What is fair value?
Fair value is an estimate of what something is worth. It is used when valuing assets for financial reporting purposes. 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. A market participant is an entity that is willing to buy or sell the asset or liability at the measurement date.
Merriam Webster Online
1: a reasonable value (as one set by courts and regulatory commissions) for property
2: FAIR MARKET 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.
In accounting, fair value reflects the market value of an asset (or liability) for which price on an active market may or may not be determinable. Under US GAAP (ASC 820 formerly FAS 157) and International Financial Reporting Standards (IFRS 13), 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.
How to determine the fair value of an asset
Some assets and liabilities have observable market prices and are said to be traded in active markets. The fair value of these items is generally determined using market prices. For example, the fair value of publicly traded shares is typically determined using the stock market price.
Other assets and liabilities do not have observable market prices and are said to be traded in inactive markets. The fair value of these items is generally determined using valuation techniques. Commonly used valuation techniques include the following:
– Discounted cash flow analysis
– Comparables analysis
– Option pricing models
The inputs used in these valuation techniques are commonly referred to as Level 2 and Level 3 inputs. Level 2 inputs are observable inputs other than Level 1 inputs. For example, quoted prices for similar assets or liabilities in active markets. Level 3 inputs are unobservable inputs. For example, the assumptions made in a discounted cash flow analysis.