ASC 820 Fair Value Measurement: Level 3 Inputs Transaction Explained with Journal Entries
Posted In | ASC Education | Gridlex AcademyThe ASC 820 accounting standard, established by the Financial Accounting Standards Board (FASB), provides guidance on how companies should measure fair value for financial reporting purposes. One key aspect of ASC 820 is the classification of valuation inputs into three levels, with Level 3 inputs being the least observable and most subjective. In this article, we will provide an overview of Level 3 inputs under ASC 820 and illustrate how journal entries can be used to account for transactions involving these inputs.
Level 3 Inputs under ASC 820
ASC 820 establishes a fair value hierarchy that categorizes the inputs used in valuation techniques into three levels:
1. Level 1 inputs: Quoted prices for identical assets or liabilities in active markets.
2. Level 2 inputs: Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.
3. Level 3 inputs: Unobservable inputs for the asset or liability, reflecting the company's own assumptions about the assumptions that market participants would use in pricing the asset or liability.
Level 3 inputs are the most subjective and least observable inputs in the fair value hierarchy. These inputs often require significant management judgment and may include assumptions about future cash flows, discount rates, and other factors that are not directly observable in the market.
Journal Entries for Level 3 Inputs Transactions
To illustrate the concept of Level 3 inputs and the accounting treatment under ASC 820, let's consider a simplified example involving a company that holds an investment in a private company, which is measured at fair value using Level 3 inputs.
1. Record the initial investment
The company initially invests $500,000 in the private company. The journal entry to record the investment is as follows:
Debit: Investment in Private Company - $500,000
Credit: Cash - $500,000
2. Measure the investment at fair value using Level 3 inputs
At the end of the reporting period, the company estimates the fair value of the investment using Level 3 inputs, such as projected cash flows and a discount rate. Based on these inputs, the company determines that the fair value of the investment has increased to $550,000.
3. Record the fair value adjustment
The company must adjust the carrying amount of the investment to its fair value at the end of the reporting period. The journal entry to record the fair value adjustment is as follows:
Debit: Investment in Private Company - $50,000
Credit: Unrealized Gain on Investment (income statement or other comprehensive income, depending on the specific circumstances) - $50,000
The ASC 820 standard requires companies to measure certain assets and liabilities at fair value, using a hierarchy of valuation inputs. Level 3 inputs, being the least observable and most subjective, often involve significant management judgment and estimation. By understanding the concept of Level 3 inputs and properly accounting for transactions involving these inputs through journal entries, organizations can maintain accurate financial reporting and compliance with ASC 820. As businesses continue to navigate the complexities of fair value measurement, it is essential to invest in the right tools and resources, such as advanced accounting software, to streamline the process and ensure ongoing compliance.