Determining Fair Value
Fair value, is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account such objective factors as:
Fair value
Fair value is defined as a rational and unbiased estimate of the potential market price of a good, service, or asset.
- acquisition/production/distribution costs, replacement costs, or costs of close substitutes
- actual utility at a given level of development of social productive capability
- supply vs. demand
- subjective factors such as: risk characteristics; cost of and return on capital; individually perceived utility
In accounting, fair value is used as an approximation of the market value of an asset (or liability) for which a market price cannot be determined (usually because there is no established market for the asset). When an active market does not exist other methods have to be used to estimate the fair value. 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, the "most advantageous market" should be used. Both the price and costs to do the transaction must be considered in determining which market is the most advantageous market.
A three-level framework is used to determine an asset or liability's fair value:
- Level One -- The preferred inputs to valuation 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.
- Level Two -- This valuation is based on market observables. FASB indicates that assumptions enter into models that use Level 2 inputs, a condition that reduces the precision of the outputs (estimated fair values), but nonetheless produces reliable numbers that are representationally faithful, verifiable and neutral.
- Level Three -- The FASB describes Level 3 inputs as "unobservable." If observable inputs from levels 1 and 2 are not available, the entity may only rely on internal information if the cost and effort to obtain external information is too high. Within this level, fair value is also estimated using a valuation technique. Significant assumptions or inputs used in the valuation technique are based upon inputs that are not observable in the market and are based on 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.
Under US GAAP (FAS 157), fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties or transferred to an equivalent party other than in a liquidation sale. 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.
An example of how to determine fair value can involve the purchase of company shares of less than 20% total equity -- assume ABC Corporation purchases 10% of XYZ's Corporation's common stock, or 50,000 shares. The market price of the stock is USD 1. When purchasing less than 20% of a company's stock, the cost method is used to account for the investment. ABC records a journal entry for the purchase by debiting Investment in XYZ Corp. for USD 50,000 and crediting Cash for USD 50,000.
Adjusting Fair Value
As required by FAS 115, investments accounted for under the cost method should be adjusted to current fair value at the end of each accounting period, in cases where the fair value is readily determinable. Adjustments are debited (for gains in fair value) or credited (for losses) to a fair value adjustment account that will adjust the investment account balance to its fair value at the end of the reporting period.
If the investment is considered a "trading security" or stock purchased for the purpose of selling it in the near term, the balancing debit or credit is charged to an unrealized loss or gain account. If the investment is an "available for sale" security, the balancing debit or credit also goes to an unrealized loss or gain account. For investments where the fair value is not readily determinable, the investment is carried at cost.