Fair value
In accounting, 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
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.
Market value
Accounting
In accounting, fair value reflects the market value of an asset for which price on an active market may or may not be determinable. Under US GAAP and International Financial Reporting Standards, 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 recognized.- Determining fair value for an item traded on an active market such as a security, industrial commodity or agricultural commodity is straight forward. Fair value simply equals market value on the measurement date.
- Determining fair value for an item sold on a market but not traded on an active market is more difficult as it requires assessing not only the item's specifications, age and condition but also market conditions.
- Determining fair value for an item neither sold on a market nor traded on an active market is much more difficult and requires assessing "unobservable inputs".
- An example of where fair value is very difficult to determine would be 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 it.
- 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 (United States markets)
Along with all other standards, FAS 157 was codified FASB Accounting Standards Codification as Topic 820, which 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.
ASC 820-10-55 provides additional guidance on how to apply the valuation techniques.
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 has been converged with US GAAP. IFRS 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." 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;see
While ASC 820 and IFRS 15 have been converged and so provide comparable guidance, US GAAP and IFRS apply this guidance in different ways. For example, under US GAAP, entities are not allowed present any property, plant or equipment at fair value. Under IFRS, IAS 16 allows entities to choose between a cost and revaluation model. If an entity applies the revaluation model, it will measure and report its property plant and equipment at fair value on its balance sheet. It will report the changes in fair value in comprehensive income and accumulate them as a "revaluation surplus" in equity. With respect to investment property, IFRS takes an additional step. IAS 40.32 requires all entities to measure investment property at fair value. An entity may choose to report this fair value on its balance sheet or disclose it in the footnotes. If the entity chooses to apply the fair value model, "A gain or loss arising from a change in the fair value of investment property shall be recognised in profit or loss for the period in which it arises.". Depending on the choices made, the financial results of an entity applying IFRS may significantly differ from the financial results of an otherwise comparable entity applying US GAAP.