NOTE 6. DERIVATIVE LIABILITIES

9 Months Ended

Sep. 30, 2014

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Derivative Instruments and Hedging Activities Disclosure [Text Block]

NOTE 6. DERIVATIVE LIABILITIES

Fair value of financial instruments is defined as an exit price, which is the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date. The degree of judgment utilized in measuring the fair value of assets and liabilities generally correlates to the level of pricing observability. Financial assets and liabilities with readily available, actively quoted prices or for which fair value can be measured from actively quoted prices in active markets generally have more pricing observability and require less judgment in measuring fair value. Conversely, financial assets and liabilities that are rarely traded or not quoted have less price observability and are generally measured at fair value using valuation models that require more judgment. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency of the asset, liability or market and the nature of the asset or liability. The Company has categorized its financial assets and liabilities measured at fair value into a three-level hierarchy.

During the nine months ended September 30, 2014, the Company issued 3,362,500 warrants to purchase common stock, all of which contain net-cash settlement features giving the warrant holder the right to net-cash settlement in the event certain transactions occur. Therefore, the Company accounted for the warrants as derivative liabilities and valued them using the Black-Scholes option valuation model and the following weighted average assumptions on the following dates:

	September 30, 2014			April 15, 2014			April 3, 2014
Warrant Liability:
Risk-free interest rate		0.40	%		0.30	%		0.30	%
Expected volatility		138.5	%		114	%		114	%
Expected life (in years)		4.5			5			5
Expected dividend yield		–			–			–
Number of shares		3,362,500			300,000			3,062,500
Fair value	$	192,122		$	74,475		$	1,006,418

The risk-free interest rate was based on rates established by the Federal Reserve. Since the Company’s stock has not been publicly traded for a sufficiently long period of time, the Company is utilizing an expected volatility figure based on a review of the historical volatilities, over a period of time, equivalent to the expected life of the instrument being valued, of similarly positioned public companies within its industry. The expected life of the warrants was determined by their expiration dates. The expected dividend yield was based upon the fact that the Company has not historically paid dividends on its common stock, and does not expect to pay dividends on its common stock in the future.

Fair Value Measurement

Valuation Hierarchy

ASC 820, “Fair Value Measurements and Disclosures,” establishes a valuation hierarchy for disclosure of the inputs to valuation used to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument. Level 3 inputs are unobservable inputs based on the Company’s own assumptions used to measure assets and liabilities at fair value. A financial asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement.

The following table provides the liabilities carried at fair value measured on a recurring basis as of September 30, 2014:

Fair Value Measurements at September 30, 2014

Quoted

Significant

Total

prices in

other

Significant

Carrying

active

observable

unobservable

Value at

markets

inputs

September 30, 2014

(Level 1)

(Level 2)

(Level 3)

Derivative liabilities

192,122

–

192,122

The Company measures the fair value of financial assets and liabilities based on the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value.

Level 3 liabilities are valued using unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the derivative liabilities. For fair value measurements categorized within Level 3 of the fair value hierarchy, the Company’s accounting department, who reports to the Principal Financial Officer, determines its valuation policies and procedures. The development and determination of the unobservable inputs for Level 3 fair value measurements and fair value calculations are the responsibility of the Company’s accounting department and are approved by the Principal Financial Officer.

Level 3 Valuation Techniques

Level 3 financial liabilities as of September 30, 2014 consist of the 3,362,500 warrants the Company issued during the nine months ended September 30, 2014, for which there is no current market such that the determination of fair value requires significant judgment or estimation. Changes in fair value measurements categorized within Level 3 of the fair value hierarchy are analyzed each period based on changes in estimates or assumptions and recorded as appropriate. A significant decrease in the volatility or a significant decrease in the Company’s stock price, in isolation, would result in a significantly lower fair value measurement.

As of September 30, 2014, there were no transfers in or out of Level 3 from other levels in the fair value hierarchy.

The following table sets forth a summary of the changes in the fair value of our Level 3 financial liabilities that are measured at fair value on a recurring basis:

	For the nine months ended			For the three months ended
	September 30, 2014			September 30, 2014
Beginning balance	$	-		$	419,026
Recognition of derivative liability - warrants		1,080,893			-
Net unrealized gain on derivative liabilities		(888,771	)		(226,904	)
Ending balance	$	192,122		$	192,122

- Definition

The entire disclosure for derivative instruments and hedging activities including, but not limited to, risk management strategies, non-hedging derivative instruments, assets, liabilities, revenue and expenses, and methodologies and assumptions used in determining the amounts.

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+ Details

AV Therapeutics, Inc. 10-Q