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What is Fair Value?
The fair value of an asset refers to its estimated worth in the market. It may also refer to the actual agreed-upon value of an asset by a buyer and a seller. These may include products, inventory, stock, or security. Any asset traded on the market will have a fair value. Determining an asset’s fair value is crucial to benefit both the buyer and the seller in a transaction.
The International Financial Reporting Standards (IFRS) define 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”. Therefore, there are various components of fair value.
What factors influence the Fair Value of an asset?
Various factors play a critical role in determining the fair value of an asset. Among these, the primary ones are the condition, restrictions on use, and location of the asset. For example, a product in bad condition will likely have a lower fair value than that in good condition. Similarly, if there are any restrictions on an asset’s usage, market participants may not be willing to pay the full value for it.
What is Fair Value Accounting?
Most companies and businesses record their assets and liabilities at historical value. These companies use the initial cost of assets or liabilities to account for them. However, companies also have the option to use the fair value accounting method.
Fair value accounting uses the current market value of assets and liabilities instead of their historical value. With this approach, there are several methods that companies may use to derive a fair value for their assets or liabilities.
Among these methods, companies can use the market approach to fair value accounting. In this method, the company can use the prices associated with actual marketing transactions for similar or identical assets or liabilities. The best way to apply this method is for securities or stocks as it is straightforward to determine their market value.
Similarly, companies may use the income approach. Here, companies use future cash flows or earnings adjusted by a discount rate to value their assets or liabilities. Companies may also use a probability-weighted-average set of possible cash flows.
Lastly, companies can use a cost approach. With this approach, they use the estimated cost of replacement for assets. They also adjust the cost for the obsolescence of their existing assets.
What is the Fair Value Hierarchy?
The fair value hierarchy represents the three levels of information related to fair value. The purpose of these levels is to help companies in evaluating their assets or liabilities. Firstly, companies can use the quoted prices for an identical item in an active market on a specific measurement date. It represents the first level of the fair value hierarchy, which is also the most reliable.
Companies may also use directly or indirectly observable inputs other than quoted prices. For example, they can use quoted prices for similar assets in active markets or identical assets in less active markets. It represents the second level of the fair value hierarchy.
Lastly, companies may use unobservable inputs to determine the fair value of their assets and liabilities. It may include cash or profit forecasts. It represents the third level of the fair value hierarchy, which has the least priority.
Conclusion
The fair value of an asset or a liability represents its estimated worth in the market based on several factors. These factors generally include condition, restriction, and location. Fair value is a crucial concept for fair value accounting, which companies can use in their accounting.
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