Fair Value AccountingExplained, Advantages & Disadvantages, and Examples

Written By:
Lisa Borga

Fair value accounting is used to determine what the value of a business’s assets or liabilities are by considering what they would be worth in the current market.

Fair value is the price that would be obtained from selling an asset or paying to transfer a liability in an orderly transaction occurring between participants in the market at the measurement date.

Definition of Fair Value Accounting

Fair value is the amount a business could expect to receive for an asset or pay to transfer a liability in a methodical procedure at the measure date.

Additionally, the seller and the buyer are well informed and not being pressured to sell.

Also, the fair value of the liability or the asset is preferably being derived from looking at similar transactions or at market prices.

Fair value is generally computed by identifying what a similar item has recently been sold for.

Assets are not recorded at their historical costs but instead for their current value on the measurement date on which the value is computed.

The Financial Accounting Standards Board (FASB) implemented the valuation principle to standardize the way financial instruments are calculated by considering their historical cost.

Fair value accounting is a vital tool in calculating the value of a business and is particularly useful when a business is being sold.

Example of Fair Value Accounting

As an example, suppose a business purchases a copy machine for $5,000.

One year later, the business decided to sell the copy machine.

The business could decide on a suitable price by looking for the price of similar products and then taking the average of several of these prices to find the copy machine’s fair value.

If the business found similar copy machines for sale, and the prices were $3,100, $3,200, $3,300, and $3,100, the average price of $3,175 could be used as an approximation of the copy machine’s fair value.

Fair market value is different than market value.

Market value is the result of the supply and demand occurring at the time an asset is sold or purchased.

Usually, the process for computing fair value starts with the market value of an asset or liability, but some adjustments will be necessary so that the transaction will be fair for the parties involved.

Fair value should take into account details, including the location of an asset, its condition, and if there are restrictions pertaining to the asset’s use or sale at the measurement date.

Levels of Fair Value Accounting

Fair value is obtained from the market on a specific date instead of using the historical quoted price of an asset or liability.

When computing fair value, risk factors, profit margins, and future growth rates are analyzed.

The specific way in which the value is computed will depend on the accounting method as well as the kind of data being used.

Although, some aspects of fair value will remain consistent even when the accounting method and data inputs change.

Fair value does not change based on a holders’ intent to pay off or sell an asset or liability.

Intent could have an inordinate influence on the assets or liabilities fair market value.

An example of this would be a person accepting a lower price for an asset they intend to sell due to a hurried sale.

Additionally, a rush to pay off a liability could lead to overvaluation.

Fair value occurs when a transaction is methodical, and an individual is not being pressured to sell.

An asset or liability must be sold to a third party in order for a fair value to be obtained.

If an asset or liability is sold to anyone with a connection to the seller, the price may be influenced.

Fair value accounting standards were established in order to provide a consistent way of gauging an item’s fair value when there is no quoted price by using the three levels of input data.

Level 1

Level one refers to quoted prices of items that are identical in an active market.

In an active market, transactions for assets and liabilities occur frequently and at a high volume which provides current pricing information.

A stock exchange would be an example of this type of market.

Level 2

Level two inputs use information that can be observed for similar items in either inactive or active markets.

This could be something, such as a quoted price for real estate located in a similar area.

Level 3

Level three inputs are best used if level one and level two inputs are not available.

Level three inputs will generally be used when markets do not exist or are not liquid.

In this situation, it is possible to estimate fair value by using unobservable inputs, including a business’s own data.

This could be specific pricing models or a company’s internally generated financial forecast, among others.

This is generally used for assets that are infrequently traded and difficult to value.

Discounted Cash Flow Methodologies

There are some assumptions that participants in the market will make that make use of substantial unobservable inputs.

Levels are not really methods that are used to compute fair value.

Rather, these levels constitute inputs that a person can choose from and then use in the valuation techniques.

There are a large variety of valuation techniques, and the best one to use will be based on the assets a company owns.

Valuation Techniques

The Fair Accounting Standards Board allows three different valuation techniques to be used in estimating an assets’ or liabilities’ fair value.

These three techniques are listed below.

Market Approach

This approach determines the value of the asset by considering the selling price of either identical or similar assets or liabilities and uses these to obtain the fair value of the asset.

Third-party data must be used in this method, so it’s possible that adjustments will be necessary depending on differences in the assets or the circumstances associated with the assets.

Income Approach

There are actually two different ways to use the income approach to valuation.

Either the Discounted Cash Flow Method or the Capitalization of Cash Flow Method can be used.

The Discounted Cash Flow Method uses the present value of the future benefits of the asset to determine its value.

Whereas the Capitalization of Cash Flow Method uses a single benefit stream and assumes that this will continue to grow at a steady rate.

Cost Approach

In the cost approach, a business will estimate what it would cost if a buyer were going to replace or reproduce an asset while considering all cost components and reducing the cost for any obsolescence.

Final Thoughts

Fair value accounting is used to measure the assets and liabilities a company lists on its financial statements based on the current market value of these assets and liabilities.

This fair value is the amount that an individual could sell the asset for or settle the liability for that would be fair for the seller as well as the buyer.

Fair value is generally derived from observable inputs.

One of the best ways to determine the fair value of an item is to look at prices in a market that has a high enough volume of transactions to allow for ongoing price information.

It is important that these inputs be obtained on the day that the fair value is computed rather than from historical transactions.

Fair value is different than market value in that it is not influenced by supply and demand.

However, this value does consider things like growth, future profit margins, and risk.