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.
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 forecastCertain pricing modelsDiscounted cash flow methodologiesAssumptions from market participants that use significant unobservable inputs
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 circumstances.
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.
