What Is ASC 820-10? Fair Value Hierarchy and Disclosures

ASC 820-10 is the U.S. GAAP standard that governs fair value measurement, defining fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It does not tell you which items on the balance sheet to measure at fair value. Other accounting topics do that. ASC 820-10 supplies the framework — the definition, the input hierarchy, the valuation approaches, and the disclosures — that applies whenever one of those other topics calls for a fair value number.¹

What ASC 820-10 Actually Governs

Fair value under ASC 820-10 is an exit price. It is measured from the perspective of the party selling the asset or transferring the liability. It is not acquisition cost, not the price the entity would like to receive, and not the price a forced sale would produce. The standard contemplates a hypothetical transaction, not one the entity actually intends to execute.¹

An orderly transaction assumes the asset or liability has been exposed to the market for a customary period before the measurement date, with normal marketing activities taking place. Distress sales and forced liquidations are excluded. The hypothetical buyer and seller are independent, knowledgeable, able to transact, and willing but not compelled to do so. Whether the entity actually plans to hold or sell the item has no bearing on the measurement.

The measurement is market-based, not entity-specific. Even when observable market data is thin, the objective stays the same: estimate the price a market participant would pay or accept, not the price the reporting entity believes is right.

The standard reaches broadly. It applies to financial instruments like derivatives and debt securities, non-financial assets such as real property and equipment, intangible assets measured in a business combination under ASC 805, and liabilities including an entity’s own debt.²

Where the Measurement Takes Place

Every fair value measurement under ASC 820-10 starts with the market in which the hypothetical transaction would occur. The standard directs you to identify the principal market — the market with the greatest volume and level of activity for the asset or liability.² You do not need an exhaustive search. Unless evidence points elsewhere, the market where you normally transact is presumed to be the principal market.

If no principal market exists, the measurement defaults to the most advantageous market — the one that maximizes the amount received for an asset or minimizes the amount paid to transfer a liability. In most cases, the two coincide. When they diverge, the principal market controls, even if a different market would produce a more favorable price.

Transaction costs such as commissions and transfer taxes are never built into the fair value figure. They can influence which market is most advantageous, but the measurement itself is a gross price. Transportation is treated differently. When location is a characteristic of the asset, the cost of moving it from its current location to the principal market adjusts the measurement.

What Falls Outside the Standard

Several fair value numbers you see on the financial statements do not come from ASC 820-10, and assuming otherwise leads to misapplication. Share-based compensation measured under ASC 718 follows its own valuation rules. Inventory measured at the lower of cost and net realizable value under ASC 330 uses a different measurement concept. Revenue allocated to performance obligations under ASC 606 relies on standalone selling prices that can incorporate entity-specific factors ASC 820 would not permit. If the measurement you are working on sits inside one of these topics, the ASC 820 framework is not the one to apply.

Highest and Best Use for Non-Financial Assets

When the item being measured is a non-financial asset, ASC 820-10 adds a step. You must determine the asset’s highest and best use from the perspective of a market participant. The concept does not apply to financial assets, liabilities, or equity instruments. For non-financial assets, fair value reflects how a market participant would use the asset to maximize its value, regardless of how the reporting entity currently uses it.

Three constraints shape the analysis. The hypothetical use must be physically possible, legally permissible, and financially feasible. An exhaustive search for alternative uses is not required. Absent indications to the contrary, the entity can presume current use is the highest and best use.

In-Use vs. Stand-Alone Valuation Premise

Highest and best use also sets the valuation premise. If the asset’s value is maximized through use in combination with other assets and liabilities, as in an operating business, the measurement assumes a market participant already holds the complementary assets needed to operate the group.¹ If value is maximized on a stand-alone basis, the measurement reflects the price a buyer would pay to use the asset independently.

Disclosure When Use Differs

When the highest and best use differs from the entity’s current use, that fact and the reasoning behind it must be disclosed. The situation arises less often than you might expect because the presumption favoring current use is strong. When it does arise, the disclosure signals that the balance sheet reflects a value premised on a different deployment of the asset.

The Three Valuation Approaches

ASC 820-10 identifies three valuation approaches. Entities select the approach, or combination, appropriate for the specific asset or liability and for which sufficient data is available. The objective is the same across all three: maximize observable inputs and minimize unobservable ones.¹

When multiple approaches are used, their results are evaluated together. Fair value is the point within the range of indicated values that best represents fair value in the circumstances, not a mechanical average. Changing a valuation technique is permitted when the change produces a measurement more representative of fair value, but the change and its rationale must be disclosed.

Market Approach

The market approach uses prices and other information from actual market transactions involving identical or comparable assets or liabilities.² When active market data exists for the exact asset, this is the most direct and often most reliable path. It works on a substitution principle: a buyer would not pay more than the price of an equivalent asset available in the market.

In practice, the market approach often involves comparable company or comparable transaction analysis. An appraiser might derive an enterprise value-to-EBITDA multiple from publicly traded peers and apply it to the subject company’s financial metrics. The result nearly always requires adjustment for differences in size, risk profile, growth trajectory, and other asset-specific characteristics. These adjustments demand professional judgment and draw the heaviest scrutiny in any fair value analysis.

Control and marketability adjustments are common when valuing equity interests. A buyer of a controlling interest pays a premium for the ability to direct strategy, set compensation, and make fundamental business decisions. A minority interest with no control rights and no liquid market typically warrants discounts. The size of these adjustments turns on the specific rights attached to the interest, the ownership structure, and relevant organizational documents.

Income Approach

The income approach converts future economic benefits into a single present value.² It is the workhorse for assets that generate predictable long-term cash flows, including intangible assets, infrastructure, and many financial instruments.

The most common technique is discounted cash flow analysis, which projects the cash flows the asset is expected to produce over its remaining useful life and discounts them to present value. The discount rate reflects the time value of money and the risk that projected cash flows may not materialize. It is usually built from a weighted average cost of capital or a comparable required rate of return, calibrated to the assumptions a market participant would use. Small changes in the rate can move the calculated fair value by material amounts, which makes rate selection one of the most consequential judgments in the entire measurement.

Other income-approach techniques include multi-period excess earnings methods, which isolate the cash flows attributable to a specific intangible asset like customer relationships or proprietary technology, and option-pricing models for instruments with contingent payoffs. Each technique must be calibrated at initial recognition so that the model output equals the transaction price, and the model must continue to reflect observable market data whenever available.¹

Cost Approach

The cost approach estimates what a market participant would spend right now to replace the service capacity of the asset.² No rational buyer would pay more than the cost to acquire or build a substitute of equivalent utility.

The calculation starts with current replacement cost, which incorporates today’s technology and construction methods rather than reproducing the original asset exactly. From that starting point, deductions are made for three forms of obsolescence: physical deterioration from wear and tear that shortens the asset’s remaining useful life relative to a new replacement; functional obsolescence from design limitations or technological advances that make the original configuration less efficient than current alternatives; and economic obsolescence from external factors like regulatory changes, demand shifts, or economic downturns that impair earning capacity regardless of physical condition. The net amount after these deductions is the fair value. The cost approach fits specialized manufacturing equipment, real estate improvements, and other non-financial assets where no active market exists and income projections are impractical. It is rarely appropriate for financial assets.

The Fair Value Hierarchy

ASC 820-10 organizes inputs into a three-level hierarchy that prioritizes observable market data over entity-specific assumptions. The purpose is to increase consistency and comparability by pushing preparers toward the most reliable inputs available.²

The overall classification of a measurement depends on the lowest-level input that is significant to the entire calculation. If a measurement uses mostly Level 2 inputs but one significant input is Level 3, the whole measurement is Level 3. The rule prevents a subjective assumption from being buried inside an otherwise observable framework.

Level 1 Inputs

Level 1 inputs are quoted prices in active markets for identical assets or liabilities, unadjusted, that the entity can access at the measurement date.¹ A market is active when transactions occur with enough frequency and volume to provide ongoing pricing information. The closing price of a widely traded stock on a major exchange is the classic example.

The population of instruments that genuinely qualifies for Level 1 is narrower than many assume. It includes listed equities on deep, liquid exchanges, on-the-run Treasury securities, exchange-traded futures and options, and open-ended mutual funds with daily published net asset values at which investors can freely subscribe or redeem. Once trading volume thins or the instrument has bespoke features, the measurement typically drops to Level 2 or below.

Level 1 measurements cannot be adjusted, even for a very large position. The standard explicitly prohibits blockage factors — discounts that would reflect the market impact of selling a large block at once. Size of holding is a characteristic of the entity’s position, not the asset. If the quoted price is $50, that is the fair value per unit whether you hold 100 shares or 10 million.

Level 2 Inputs

Level 2 inputs are observable for the asset or liability but do not meet the Level 1 standard.² They include quoted prices for similar but not identical assets in active markets, quoted prices for identical assets in markets that are not active, and market-corroborated data points like interest rates, yield curves, and credit spreads.

Most U.S. public debt sits in Level 2, along with short-term cash instruments, many derivative products, and off-the-run Treasury securities. Prices exist and derive from real market activity, but the specific instrument either trades infrequently or requires modeling to translate observable data into a fair value estimate.

Adjustments to Level 2 inputs are permitted and often necessary. If you are using a similar bond’s quoted price to estimate the fair value of your bond, you may need to adjust for maturity, coupon rate, or collateral structure. The adjustments must be systematic, based on factors a market participant would consider, and internally consistent. The more significant and subjective they become, the greater the risk the measurement slides into Level 3.

Level 3 Inputs

Level 3 inputs are unobservable. They are used only when observable data is unavailable, and they carry the greatest subjectivity.¹ Private equity investments, complex structured products, and illiquid derivatives frequently sit here.

The entity develops Level 3 inputs using the best information available, which often means internal financial forecasts, proprietary models, or management assumptions about variables such as revenue growth, customer attrition, or volatility. The assumptions must reflect what a market participant would use, not what management hopes will happen. All available market information must be considered, even when the final inputs are unobservable.

Non-binding broker quotes and consensus pricing data generally qualify as Level 3 unless corroborated by other market evidence. Receiving a dealer quote does not make the input observable on its own; if the dealer is not standing ready and able to transact at that price, the quote does not meet the Level 2 bar.

Level 3 measurements draw the heaviest scrutiny from auditors, regulators, and investors. The PCAOB has identified fair value estimates as a common area of audit deficiency, particularly where auditors fail to evaluate whether management’s significant assumptions are reasonable or test those assumptions through procedures beyond inquiry and recalculation.³

Measuring Liabilities and Nonperformance Risk

For liabilities, the exit-price concept still applies, but the perspective flips. The measurement asks what a market participant would charge to assume the obligation. A liability’s fair value includes the effect of nonperformance risk, which covers the entity’s own credit risk along with other risk factors such as regulatory or operational risk.

That produces a result that often reads as counterintuitive. If an entity’s creditworthiness deteriorates, the fair value of its liabilities decreases, because a market participant would accept less cash to take on a debt from a riskier counterparty. The entity then recognizes a gain on remeasurement even though its financial health has worsened. The standard addresses the tension through disclosure and, in some cases, through recognition of certain gains and losses in other comprehensive income rather than earnings.

For liabilities with observable market prices, nonperformance risk is already embedded in the price and need not be separately measured. For liabilities measured using a model, credit risk must be explicitly incorporated and re-evaluated each reporting period, using market participant assumptions rather than the entity’s internal view of its own creditworthiness.

Day-One Gains and Losses

When an entity initially recognizes an asset or liability at fair value and the transaction price differs from the fair value measurement, the difference creates a day-one gain or loss. ASC 820-10 directs the entity to recognize the gain or loss in earnings unless the specific accounting topic governing that asset or liability says otherwise.¹

This matters most when the initial fair value measurement relies on unobservable inputs. The standard requires the valuation technique to be calibrated so its output equals the transaction price at initial recognition. The calibration ensures the model reflects actual market conditions on day one and provides a baseline for evaluating later changes. If the model and the transaction price diverge from the start, the divergence should prompt hard questions about whether the model captures all relevant characteristics of the instrument.

Disclosures the Standard Requires

The disclosure framework was reshaped by ASU 2018-13, which streamlined some requirements, added others, and eliminated a few the FASB concluded were not providing useful information. Current requirements apply differently depending on whether the entity is public or nonpublic and whether the measurement is recurring or nonrecurring.

Core Disclosures

For each class of assets and liabilities measured at fair value, the entity must disclose the fair value at period end, the level in the hierarchy where the measurement falls, and a description of the valuation techniques and inputs used for Level 2 and Level 3 measurements.¹ A change in valuation technique since the prior period must be disclosed along with the reason for the change. Nonrecurring measurements also require an explanation of why the measurement was taken.

For Level 3 measurements, the entity must provide quantitative information about significant unobservable inputs. Since ASU 2018-13 took effect, public entities must also disclose the range and weighted average of those inputs, giving users a concrete sense of the assumptions driving the most subjective valuations on the balance sheet.

Level 3 Roll-Forward and Sensitivity

Recurring Level 3 measurements require a reconciliation from opening to closing balances, broken out by total gains and losses recognized in earnings, total gains and losses recognized in other comprehensive income, purchases, sales, issuances, settlements, and transfers into and out of Level 3 along with the reasons for those transfers.¹ This roll-forward is the single most important disclosure for Level 3 items because it gives users a complete audit trail of how and why these subjective valuations changed during the period.

Entities must also provide a narrative description of measurement uncertainty. If changing a significant unobservable input to a different reasonable amount might result in a materially higher or lower fair value, the entity must say so and describe any interrelationships between inputs that could amplify or offset the effect. The intent is to communicate uncertainty as of the measurement date, not to predict future changes.

What ASU 2018-13 Changed

ASU 2018-13 eliminated the requirement to disclose the amount and reasons for transfers between Level 1 and Level 2, removed the obligation to describe valuation processes for Level 3 measurements, and struck the requirement to disclose the entity’s policy for timing of transfers between hierarchy levels. It added a requirement for public entities to disclose unrealized gains and losses included in other comprehensive income for recurring Level 3 items held at the end of the reporting period. Nonpublic entities received a simplification: they may disclose transfers into and out of Level 3 and purchases and issuances of Level 3 items in lieu of the full opening-to-closing reconciliation.

Where Application Gets Hard

The boundary between Level 2 and Level 3 is genuinely blurry. An input can start as Level 2 and migrate to Level 3 as adjustments become more significant and subjective. Entities sometimes resist reclassifying measurements downward because Level 3 triggers heavier disclosure requirements and invites closer audit scrutiny. The resistance creates a credibility problem: if the inputs are unobservable, calling them Level 2 does not make the measurement more reliable. It just makes the disclosures less informative.

Discount rate selection in the income approach is a persistent challenge. The rate embeds assumptions about risk, cost of capital, and market conditions. Two equally competent valuation professionals can arrive at different rates for the same asset and both be defensible. ASC 820-10 addresses this by requiring calibration to the transaction price at initial recognition and by insisting the rate reflect market participant assumptions, but reasonable people still disagree about what those assumptions are.

Management bears ultimate responsibility for every fair value measurement in the financial statements, even when the number comes from a third-party pricing service or valuation specialist. Outsourcing the calculation does not outsource the accountability. Entities must understand the methodologies and assumptions behind externally provided valuations and be prepared to explain and defend them.

1
FASB. Accounting Standards Update – Fair Value Measurement (Topic 820)
2
U.S. Securities and Exchange Commission. Note 10 – Fair Value Measurements
3
PCAOB. Audit Focus: Auditing Accounting Estimates