A fair value hierarchy is a preference system used in valuing assets and liabilities. This creates a standardized method for determining values for accounting purposes to reduce the risk of confusion and create uniform accounting practices. One example of such a hierarchy was released in 2006 by the Financial Accounting Standards Board (FASB), which issues periodic statements to update Generally Accepted Accounting Principles (GAAP). These recommendations are applied consistently by accountants to increase the reliability and accuracy of their reports.
Under the FASB’s fair value hierarchy, the first preference when establishing the value of an asset is looking for quoted values on identical assets. A classic example can be seen when a company wants an estimate of the value of a stock it is holding. Accountants can check quotes on the open market to find out how much that stock is worth. This is the most immediate and direct way to determine fair value.
Assets are not necessarily identical, or may not be traded on the same markets. The next step of the fair value hierarchy covers observations of similar assets and markets to come up with a reasonable estimation of value. It may not be precisely identical, but should be similar. An example can be seen in housing valuations, where obviously the same house on the same lot cannot be sold twice, but a similar house on a similar lot could be sold, and its sale price would provide information about the value of the house in question.
Finally, the bottom of the fair value hierarchy covers assets with unobservable values. They, or their markets, are too unique for observations of similar market activity to provide information about their value. In this case, accountants need to make educated guesses based on the available information. They can note that an asset is in category three of the fair value hierarchy to alert observers to the fact that the value may not be precise.
This ranked preference method can be valuable both for accountants who want to be consistent in their reporting, and for observers who read their reports. People looking at fair value estimations want as much information as possible about how value was determined. This can help them decide if the information is accurate. It can also play a role in considerations about whether and how to dispose of assets. A company dumping a large stock portfolio, for instance, could create a ripple effect on the market.