or announcements. Recently, we’ve seen announcements with immediate and substantial effects on asset valuations. For example, Carnival Corporation & Plc (CCL) stock recently jumped over 7% on the news that it would offer its cruise ships as temporary hospitals. Domino’s Pizza, Inc. (DPZ) shot up over 11% when it announced plans to hire more workers to meet demand for takeout and deliveries. What if, after hours, the government declares a new drug approved to treat coronavirus…. or a concrete bailout for a particular industry or company? Could this happen to an industry or company where you have exposure and could the impact be material? A significant event could require adjustment to a Level 1 input if that event takes place in the window between market close and the measurement date. Any adjustment, however, would require substantial judgment and necessitate supporting documentation.
Disclosure takes on heightened importance in periods of uncertainty and rapidly-changing market conditions. Make sure your disclosures meet the objectives and requirements laid out in Section 820-10-50, Fair Value Measurement—Overall—Disclosure. In particular, it will be important to highlight changes to your fair value measurements due to the coronavirus. For instance, stakeholders will want to understand any changes in the inputs and valuation techniques used to measure fair value. Stakeholders also may focus on reclassifications between levels of the fair value hierarchy (such as changes from Level 1 to Level 2 or Level 2 to Level 3). Given the pace of change, a reporting entity should also be on the lookout for subsequent events requiring disclosure under Topic 855, Subsequent Events.
The accounting effects of the coronavirus on the fair value hierarchy may be substantial. The same is true for your related fair value disclosures. COVID-19 is a rapidly evolving situation. In the coming weeks and months, we may witness additional accounting effects as the full impact of this disease manifests itself. We encourage you to stay informed on accounting and financial reporting developments.