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There are various methods of valuing bonds that companies may use. Among these, the prevalent method is using the amortized cost technique of valuation. However, some companies may also evaluate their bonds using the fair value method. There are some differences between both of them. It is better to understand both of these methods individually to differentiate between them.
What is Amortized Cost?
The amortized cost of a bond represents its initial cost after making deductions. These deductions include adjustments for principal repayments, amortization, and impairment if any. Companies that use the cost accounting method of valuing their assets and liabilities also use the amortized cost method. While the cost may be close to the instrument’s fair value, it isn’t the same.
Apart from financial instruments and securities, the amortized cost may also apply to fixed assets. The amortized cost of a fixed asset represents the accumulated portion of its recorded cost. These may include expenses such as depreciation and amortization. Both of these are costs that companies charge directly to the income statement to reduce the cost of fixed assets.
The term amortized cost may also refer to the accumulated amount of depletion of natural resources. Overall, any cost that reduces the value of a fixed asset and companies charge as an expense is considered an amortized cost.
The amortized cost of an asset may not relate to its market value. The market value depends on market forces, which do not translate into amortized costs. In contrast, the amortized cost depends on factors such as amortization and depreciation. Therefore, the higher the rates for these are, the higher the amortized cost is as well.
What is Fair Value?
Fair value is a valuation method used to derive the intrinsic value of an asset or liability. Companies use the mark-to-market method to measure the fair value of accounts that fluctuate over time. These may include both assets and liabilities. Through this method, companies can obtain a realistic appraisal of their current financial position based on current market conditions.
The fair value of an asset or liability represents the amount paid in a transaction between two parties. Similarly, the transaction should conclude in an orderly manner in an open market, which signifies both the parties should be willing. Likewise, both parties must agree upon the value for it to be considered fair value. As the fair value of an asset or liability depends on market conditions, it may fluctuate over time.
For securities and stocks, the fair value is the amount that buyers would be willing to pay for it in a publicly-traded marketplace. For the seller, it may be close to the asking price. In contrast, for the buyer, it is close to the bid price. Using both these prices, companies can estimate the fair value of their assets and liabilities.
Unlike amortized cost, the fair value of an asset or liability does not consider factors such as depreciation and amortization. Similarly, companies may recalculate the fair value of their assets or liabilities after a reasonable time. They do not rely on the historical cost or value of their items.
Examples
The post Valuing a Fixed Rate Bond provides a concrete example of calculating the fair value for a fixed-rate bond.
The post Valuation of Callable Putable Bonds presents a guide and example for valuing a bond with embedded options.
Conclusion
The amortized cost and fair value are different methods of valuation used by companies. Amortized cost refers to the value of an asset or liability after making adjustments to its initial cost. These adjustments include items like depreciation, amortization, or impairment. Fair value refers to an asset’s or a liability’s value in the open market agreed upon by market participants in an orderly transaction.
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