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In accounting and in most Schools of economic thought, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset. It takes into account such objective factors as:
Contents
- Fair value vs market price
- Fair value vs market value
- Fair value measurements US markets
- IFRS 13
- References
and subjective factors such as
In accounting, fair value is used as a certainty of the market value of an asset (or liability) for which a market price cannot be determined (usually because there is no established market for the asset). Under US GAAP (FAS 157), fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This is used for assets whose carrying value is based on mark-to-market valuations; for assets carried at historical cost, the fair value of the asset is not used. One example of where fair value is an issue is a college kitchen with a cost of $2 million which was built five years ago. If the owners wanted to put a fair value measurement on the kitchen it would be a subjective estimate because there is no active market for such items or items similar to this one. In another example, if ABC Corporation purchased a two-acre tract of land in 1980 for $1 million, then a historical-cost financial statement would still record the land at $1 million on ABC’s balance sheet. If XYZ purchased a similar two-acre tract of land in 2005 for $2 million, then XYZ would report an asset of $2 million on its balance sheet. Even if the two pieces of land were virtually identical, ABC would report an asset with one-half the value of XYZ’s land; historical cost is unable to identify that the two items are similar. This problem is compounded when numerous assets and liabilities are reported at historical cost, leading to a balance sheet that may be greatly undervalued. If, however, ABC and XYZ reported financial information using fair-value accounting, then both would report an asset of $2 million. The fair-value balance sheet provides information for investors who are interested in the current value of assets and liabilities, not the historical cost.
Fair value vs market price
There are two schools of thought about the relation between the market price and fair value in any kind of market, but especially with regard to tradable assets:
Fair value vs market value
The latest edition of International Valuation Standards (IVS 2007), clearly distinguishes between fair value, as defined in the IFRS, and market value, as defined in the IVS:
So As the term is generally used, Fair Value can be clearly distinguished from Market Value. It requires the assessment of the price that is fair between two specific parties taking into account the respective advantages or disadvantages that each will gain from the transaction. Although Market Value may meet these criteria, this is not necessarily always the case. Fair Value is frequently used when undertaking due diligence in corporate transactions, where particular synergies between the two parties may mean that the price that is fair between them is higher than the price that might be obtainable on the wider market. In other words Special Value may be generated. Market Value requires this element of Special Value to be disregarded, but it forms part of the assessment of Fair Value.Fair value measurements (US markets)
The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157: Fair Value Measurements ("FAS 157") in September 2006 to provide guidance about how entities should determine fair value estimations for financial reporting purposes. FAS 157 broadly applies to financial and nonfinancial assets and liabilities measured at fair value under other authoritative accounting pronouncements. However, application to nonfinancial assets and liabilities was deferred until 2009. Absence of one single consistent framework for applying fair value measurements and developing a reliable estimate of a fair value in the absence of quoted prices has created inconsistencies and incomparability. The goal of this framework is to eliminate the inconsistencies between balance sheet (historical cost) numbers and income statement (fair value) numbers.
Subsequently, FAS 157 was subsumed into FASB Accounting Standards Codification (ASC) Topic 820 (Fair Value Measurement), which now defines fair value as "The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." This is sometimes referred to as "exit value". In the futures market, fair value is the equilibrium price for a futures contract. This is equal to the spot price after taking into account compounded interest (and dividends lost because the investor owns the futures contract rather than the physical stocks) over a certain period of time. On the other side of the balance sheet the fair value of a liability is the amount at which that liability could be incurred or settled in a current transaction.
Topic 820 emphasizes the use of market inputs in estimating the fair value for an asset or liability. Quoted prices, credit data, yield curve, etc. are examples of market inputs described by Topic 820. Quoted prices are the most accurate measurement of fair value; however, many times an active market does not exist so other methods have to be used to estimate the fair value on an asset or liability. Topic 820 emphasizes that assumptions used to estimate fair value should be from the perspective of an unrelated market participant. This necessitates identification of the market in which the asset or liability trades. If more than one market is available, Topic 820 requires the use of the "most advantageous market". Both the price and costs to do the transaction must be considered in determining which market is the most advantageous market.
The framework uses 3-level fair value hierarchy to reflect the level of judgment involved in estimating fair values. The hierarchy is broken down into three levels:
For instance, the price of an option based on Black–Scholes and market implied volatility. Within this level, fair value is estimated using a valuation technique. Significant assumptions or inputs used in the valuation technique requires the use of inputs that are observable in the market. Examples of observable market inputs include: quoted prices for similar assets, interest rates, yield curve, credit spreads, prepayment speeds, etc. In addition, assumptions used in estimating fair value must be assumptions that an unrelated party would use in estimating fair value. Notably, FASB indicates that assumptions enter into models that use Level 2 inputs, a condition that reduces the precision of the outputs (estimated fair values), but nonetheless produces reliable numbers that are representationally faithful, verifiable and neutral.
The FASB, after extensive discussions, has concluded that fair value is the most relevant measure for financial instruments. In its deliberations of Statement 133, the FASB revisited that issue and again renewed its commitment to eventually measuring all financial instruments at fair value.
FASB published a staff position brief on October 10, 2008, in order to clarify the provision in case of an illiquid market.
IFRS 13
IFRS 13, Fair Value Measurement, was adopted by the International Accounting Standards Board on May 12, 2011. IFRS 13 provides guidance for how to perform fair value measurement under IFRS and takes effect on January 1, 2013. It does not provide guidance as to when fair value should be used. The guidance is similar to the US GAAP guidance.