Required Disclosures

22.3 Required Disclosures

Accurate and transparent disclosures are a critical component of fair value measurement reporting. They provide financial statement users with the context and data necessary to evaluate an entity’s valuation methodologies, assess measurement uncertainty, and identify the inherent risks associated with fair value estimations. This section addresses U.S. GAAP disclosure requirements under ASC 820 (Fair Value Measurement) and offers comparative insights into IFRS requirements (primarily IFRS 13, “Fair Value Measurement”). We will examine the key elements of required disclosures, offer sample footnotes for recurring and nonrecurring fair value measurements, discuss transfers between different hierarchy levels, and illustrate how to present a sensitivity analysis for Level 3 measurements.

Overview of Fair Value Disclosure Objectives

Fair value disclosures exist to:

• Enhance the consistency, relevance, and comparability of fair value measurements
• Enable users to assess valuation methodologies and their effects on financial performance
• Uncover measurement uncertainty where greater judgment or complexity is involved
• Provide insights into transfers between Levels 1, 2, and 3, as well as changes in assumptions for recurring and nonrecurring measurements

Under ASC 820 (U.S. GAAP) and IFRS 13 (IFRS), disclosures are grouped based on whether assets and liabilities are measured at fair value on (a) a recurring basis or (b) a nonrecurring basis. Both frameworks require details on the fair value hierarchy and qualitative/quantitative information about assumptions used for Level 3 valuations. Understanding the differences and similarities between these frameworks is key for multinational corporations and entities that issue financial statements under both GAAP and IFRS.

Recurring vs. Nonrecurring Fair Value Measurements

A crucial distinction arises between fair value measurements that occur on a recurring basis (e.g., measured at fair value at each fiscal period, such as investment securities in an active market) versus a nonrecurring basis (e.g., only measured at fair value once certain conditions apply, such as impaired assets measured at fair value when an impairment is recognized).

• Recurring Fair Value Measurements

• These measurements happen each reporting period. Examples include equity investments held at fair value, debt investments classified as trading securities, and derivative instruments that require ongoing fair value adjustments.

• Nonrecurring Fair Value Measurements

• These occur due to particular events or circumstances, such as impairment testing or business combinations. Examples include intangible assets written down to fair value after an impairment indicator is triggered, or assets acquired in a business combination measured at fair value on the acquisition date.

Both categories require separate disclosures under ASC 820 and IFRS 13.

Primary Disclosure Requirements

Entities are generally required to disclose the following details regarding fair value measurements:

• The fair value hierarchy level (Levels 1, 2, or 3) for each asset and liability measured at fair value
• The valuation techniques and inputs used to measure fair value
• For recurring and nonrecurring fair value measurements, an explanation regarding the reason for the measurement (if nonrecurring)
• For Level 3 measurements, a reconciliation of the beginning and ending balances, along with significant transfers in and out of Level 3
• Details about the sensitivity of Level 3 measurements to changes in unobservable inputs (sensitivity analysis)
• Transfers into and out of Levels 1 and 2, if material, with explanations for the transfers

IFRS Note

Under IFRS 13, fair value disclosures are broadly similar to U.S. GAAP. However, IFRS 13 emphasizes disclosing a narrative description of the sensitivity of fair value measurements to changes in observable and unobservable inputs more explicitly than some U.S. GAAP reporting entities historically practiced.

Transfers Between Hierarchy Levels

Transfers between the three levels (Level 1, Level 2, and Level 3) signify changes in the observability of inputs. A move from Level 2 to Level 1 might occur when previously unavailable quoted market prices become readily observable, whereas transfers from Level 2 to Level 3 may happen if critical pricing inputs are no longer observable in an active market.

Key Points to Disclose:

1. The timing of the transfer (e.g., the specific date or period)
2. The rationale for the transfer, clarifying changes in valuation methodology or availability of market data
3. The effect on the financial statements, highlighting the monetary value of transferred items

To comply with both ASC 820 and IFRS 13, companies sometimes adopt policies specifying that transfers are recognized at the beginning or end of each reporting period. They should be consistent about which date they choose and disclose this policy.

Sensitivity Analysis for Significant Unobservable Inputs (Level 3)

When fair value measurements rely significantly on unobservable inputs (Level 3), entities must disclose:

• Description of the process for developing unobservable inputs
• Quantitative data on the unobservable inputs used (e.g., discount rates, growth rates, expected default rates)
• Narrative sensitivity analysis that describes how significant changes in inputs affect the fair value
• Range of possible values for inputs, if estimable

A sensitivity analysis demonstrates how alternative assumptions could produce different fair value results. For instance, a reporting entity might disclose that a 1% increase in the discount rate for a certain cash flow projection would reduce the asset’s fair value by a material amount.

Sample Footnotes and Illustrations

Below are illustrative disclosures and footnote examples for fair value measurements under ASC 820 (with parallels to IFRS 13). These examples assume a year-end reporting date of December 31, 20XX, for demonstration and educational purposes. In practice, entities would tailor these disclosures to reflect their unique circumstances, accounting policies, and materiality considerations.

1. Recurring Fair Value Measurements

Footnote Example: Recurring Fair Value Measurements

The Company measures certain financial instruments at fair value on a recurring basis in accordance with ASC 820. The following table presents the Company’s assets and liabilities measured at fair value on a recurring basis as of December 31, 20XX:

(1) Equity securities consist primarily of publicly traded, large-cap equities. Quoted prices in active markets (Level 1) are used to determine fair value.
(2) Corporate bonds are valued using observable market inputs such as benchmark yields and reported trades (Level 2).
(3) Interests in the private equity fund are not actively traded, and significant unobservable inputs are employed to value the fund using the net asset value as a practical expedient. Where net asset value is not representative of fair value, a Level 3 methodology is applied.

Valuation Techniques and Inputs
Equity securities are valued using quoted market prices in active markets. Corporate bonds and asset-backed securities are priced using third-party valuation services that utilize observable market transactions for similar instruments and standard valuation models incorporating relevant market information. The private equity investment is valued using a combination of the investee’s net asset value and inputs such as projected future cash flows, discount rates, and market multiples.

Transfers
During the year ended December 31, 20XX, there were no transfers between Level 1, Level 2, or Level 3.

2. Nonrecurring Fair Value Measurements

Footnote Example: Nonrecurring Fair Value Measurements

The Company measures certain assets at fair value on a nonrecurring basis when events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable, or when it acquires assets in a business combination. During the year ended December 31, 20XX, the Company recognized a nonrecurring fair value adjustment for certain fixed assets in its retail segment.

(1) The Company recognized an impairment loss of $750,000 on retail equipment, measured at fair value using an internally developed discounted cash flow model that incorporated significant unobservable inputs (Level 3).

Reason for Measurement
The retail equipment was tested for impairment following a major decline in retail store traffic and subsequent negative cash flow forecasts. Management used a discounted cash flow analysis to determine the recoverable amount, resulting in an impairment loss charged to operations.

Valuation Technique
A market-based approach was not feasible due to the lack of comparable recent market transactions. Therefore, the fair value of the impaired equipment was measured using a discounted cash flow (DCF) model consistent with industry practices.

Assumptions
Key unobservable inputs included a discount rate of 10% to 12%, estimated salvage values, and a projected five-year decline in revenue.

3. Transfers Between Hierarchy Levels

Footnote Example: Transfers Between Levels

Policy for Recording Transfers
The Company’s policy is to record transfers between fair value hierarchy levels on the date that the underlying event or change in circumstances occurs, or at the end of the reporting period if the event extends over a period.

Transfers
During the year ended December 31, 20XX, the Company transferred $500,000 of corporate bonds from Level 2 to Level 3. This transfer was due to a lack of observable market information for these bonds following diminished trading volume in the secondary market. Management applied discounted cash flow techniques and unobservable inputs to assess the bonds’ fair value.

No other transfers between Levels 1, 2, or 3 occurred during the current reporting period.

4. Sensitivity Analysis for Level 3 Measurements

Footnote Example: Sensitivity Analysis

Level 3 Measurements
The Company’s Level 3 measurements primarily consist of private equity investments, certain impaired property, plant, and equipment, and illiquid corporate bonds.

Quantitative Information
The table below provides information about the significant unobservable inputs used to value the Company’s Level 3 assets as of December 31, 20XX:

Sensitivity of the Estimate to Changes in Inputs
If the discount rate applied to the private equity fund’s future cash flows increases by 1%, the fair value of the investment declines by approximately $200,000. Conversely, a 1% decrease in the discount rate increases the fair value by an estimated $210,000.

Narrative Sensitivity
Management believes that a reasonable range for growth rates is between 2% and 5%. Changes beyond the upper or lower bounds may significantly alter the valuation outcomes and could lead to additional gains or losses on the Company’s financial statements.

Real-World Scenario: Example of a Multinational Corporation

Imagine a multinational consumer electronics company, GlobalTech Inc., which holds diverse financial instruments: actively traded equities, over-the-counter derivatives, and private venture capital investments across multiple regions. In addition to U.S. operations, GlobalTech has significant European subsidiaries. Under IFRS 13, the group must disclose fair value measurements that align with local (IFRS-based) financial statement requirements.

1. For private ventures in emerging markets where observable data is scarce, GlobalTech relies on discounted cash flow models and industry indexes. These investments fall under Level 3 both in the entity’s U.S. GAAP and IFRS consolidated statements.
2. If there is a partial freeze in secondary markets for certain corporate bonds, those measurements may be reclassified to Level 3.
3. For each bond reclassification, a sensitivity analysis must convey how changes in discount rates or assumptions might shift the fair value.

Such disclosures enable investors, creditors, and other users to grasp the complexity and uncertainty underlying GlobalTech’s valuations.

Visual Representation of the Fair Value Measurement Disclosure Process

Below is a simple Mermaid diagram that shows the flow of how an entity arrives at and then discloses its fair values in the financial statements.

    flowchart LR
	    A[Identify Assets/Liabilities for Fair Value Measurement] --> B{Determine Level \n(1, 2, or 3)?}
	    B -->|Level 1| C[Use Quoted Prices \nActive Markets]
	    B -->|Level 2| D[Use Observable Inputs: \nComparable Prices, Benchmarks]
	    B -->|Level 3| E[Use Significant Unobservable Inputs:\nDCF, Internal Models]
	    E --> F{Sensitivity Analysis\nand Disclosures}
	    D --> F
	    C --> F
	    F --> G[Full Disclosures in \nFinancial Statements]

• Step 1: Identify which assets and liabilities require fair value measurement (either recurring or nonrecurring).
• Step 2: Determine the appropriate hierarchy level.
• Step 3: Select valuation techniques accordingly.
• Step 4: Present sensitivity analysis for Level 3 measurements.
• Step 5: Integrate all results into the financial statements and footnotes.

Common Pitfalls and Best Practices

Pitfalls

1. Incomplete Disclosure on Level 3 Inputs
   Failing to clearly describe significant unobservable inputs and how they relate to fair value can reduce the transparency of financial statements.

2. Inconsistent Treatment of Transfers
   Entities sometimes apply inconsistent policies for transfers and fail to consistently report them at the beginning or end of the reporting period.

3. Lack of Sensitivity Analyses
   Omitting or skimping on sensitivity disclosures for material Level 3 items can lead to regulatory scrutiny or confusion among users.

4. Overlooked Nonrecurring Measurements
   Some companies forget to disclose items that are only measured at fair value once triggering events occur (like impairments).

Best Practices

1. Clearly Document Valuation Processes
   Maintain robust documentation of how each fair value measurement is derived, including the data sources, key assumptions, and internal controls.

2. Provide Meaningful Ranges and Narrative Explanations
   For Level 3 measurements, offering both numeric ranges of possible outcomes and qualitative context helps users understand risk and volatility.

3. Proactive Monitoring of Market Conditions
   Adopt an internal review process to detect changes in liquidity or trading volume that would necessitate transfers across hierarchy levels.

4. Use Consistent and Transparent Sensitivity Analyses
   Ensure that sensitivity disclosures highlight both the direction and magnitude of changes in value based on possible fluctuations in significant unobservable inputs.

5. Cross-Referencing and Clear Organization
   Cross-reference disclosures in a way that helps readers connect the footnotes and the related lines in the financial statements. Good organization decreases confusion and duplicates.

IFRS Considerations and Convergence

IFRS 13 parallels ASC 820 in most respects; however, certain differences exist relating to:

1. Extent of Sensitivity Analysis
   IFRS 13 often emphasizes more granular and narrative sensitivity disclosures.
2. Timing and Scope
   IFRS filers with multinational operations must be mindful of local regulatory requirements that may exceed IFRS baseline requirements, even if they do not conflict directly.
3. Small Entities
   IFRS for SMEs has a simplified approach, but many SMEs prefer adopting full IFRS 13 if they operate in capital markets or desire uniformity with U.S. GAAP.

Ongoing convergence efforts continued to align fair value disclosures, intending to reduce complexity for multinational entities. Familiarity with both ASC 820 and IFRS 13 is indispensable for organizations reporting under dual frameworks.

Summary and Key Takeaways

• Disclosure Requirements
Recurring and nonrecurring measurements must be separately disclosed, highlighting the hierarchy level, valuation methodology, and reasons for nonrecurring measurements.

• Transfers and Hierarchy
Companies must disclose transfers between levels, explaining changes in market conditions or valuation approaches.

• Sensitivity Analysis
For Level 3 measurements, a narrative discussion of how changes to unobservable inputs impact fair value is crucial for transparency.

• Comparative IFRS
IFRS 13 broadly converges with U.S. GAAP, but IFRS may require more robust narratives around valuation sensitivities.

• Sample Footnotes
Illustrations provide a template, but each entity should tailor disclosures to their particular circumstances, keeping in mind materiality and clarity.

By diligently following fair value measurement disclosure requirements, businesses can boost the reliability and comparability of their financial statements while educating stakeholders on the judgments and assumptions that influence reported fair values.

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