In the finance industry, the word "fair value" has multiple definitions. In terms of investment, it refers to the price at which willing sellers and buyers agree to sell an asset, providing that both parties are informed and ready to do the deal. For example, securities have a fair value that is decided by the market in which they are exchanged.
Fair Value Accounting: An Overview
In the widest economic aspect, fair value is the prospective price, or the value attributed to an item or service, based on its utility, market forces i.e demand and supply, and the level of competition for it. Although it indicates a free market, it differs from market value, which merely refers to the value of the asset in the marketplace (not intrinsic worth).
In the investing sector, listing security or asset on a publicly-traded exchange, such as a stock exchange, is a popular technique to assess their fair worth. On a daily basis, big investors give a bid and ask price for shares of business XYZ that trade on an exchange.
An investor can sell the stock to the professional trader at the bid price and acquire it at the asking price from the merchant. The exchange is a reliable method for evaluating a company's fair value since the bid and ask prices are mostly driven by investor demand for the shares.
The value of an underlying asset is used to assess the fair value of a variant. When you acquire a 100 call option on ABC stock, you are purchasing the right to buy 200 shares of ABC stock at $100 per share for a set period of time. When the market price of ABC stock rises, so does the value of the stock option.
Fair value can be considered as the equilibrium price for a futures contract in the futures market—that is, the point when supply and demand are equal. This is the spot price adjusted for compounding interest (as well as dividends missed since the investor holds the futures contract rather than the underlying stock) over a period of time.
Common Concepts & Terms Used in Fair Value Accounting
Current market values are used as the foundation for identifying some assets and liabilities in fair value accounting. Under present market conditions, fair value is the approximate price at which an asset or liability may be sold or settled in an ongoing manner to a third party. The concepts listed below are included in this definition:
Current Market Conditions
Fair value should be determined based on market circumstances on the date of valuation, rather than a transaction that happened at a previous date.
The intention of the Holder
The intention of the asset or liability’s holder to keep them is not important in determining the fair value. In the absence of such intent, the calculated fair value might be biased. If the objective is to sell an asset right away, for example, this might be interpreted as a hasty sale, which could result in a reduced sale price.
The fair value must be estimated on the basis of an orderly transaction, that signifies something in which there is no unreasonable pressure to sell, such as in a corporate liquidation circumstance.
Selling to a Third-Party
Fair value is determined based on the assumption of a sale to an entity that is neither a company insider nor affiliated to the seller in any manner. A related-party transaction, on the other hand, might impact the price paid.
The best way to determine fair value is to look at the pricing in an active market. An active market is one with a high sufficient volume of transactions to offer real-time pricing information. Also, the market where a fair value is calculated should be the asset or liability's primary market, as the greater transaction volume linked with this market should logically result in the highest pricing for the seller.
The major market is understood to be the place where a company generally sells the asset type in consideration or settling liabilities.
What is Fair Value Accounting in terms of Financial Statements?
Fair value is defined by the International Accounting Standards Board as the amount paid to sell an object or the payment made to shift liability in a recorded value on a certain date, generally for use as a reference point on financial statements over time. In a mark-to-market valuation, all of a firm's assets and liabilities must be placed on the books at their fair value. In most circumstances, the original cost is taken to value assets.
In some scenarios, determining a fair value for an asset might be difficult if there is no open market for it. This is a common issue when accountants do an organization’s valuation. Let's say an accountant is unable to estimate the fair market value of a unique piece of equipment.
To calculate a fair value, the accountant can use the asset's discounted value method. He, in this scenario, uses the cash outflow to acquire the machinery and the cash inflows produced by using the machinery over its expected lifetime. The fair value of an asset is the sum of discounted cash flows.
Advantages of Fair Value Accounting
Fair value helps in providing timely and actual information that benefits the investors to understand the market better and make the best decision for their organization. Following are a few advantages listed for fair value accounting:
Improved financial transparency:
Financial statements prepared using fair value accounting boost an organization's transparency, which is notably beneficial to potential investors, vendors, and lenders since they gain a better understanding of the organization's stability and profitability.
Financial data should be verified and unbiased in order to be considered trustworthy. That trustworthy information is provided by fair value.
Provides the Real Value of the Assets:
People want to know the true value of an asset as of a certain date in this dynamic and unpredictable market. And with fair value, you are able to provide the real value of the assets.
Relevant & Timely Information:
Fair value accounting seeks to produce the most relevant estimations possible by utilizing information that is particular to the period and current market circumstances. It offers a lot of useful information for a company and encourages quick corrective measures.
Possibility of Additional Details in the Financial Statements:
In comparison to the other accounting approach, historical cost, fair value accounting improves the informational potential of a financial statement. A detailed financial statement requires a company to provide significant information regarding the technique used, the estimates made, risk exposure, associated sensitivities, and other concerns.
Fair value accounting is considered the most important measure for financial investments, according to the Financial Accounting Standards Board.
Disadvantages of Fair Value Accounting
The information produced in the financial statements by the FVA technique is only valid and reliable for a short period of time. Because the data in financial statements is time-sensitive for certain market circumstances, a shift in the market situation might have a substantial impact on an entity's real financial status.
Unpredictability is an Issue:
It is directly connected to low dependability. The unpredictability of a market can negatively influence a company's investment capacity if an asset's fair value tracks the growth of the market situation.
The ambiguity of the asset assessment method for financial statements is one of the most often cited problems of fair value accounting. This ambiguity in the measuring technique opens the door to price deviations.
A danger in establishing fair value estimates is price manipulation by the companies themselves. Firm trading in illiquid markets can alter both traded and quoted prices.
The Absence of Market Price:
A fair value estimate, which is meant to provide the most trustworthy information, is more difficult to achieve in the absence of market price - if a market for a specific item is not present in the current market.
To move ahead and understand fair value accounting in deep, we need to understand what makes fair value different from other values present in accounting. Let’s take a look:
Difference Between Fair Value & Carrying Value
Fair value and carrying value are two completely different accounting terms. Let’s check the following points:
- The real selling value of an item that is agreed to be paid by the buyer and established by the seller is known as fair value. The sale benefits both parties. Profit margins, projected growth rates, and risk elements are all considered when determining the fair value.
- The quantity or valuation of an asset as it shows on the balance sheet is referred to as carrying value, also known as book value. It is calculated by subtracting the asset's cumulative depreciation and impairment expenditures from the asset's initial purchase price as shown on the balance sheet.
- The carrying value of an item does not reflect the asset's original purchase price, but rather its current worth over a period of time.
Let’s understand this with a simple example:
There’s a firm ABC, an infrastructure firm, that spent $60,000 on machinery for its operations. And it lasts 10 years and costs $4,000 per year as depreciation, then its carrying value would already be $20,000.
Carrying Value = $60,000 - ($4,000*10) = $20,000
Difference Between Fair Value & Market Value
Market value is very different from fair value. Let’s understand it in the given points followed by an example:
- Market value varies considerably as compared to fair value.
- It might be based on an asset's most current pricing or quote. For example, if the price of the share in Company XYZ was $60, three months ago and was $30 in the recent valuation, then the share's market value will be $30.
- The market value of an item is determined by supply and demand in the market where it is purchased and sold. For example, the price of a property to be sold will be determined by current market circumstances in the region.
If a seller chooses to sell his property for $400,000 during a period of low demand in the real estate industry, the property may not be sold. However, if it is offered for $600,000 at a peak moment, it may be sold for that amount.
Types of Approaches to Derive Fair Value
There are basically three types of approaches to derive fair value, under fair value accounting. They are listed below:
To calculate a fair value, the market approach examines the prices linked with real market transactions for substantially similar assets and liabilities. The values of securities owned, for example, can be received from a national exchange where these securities are purchased and sold on a regular basis.
To establish a discounted present value, the income approach uses expected future cash flows or profits, modified by a discount rate that captures the time value of money and the chance of cash flows not being realized. A probability-weighted-average collection of anticipated future cash flows is another technique to include risk into this strategy.
The cost approach takes into account the expected cost of replacing an asset, adjusted for the old asset's obsolescence.
The Hierarchy of Fair Value Accounting
GAAP establishes a hierarchy of data sources, ranging from Level 1 (best) to Level 3 (worst). The goal of these levels of data is to guide the bookkeeper through a succession of valuation options, with Level 1 solutions favored above Level 3 solutions. The differences between the three tiers are listed below.
The fair value scale is made up of these three tiers. Please keep in mind that these three levels are solely used to pick valuation inputs (such as the market approach). The levels aren't employed to directly calculate asset or liability fair values.
Level 1 of Fair Value Accounting
On the date of valuation, Level 1 is a stated price for an item listed in an active market. When this information is accessible, it should be taken as the most trustworthy proof of fair value. When there is a bid-ask price spread, select the price that is best indicative of the asset or liability's fair value. This might entail valuing an asset with a bid price and valuing a liability with an asking price.
When you change a quoted Level 1 price, the result is immediately shifted to a lower level.
Level 2 of Fair Value Accounting
This level of the Fair Value Hierarchy is comprised of measurable inputs other than quoted prices, either directly or indirectly. A valuation multiple for a business segment based on the sale of comparable companies is an example of a Level 2 input. This definition covers asset or liability prices that are:
- In active marketplaces, for similar products; or
- In dormant marketplaces, for same or comparable commodities; or
- For inputs other than reported prices, such as credit risks, default rates, and interest rates;
- For inputs produced from market data that can be observed.
Level 3 of Fair Value Accounting
Level 3 is an input that cannot be seen. It might include the firm's own data, modified for additional information that is properly available. An internally developed financial estimate and the pricing mentioned inside a distributor's supplied quote are examples of Level 3 inputs.
- In accounting terms, fair value is described as the estimated worth of different assets and liabilities that must be recorded on books of accounts.
- Current market conditions, the intention of the holder, orderly transaction, selling to a third party, active market are some common concepts used in fair value accounting.
- Along with having some advantages, fair value accounting also has some disadvantages that you should keep in mind, especially if you are an accountant.
- You can have three approaches to derive fair value that has been described in the article.
- Having an understanding of the hierarchy of fair value accounting will help the accountants in the successful evaluation of the organization’s assets