Fair value
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. The derivation takes into account such objective factors as the costs associated with production or replacement, market conditions and matters of supply and demand. Subjective factors may also be considered such as the risk characteristics, the cost of and return on capital, and individually perceived utility.
Economic understanding
Vs market price
There are two schools of thought about the relation between the market price and fair value in any form of market, but especially with regard to tradable assets:- The efficient-market hypothesis asserts that, in a well organized, reasonably transparent market, the market price is generally equal to or close to the fair value, as investors react quickly to incorporate new information about relative scarcity, utility, or potential returns in their bids; see also Rational pricing.
- Behavioral finance asserts that the market price often diverges from fair value because of various, common cognitive biases among buyers or sellers. However, even proponents of behavioral finance generally acknowledge that behavioral anomalies that may cause such a divergence often do so in ways that are unpredictable, chaotic, or otherwise difficult to capture in a sustainable profitable trading strategy, especially when accounting for transaction costs.
Vs market value
Accounting
In accounting, fair value is used as a certainty of the market value of an asset for which a market price cannot be determined. Under US GAAP, 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 measurements (US markets)
Subsequently, FAS 157 was subsumed into FASB Accounting Standards Codification Topic 820, 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 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:
;Level One: The preferred inputs to valuation efforts are “quoted prices in active markets for identical assets or liabilities,” with the caveat that the reporting entity must have access to that market. An example would be a stock trade on the New York Stock Exchange. Information at this level is based on direct observations of transactions involving the identical assets or liabilities being valued, not assumptions, and thus offers superior reliability. However, relatively few items, especially physical assets, actually trade in active markets. If available, a quoted market price in an active market for identical assets or liabilities should be used. To use this level, the entity must have access to an active market for the item being valued. In many circumstances, quoted market prices are unavailable. If a quoted market price is not available, preparers should make an estimate of fair value using the best information available in the circumstances. The resulting fair value estimate would then be classified in Level Two or Level Three.
;Level Two: This is valuation based on market observables. FASB acknowledged that active markets for identical assets and liabilities are relatively uncommon and, even when they do exist, they may be too thin to provide reliable information. To deal with this shortage of direct data, the board provided a second level of inputs that can be applied in three situations: The first involves less-active markets for identical assets and liabilities; this category is ranked lower because the market consensus about value may not be strong. The second arises when the owned assets and owed liabilities are similar to, but not the same as, those traded in a market. In this case, the reporting company has to make some assumptions about what the fair value of the reported items might be in a market. The third situation exists when no active or less-active markets exist for similar assets and liabilities, but some observable market data is sufficiently applicable to the reported items to allow the fair values to be estimated.
;Level Three: The FASB describes Level 3 inputs as “unobservable.” If inputs from levels 1 and 2 are not available, FASB acknowledges that fair value measures of many assets and liabilities are less precise. Within this level, fair value is also estimated using a valuation technique. However, significant assumptions or inputs used in the valuation technique are based upon inputs that are not observable in the market and, therefore, necessitates the use of internal information. This category allows “for situations in which there is little, if any, market activity for the asset or liability at the measurement date.” FASB explains that “observable inputs” are gathered from sources other than the reporting company and that they are expected to reflect assumptions made by market participants. In contrast, “unobservable inputs” are not based on independent sources but on “the reporting entity’s own assumptions about the assumptions market participants would use.” The entity may only rely on internal information if the cost and effort to obtain external information is too high. In addition, financial instruments must have an input that is observable over the entire term of the instrument. While internal inputs are used, the objective remains the same: estimate fair value using assumptions a third party would consider in estimating fair value. Also known as mark to management. Despite being “assumptions about assumptions,” Level 3 inputs can provide useful information about fair values when they are generated legitimately and with best efforts, without any attempt to bias users’ decisions.
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.
International standards (IFRS)
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 became effective on January 1, 2013.The guidance is similar to the US GAAP guidance. It 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. When measuring fair value, an entity uses the assumptions that market participants would use when pricing the asset or the liability under current market conditions, including assumptions about risk." As a result, IFRS 13 requires entities to consider the effects of credit risk when determining a fair value measurement, e.g. by calculating a credit valuation adjustment or debit valuation adjustment on their derivatives.