Key Takeaways
- Fair value accounting is the process of calculating a company’s assets and liabilities based on their current value in the free market. This assumes the buyer and seller are both knowledgeable, motivated to sell, and are not under duress.
- Fair value is derived from observable inputs, such as quoted prices in an active market with a sufficiently high volume of transactions to provide ongoing pricing information. Inputs must be obtained on the day the fair value is calculated and not from historical transactions.
- Unlike market value, fair value is not affected by supply and demand. Calculations also take into account factors like risk, growth, and future profit margins.
Definition and Examples of Fair Value Accounting
Fair value is the highest price an asset would sell for in the free market based on its current market value. This means the buyer and seller are both knowledgeable, motivated to sell, and there is no pressure to sell (as in the event of a corporate liquidation). The fair value of an asset or liability is ideally derived from observable market prices of similar transactions. Fair value is calculated by looking at what a nearly identical item has already sold for. Assets are recorded at their current value on the date the value is calculated, not the historical cost.
Implemented by the Financial Accounting Standards Board (FASB) to standardize the calculation of financial instruments by looking at their historical cost, fair value accounting is one of the most widely recognized valuation standards. Fair value accounting is an important step when determining the value of a company, especially when the company is sold, assets are acquired, or strategic investments are made.
Alternate name: Mark-to-market accounting
For example, say your business acquires a delivery truck worth $10,000. After two years, you decide to sell the truck. You can determine the appropriate sale price (minus depreciation) by searching for listings of similar items, and use the average of these sale prices to calculate the fair value of your asset.
If you find three similar trucks at $8,500, $8,100, and $8,000, their average would be $8,200. Therefore, the estimate of the fair value of the delivery truck is $8,200.
Note
Fair value is not the same as market value, which is determined by supply and demand in the market where the asset is bought and sold. While market value is typically the starting point for calculating fair value, adjustments may be made in order to treat all parties fairly. The fair value should also consider attributes specific to the asset or liability, such as the condition, location, or any restrictions on the sale or use of the asset at the measurement date.
How Fair Value Accounting Works
Fair value is derived from market conditions on the measurement date, rather than a historical quoted price. Calculating fair value also involves analyzing profit margins, future growth rates, and risk factors. Exactly how that calculation process plays out depends on the type of data and the accounting method you use for your calculation. While the data inputs and accounting methods may change, certain characteristics of fair value don’t change.
Fair value is not affected by whether or not the holder of an asset or liability intends to sell or pay it off. Intent could unduly influence the fair market value. For example, the intention to sell could trigger a rushed sale and result in a lower sale price. Similarly, pressure to settle a liability could result in overvaluation.
Fair value results from an orderly transaction, meaning there is no undue pressure to sell, as in a corporate liquidation. A fair value can only be derived from a sale to a third party. Otherwise, selling to a corporate insider or anyone with ties to the seller can influence the price paid for an asset.
Fair value accounting standards were introduced to establish a consistent framework for estimating fair value in the absence of quoted prices based on the notion of a three-level hierarchy, or “FAS 157,” introduced by the FASB in 2006.
Level 1
This level includes the quoted price of identical items in an active, liquid, and visible market, such as a stock exchange. Prices must come from a market where assets and liabilities are traded frequently at suitable volumes that can provide ongoing pricing information. Quoted prices, whenever available, are the number-one criteria for measuring an asset’s fair value.
Level 2
When quoted prices are not available, Level 2 inputs represent directly or indirectly observable information regarding transactions for similar items. This calculation can also include quoted prices for similar (but not identical) items, such as observing the price of real estate in a similar location.
Level 3
For nonexistent or illiquid markets, Level 3 inputs should only be used when Level 1 and 2 inputs are not available. This is generally reserved for assets that are not traded frequently and are the hardest to value, such as mortgage-related assets and complex derivatives.
Fair value can be estimated using unobservable inputs such as the company’s own data:
- An internally generated financial forecast
- Certain pricing models
- Discounted cash flow methodologies
- Assumptions from market participants that use significant unobservable inputs
Note
These levels aren’t actually methods for calculating fair value. Instead, they represent inputs you can select from to use in different valuation techniques. Valuation techniques vary wildly; the best technique depends on the types of assets your company holds.
Types of Fair Value Accounting Methods
According to the FASB, there are three valuation techniques that can be used to estimate the fair value of an asset or liability:
Market Approach
The market approach uses the selling prices associated with similar or identical assets or liabilities to derive a fair value. While this method relies on third-party data, adjustments may be made to account for any differences or unique circ*mstances.
Income Approach
The income approach uses an estimate of the future cash flows or earnings the asset is expected to generate over its lifetime to calculate the fair value of a tangible or intangible asset, liability, or entity (such as a business). Future earnings are converted into a present amount using a discount rate which represents risk and the time value of money. The discount rate compensates for the risk of projected future cash flows not being achieved.
Cost Approach
The cost approach uses the estimated cost to replace an asset were the buyer to buy or build their own version of the asset using identical methods and resources (eg: labor, materials, overhead) . The cost approach factors in a decrease in the asset’s value due to it becoming outdated.
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Fair Value Accounting: An Overview
Fair value accounting is a crucial process for assessing a company's assets and liabilities based on their current market value. This valuation method, implemented by the Financial Accounting Standards Board (FASB), is designed to standardize the calculation of financial instruments. The key premise is to determine the highest price an asset would sell for in the free market, assuming both buyer and seller are knowledgeable, motivated, and not under duress.
Observable Inputs and Calculation Process:
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Observable Inputs: Fair value is derived from observable inputs, primarily quoted prices in an active market with sufficient transaction volume. The inputs must be obtained on the day of calculation, distinguishing it from historical transactions.
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Factors Considered: Unlike market value, fair value is not influenced by supply and demand. Calculations take into account various factors, including risk, growth, and future profit margins.
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Calculation Example: The article provides an example where the fair value of an asset, like a delivery truck, is determined by looking at similar transactions in the market. The average of these sale prices is used to calculate the fair value.
Levels of Fair Value Accounting Standards (FAS 157):
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Level 1: Quoted prices of identical items in an active, liquid market (e.g., stock exchange).
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Level 2: Directly or indirectly observable information for similar items when quoted prices are unavailable.
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Level 3: Used when Level 1 and 2 inputs are not available, typically for illiquid markets or nonexistent assets. Involves unobservable inputs like internally generated financial forecasts or complex derivatives.
Fair Value Accounting Methods:
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Market Approach: Utilizes selling prices of similar or identical assets to derive fair value, with adjustments for any differences or unique circ*mstances.
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Income Approach: Estimates future cash flows or earnings an asset is expected to generate, converted into present value using a discount rate to account for risk and the time value of money.
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Cost Approach: Determines fair value by estimating the cost to replace an asset using identical methods and resources, factoring in depreciation due to obsolescence.
In summary, fair value accounting is a comprehensive and standardized approach crucial in various financial scenarios, including company sales, asset acquisitions, and strategic investments. The article provides insights into the principles, calculation methods, and standards associated with fair value accounting.
