Fair Value

Subjectivity

The valuation of assets and liabilities appears to be straightforward but isn’t. The problem centres on market liquidity and the information that is available.

Level 1

In actively traded markets, where there is proper depth, liquidity and transparency valuation using current market prices should prove robust. Hardly any or indeed no subjectivity is required. Assets and liabilities that conform to this are referred to as Level 1. Examples include active exchange traded contracts and high quality government bonds.

Level 2

Not all items conform to this ideal. Sometimes valuation methodologies require more subjectivity. This may mean there is a quantitative model and this relies on verifiable inputs from the market place. Assets and liabilities valued in this way are referred to as Level 2. Oft cited examples include some bonds, swaps and options. Inputs to the model may include yield curve data, volatility and credit spreads.

Level 3

Some items fail to meet even this criteria. They are illiquid and it is hard to clearly ascertain their value. Indeed, the value to one firm may differ from another. The level of subjectivity that is applied makes the process much more questionable not least because the inputs to valuation cannot be readily verified. These are Level 3 assets and liabilities.

The valuation of assets/liabilities is important for accounting (IFRS 13) and management information. This means that firms need to consider the best approach in order that true and fair information results. What works today may not work tomorrow. That’s because financial markets can go from continuous activity to discontinuity. Under such circumstances almost all valuation methods become subjective.

First Published by Barbican Consulting Limited 2017