Within the context of investing and accounting, producers and consumers have the right to know the reasonable price of items bought or sold on the market. The values of items fluctuate based on several factors, but one price is essential to recognize and understand. This lesson will detail the fair value principle, methods for identifying the fair value of an item, and examples of fair values in economics.
What is fair value? The concept of fair value relates to an item's current price or value. More specifically, it is the amount for which an item could be fairly exchanged between two informed and willing parties. The buyer sets a specific price based solely on the true value of the item, and the buyer freely agrees to pay the listed price in return for the product. For example, if an appraiser priced a 50-year-old trading card at $500, then the consumer could willingly agree to purchase it for that price because it is fair. The fair value principle can be applied to selling singular items, multiple assets, and even entire organizations.
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Fair Value Definition
The fair value definition is critical to understand in the fields of economics and accounting. It becomes especially significant when products or assets are sold, and companies are acquired. When a fair value is used, the appropriate sales prices for individual items or large companies can be determined. If a company is purchased, the fair value can help determine the cost of assets to negotiate a reasonable sales price between the buyer and the seller. Fair value does not apply to assets being sold under particular circ*mstances such as liquidation; it only determines sales prices under normal and reasonable conditions. Further, fair value prices do not often fluctuate because they are a broad estimate of an asset's current and honest price. They can go down with depreciation, market values, and changes in replacement costs, however.
Fair value principles also hold meaning in terms of financing. When a product falls in value, the value of assets within a company or the company's value may also decrease. In turn, the fair value of the organization will be less than before. Conversely, if the price of a product increases, the value of the assets or entire company may grow to a higher fair price of sale. Fair value can also be applied to the value of stocks and security on the open market, but note that the fair value of an item is not the same as the market price.
Fair Value vs. Market Value
The market value of an item or asset represents the price according to the stock market. While the fair value of an item and the market value of an item may be similar, the two values are distinct for several reasons. Primarily, the market value heavily relies on supply and demand factors in the market, which can fluctuate often. The fair value principle measures an item's worth purely and fundamentally based on the true value of an asset, which does not change regularly. For instance, while the fair value of an item may be $500, low supply means that the price of the item on the market could be reflected as higher. Market value is not the most appropriate method to judge the true value of an asset for this reason.
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When companies are sold, the fair value of an asset is always adjusted for impairment or when the asset has a lower market value than what is listed on its company's balance sheet, helping to clarify the asset's true value before negotiation takes place. Conversely, the exact market value is negotiated and determined by the buying and selling parties at the time of sale. Market prices, in this sense, are often irrationally driven and illogically thought out. The fair value model of price determination is a globally accepted and commonly used principle of accounting.
Fair value vs. market value in accounting and economics can be confusing because they are so closely related. The following chart presents a side-by-side comparison to easily recognize the difference between an asset's fair value and market value:
| Fair Value | Market Value |
|---|---|
| The true worth of an asset that is not determined based on market forces | The value of an asset based on the stock market |
| Based solely on the fundamental and true value | Based on the factors of supply and demand |
| Value often remains constant | Value fluctuates often |
| Globally accepted and used to determine the intrinsic worth of an asset | Not globally accepted or frequently used because of large fluctuation |
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