ASC 820-10-35-24A describes three main approaches to measuring the fair value of assets and liabilities: the market approach, the income approach, and the cost approach. ASC 820-10-55-3A through ASC 820-10-55-3G also provides examples of valuation techniques that are consistent with each valuation approach. In practice, valuation professionals often refer to valuation methods. In our experience, valuation techniques and methods are synonymous. We use the terms interchangeably in this guide.
ASC 820-10-35-24A and ASC 820-10-50-2(bbb) clarify meaning of the terms “valuation technique” and “valuation approach.” At times, the literature uses these terms interchangeably; however, they were designed to have different meanings. While “valuation technique” is not a defined term, the guidance provides examples of valuation techniques, indicating that valuation techniques are more granular than valuation approaches. In certain instances, a valuation of a single instrument or a class of instruments may include multiple approaches and/or techniques.
The technical correction also clarified the disclosure requirement relating to changes in valuation approaches and techniques. See FSP 20 for discussion of the disclosure requirement.

4.4.1 Market approach

The market approach is often used as the primary valuation approach for financial assets and liabilities when observable inputs of identical or comparable instruments are available. ASC 820-10-55-3A through ASC 820-10-55-3B defines the market approach.

ASC 820-10-55-3A

The market approach uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business.

ASC 820-10-55-3B

For example, valuation techniques consistent with the market approach often use market multiples derived from a set of comparables. Multiples might be in ranges with a different multiple for each comparable. The selection of the appropriate multiple within a range requires judgment, considering qualitative and quantitative factors specific to the measurement.

The market approach is also used commonly for real estate when comparable transactions and prices are available, and can be used to value a business or elements of equity (e.g., NCI). The market approach may also be used as a secondary approach to evaluate and support the conclusions derived using an income approach.
Matrix pricing is a valuation technique within the market approach. It is a mathematical technique that may be used to value debt securities by relying on the securities’ relationship to other benchmark quoted prices and is commonly used to price bonds, most notably corporate and municipal bonds.

4.4.2 Cost approach

The cost approach assumes that the fair value would not exceed what it would cost a market participant to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence. ASC 820-10-55-3D defines the cost approach.

ASC 820-10-55-3D

The cost approach reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost).

This approach assumes that a market participant buyer would not pay more for an asset than the amount for which it could replace the service capacity of that asset. Obsolescence includes “physical deterioration, functional (technological) obsolescence, and economic (external) obsolescence.” Therefore, in using a replacement cost approach, a reporting entity would need to consider the impact of product improvements.
The cost approach is typically used to value assets that can be easily replaced, such as property, plant, and equipment.

4.4.3 Income approach

The income approach is applied using the valuation technique of a discounted cash flow (DCF) analysis, which requires (1) estimating future cash flows for a certain discrete projection period; (2) estimating the terminal value, if appropriate; and (3) discounting those amounts to present value at a rate of return that considers the relative risk of the cash flows and the time value of money. Terminal value represents the present value at the end of the discrete projection period of all subsequent cash flows to the end of the life of the asset or into perpetuity if the asset has an indefinite life.
ASC 820-10-55-3F defines the income approach.

ASC 820-10-55-3F

The income approach converts future amounts (for example, cash flows or income and expenses) to a single current (that is, discounted) amount. When the income approach is used, the fair value measurement reflects current market expectations about those future amounts.

Income approaches are used to measure the value of liabilities, intangible assets, businesses (e.g., for purposes of computing an internal rate of return, or to measure the fair value of an NCI or previously held equity interest when the price is not observable), and financial instruments when those assets are not traded in an active market.
ASC 820-10-55-4 discusses the use of present value techniques in the determination of fair value. Those techniques include the “discount rate adjustment” technique and the “expected cash flow (expected present value)” technique.
ASC 820 neither prescribes the use of one single specific present value technique nor limits the use of specific present value techniques to measure fair value, instead indicating that a reporting entity should use the appropriate technique based on facts and circumstances specific to the asset or liability being measured and the market in which they are transacted, and with all valuation techniques, maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs.
ASC 820-10-55-5 indicates that the following key elements from the perspective of market participants should be captured in developing a fair value measurement using present value:

Excerpt from ASC 820-10-55-5

a. An estimate of future cash flows for the asset or liability being measured.
b. Expectations about possible variations in the amount and timing of cash flows representing uncertainty inherent in the cash flows.
c. The time value of money, represented by the rate on risk-free monetary assets that have maturity dates or durations that coincide with the period covered by the cash flows and pose neither uncertainty in timing nor risk of default to the holder (that is, a risk-free interest rate)….
d. The price for bearing the uncertainty inherent in the cash flows (that is, a risk premium).
e. Other factors that market participants would take into account in the circumstances.
f. For a liability, the nonperformance risk relating to that liability, including the reporting entity’s (that is, the obligor’s) own credit risk.

ASC 820-10-55-6 also discusses general principles that govern the application of all present value techniques.

ASC 820-10-55-6

  1. Cash flows and discount rates should reflect assumptions that market participants would use when pricing the asset or liability.
  2. Cash flows and discount rates should take into account only the factors attributable to the asset or liability being measured.
  3. To avoid double counting or omitting the effects of risk factors, discount rates should reflect assumptions that are consistent with those inherent in the cash flows. For example, a discount rate that reflects the uncertainty in expectations about future defaults is appropriate if using contractual cash flows of a loan (that is, a discount rate adjustment technique). That same rate should not be used if using expected (that is, probability-weighted) cash flows (that is, an expected present value technique) because the expected cash flows already reflect assumptions about the uncertainty in future defaults; instead, a discount rate that is commensurate with the risk inherent in the expected cash flows should be used.
  4. Assumptions about cash flows and discount rates should be internally consistent. For example, nominal cash flows, which include the effect of inflation, should be discounted at a rate that includes the effect of inflation. The nominal risk-free interest rate includes the effect of inflation. Real cash flows, which exclude the effect of inflation, should be discounted at a rate that excludes the effect of inflation. Similarly, after-tax cash flows should be discounted using an after-tax discount rate. Pretax cash flows should be discounted at a rate consistent with those cash flows.
  5. Discount rates should be consistent with the underlying economic factors of the currency in which the cash flows are denominated.

In practice, adjusting the expected cash flows to reflect systematic risk is often difficult. In most instances, therefore, for nonfinancial assets, the discount rate that is applied to cash flows incorporates systematic or non-diversifiable risk, which is often represented by a weighted-average cost of capital that would be required by a marketplace participant. However, adjustments made to the discount rate tend to underweight risk. Additionally, the discount rate is a single point estimate, while expected cash flows are weighted by different probabilities of occurrence in the future.

4.4.4 Application of valuation techniques

Figure FV 4-1 highlights common valuation techniques within each of the valuation approaches.
Figure FV 4-1
Valuation approaches and techniques
Cost approach
Market approach
Income approach
  • Replacement cost method
  • Market pricing based on recent transactions
  • Relief from royalty method
  • Reproduction cost method
  • Multiples
  • Price premium method
  • Multi-period excess-earnings method (MEEM)
  • Incremental cash flow method
  • Contingent claims/real option models
  • Discounted cash flow method

The selection of appropriate valuation techniques may be affected by the availability of relevant inputs and the relative reliability of the inputs, or by the type of asset or liability being valued. In some cases, one valuation technique may provide the best indication of fair value (e.g., the use of the market approach in the valuation of an actively traded equity security); however, in other circumstances, multiple valuation techniques may be appropriate (e.g., in valuing a reporting unit or cash-generating unit for purposes of step 1 of a goodwill impairment test).
The application of each technique may indicate different estimates of fair value. These estimates may not be equally representative of the fair value due to the assumptions made in the valuation or the quality of inputs used. Using multiple valuation techniques can act as a check on these assumptions and inputs. The reporting entity should carefully evaluate the inputs and assumptions used if the range of values is wide. Fair value should be based on the most representative point within the range considering the specific circumstances.

ASC 820-10-35-24C

If the transaction price is fair value at initial recognition and a valuation technique that uses unobservable inputs will be used to measure fair value in subsequent periods, the valuation technique shall be calibrated so that at initial recognition the result of the valuation technique equals the transaction price. Calibration ensures that the valuation technique reflects current market conditions, and it helps a reporting entity to determine whether an adjustment to the valuation technique is necessary (for example, there might be a characteristic of the asset or liability that is not captured by the valuation technique). After initial recognition, when measuring fair value using a valuation technique or techniques that use unobservable inputs, a reporting entity shall ensure that those valuation techniques reflect observable market data (for example, the price for a similar asset or liability) at the measurement date.

As discussed in ASC 820-10-35-25 through ASC 820-10-35-26, reporting entities should consistently apply the valuation techniques used to measure fair value for a particular type of asset or liability. However, it is appropriate to change a valuation technique or an adjustment that is applied to a valuation technique if the change will result in a measurement that better represents fair value; for instance, a change in a particular technique’s weighting when multiple valuation techniques are used may be appropriate based on changes in facts and circumstances. A change in valuation technique may also be warranted as new markets develop, new information becomes available, information previously used is no longer available, valuation techniques improve, or market conditions change. Revised valuations resulting from a change in the valuation technique or its application are accounted for as a change in accounting estimate, with the change impacting the current and future periods, if applicable. Application of the income approach to foreign currencies

When a discounted cash flow analysis is done in a currency that differs from the currency used in the cash flow projections, the cash flows should be translated using one of the following two methods:
  • Discount the cash flows in the reporting currency using a discount rate appropriate for that currency. Convert the present value of the cash flows at the spot rate on the measurement date.
  • Use a currency exchange forward curve, if available, to translate the reporting currency projections and discount them using a discount rate appropriate for the foreign currency.
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