HOME

TheInfoList




In
accounting Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to compare with other ob ...
and in most
schools of economic thought A school is an educational institution designed to provide learning spaces and learning environments for the teaching of students (or "pupils") under the direction of teachers. Most countries have systems of formal education, which is someti ...
, fair value is a rational and unbiased
estimate Estimation (or estimating) is the process of finding an estimate, or approximation, which is a value that is usable for some purpose even if input data may be incomplete, uncertainty, uncertain, or Instability, unstable. The value is nonetheless ...
of the potential
market price A price is the (usually not negative) quantity Quantity is a property that can exist as a multitude or magnitude, which illustrate discontinuity and continuity. Quantities can be compared in terms of "more", "less", or "equal", or b ...
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 In microeconomics Microeconomics is a branch of that studies the behavior of individuals and in making decisions regarding the allocation of and the interactions among these individuals and firms. Microeconomics focuses on the study ...

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 As a topic of economics Economics () is a social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among individuals within thos ...

utility
.


Economic understanding


Vs 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 The efficient-market hypothesis (EMH) is a hypothesis in financial economics Financial economics is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear o ...
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 Rational pricing is the assumption in financial economics Financial economics is the branch of economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), productio ...
. *
Behavioral finance Behavioral economics (also, behavioural economics) studies the effects of psychological Psychology is the scientific Science () is a systematic enterprise that Scientific method, builds and organizes knowledge in the form of Te ...
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.


Vs market value

The latest edition of International Valuation Standards (IVS 2017), clearly distinguishes between fair value (now referred to as "equitable value"), as defined in the IVS, and
market value Market value or OMV (Open Market Valuation) is the price at which an asset would trade in a Market (economics), competitive auction setting. Market value is often used interchangeably with ''open market value'', ''fair value'' or ''fair market va ...
, as defined in the IVS: :So as the term is generally used, ''Fair Value'' can be clearly distinguished from ''Market Value''. It requires the assessment of the price that is fair between two specific parties taking into account the respective advantages or disadvantages that each will gain from the transaction. Although ''Market Value'' may meet these criteria, this is not necessarily always the case. ''Fair Value'' is frequently used when undertaking due diligence in corporate transactions, where particular synergies between the two parties may mean that the price that is fair between them is higher than the price that might be obtainable on the wider market. In other words ''Special Value'' may be generated. ''Market Value'' requires this element of ''Special Value'' to be disregarded, but it forms part of the assessment of ''Fair Value''.


Accounting

In
accounting Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to compare with other ob ...
, fair value is used as a certainty 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). Under
US GAAP Generally Accepted Accounting Principles (GAAP or U.S. GAAP, pronounced like "gap") is the accounting standard adopted by the U.S. Securities and Exchange Commission (SEC). While the SEC previously stated that it intends to move from U.S. GAAP ...
( FAS 157), 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 In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Trad ...
is based on
mark-to-market Mark-to-market (MTM or M2M) or fair value accounting refers to accounting for the "fair value In accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about econo ...
valuations; for assets carried at
historical cost In accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as businesses and corporations. Accounting, which has been called ...
, the fair value of the asset is not used. *One example of where fair value is an issue is 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 this one. *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 (US markets)

The Financial Accounting Standards Board (
FASB The Financial Accounting Standards Board (FASB) is a private standard-setting body whose primary purpose is to establish and improve Generally Accepted Accounting Principles Publicly traded companies typically are subject to the most rigorous ...
) issued Statement of Financial Accounting Standards No. 157: Fair Value Measurements (" FAS 157") in September 2006 to provide guidance about how entities should determine fair value estimations for financial reporting purposes. FAS 157 broadly applies to financial and nonfinancial assets and liabilities measured at fair value under other authoritative accounting pronouncements. However, application to nonfinancial assets and liabilities was deferred until 2009. Absence of one single consistent framework for applying fair value measurements and developing a reliable estimate of a fair value in the absence of quoted prices has created inconsistencies and incomparability. The goal of this framework is to eliminate the inconsistencies between balance sheet (historical cost) numbers and income statement (fair value) numbers. Subsequently, FAS 157 was subsumed into
FASB The Financial Accounting Standards Board (FASB) is a private standard-setting body whose primary purpose is to establish and improve Generally Accepted Accounting Principles Publicly traded companies typically are subject to the most rigorous ...
Accounting Standards Codification In US accounting practices, the Accounting Standards Codification is the current single source of United States Generally Accepted Accounting Principles (GAAP). It is maintained by the Financial Accounting Standards Board (FASB). FASB accounting s ...
(ASC) Topic 820 (Fair Value Measurement), which now 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 (and dividends lost because the investor owns the futures contract rather than the physical stocks) 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 In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money avai ...

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. The framework uses 3-level fair value hierarchy to reflect the level of judgment involved in estimating fair values. The hierarchy is broken down into three levels: ;Level One: The preferred inputs to valuation efforts 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, not assumptions, and thus offers superior reliability. However, relatively few items, especially physical assets, actually trade in active markets. If available, a quoted market price in an active market for identical assets or liabilities should be used. To use this level, the entity must have access to an active market for the item being valued. In many circumstances, quoted market prices are unavailable. If a quoted market price is not available, preparers should make an estimate of fair value using the best information available in the circumstances. The resulting fair value estimate would then be classified in Level Two or Level Three. ;Level Two: This is ''valuation'' based on ''market observables''. FASB acknowledged that active markets for identical assets and liabilities are relatively uncommon and, even when they do exist, they may be too thin to provide reliable information. To deal with this shortage of direct data, the board provided a second level of inputs that can be applied in three situations: The first involves less-active markets for identical assets and liabilities; this category is ranked lower because the market consensus about value may not be strong. The second arises when the owned assets and owed liabilities are similar to, but not the same as, those traded in a market. In this case, the reporting company has to make some assumptions about what the fair value of the reported items might be in a market. The third situation exists when no active or less-active markets exist for similar assets and liabilities, but some observable market data is sufficiently applicable to the reported items to allow the fair values to be estimated. :For instance, the price of an option based on Black–Scholes and market
implied volatilityIn financial mathematicsMathematical finance, also known as quantitative finance and financial mathematics, is a field of applied mathematics, concerned with mathematical modeling of financial markets. Generally, mathematical finance will derive and ...
. Within this level, fair value is estimated using a valuation technique. Significant assumptions or inputs used in the valuation technique requires the use of inputs that are observable in the market. Examples of observable market inputs include: quoted prices for similar assets, interest rates, yield curve, credit spreads, prepayment speeds, etc. In addition, assumptions used in estimating fair value must be assumptions that an unrelated party would use in estimating fair value. Notably, 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 inputs from levels 1 and 2 are not available, FASB acknowledges that fair value measures of many assets and liabilities are less precise. Within this level, fair value is also estimated using a valuation technique. However, significant assumptions or inputs used in the valuation technique are based upon inputs that are ''not'' observable in the market and, therefore, necessitates the use of 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.” FASB explains that “observable inputs” are gathered from sources other than the reporting company and that they are expected to reflect assumptions made by market participants. In contrast, “unobservable inputs” are not based on independent sources but on “the reporting entity’s own assumptions about the assumptions market participants would use.” The entity may only rely on internal information if the cost and effort to obtain external information is too high. In addition, financial instruments must have an input that is observable over the entire term of the instrument. While internal inputs are used, the objective remains the same: estimate fair value using assumptions a third party would consider in estimating fair value. Also known as mark to management. Despite being “assumptions about assumptions,” Level 3 inputs can provide useful information about fair values (and thus future cash flows) when they are generated legitimately and with best efforts, without any attempt to bias users’ decisions. 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 The International Accounting Standards Board (IASB) is the independent, accounting standard Publicly traded companies typically are subject to the most rigorous standards. Small and midsized businesses often follow more simplified standards, plus ...
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 is similar to the US GAAP guidance. It 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 (an exit price). When measuring fair value, an entity uses the assumptions that market participants would use when pricing the asset or the liability under current market conditions, including assumptions about risk." As a result, IFRS 13 requires entities to consider the effects of
credit risk A credit risk is risk of default Default may refer to: Law * Default (law), the failure to do something required by law ** Default (finance) In finance Finance is the study of financial institutions, financial markets and how they ope ...
when determining a fair value measurement, e.g. by calculating a credit valuation adjustment (CVA) or debit valuation adjustment (DVA) on their
derivatives Derivative may refer to: In mathematics and economics *Brzozowski derivative in the theory of formal languages *Derivative in calculus, a quantity indicating how a function changes when the values of its inputs change. *Formal derivative, an opera ...
.


See also

* Deprival value *
Fair value accounting Mark-to-market (MTM or M2M) or fair value accounting refers to accounting for the "fair value" of an asset or liability based on the current market price, or the price for similar assets and liabilities, or based on another objectively assessed " ...
*
Hedge accounting Hedge accounting is an accountancy practice, the aim of which is to provide an offset to the mark-to-market movement of the derivative (finance), derivative in the profit and loss account. There are two types of hedge (finance), hedge recognized. ...
*
Tax amortization benefitIn accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as businesses and corporations. Accounting, which has been called ...
*
Valuation risk Valuation risk is the financial risk that an asset is overvalued and is worth less than expected when it matures or is sold. Factors contributing to valuation risk can include data management, incomplete data, market instability, financial mode ...


References

{{Authority control United States Generally Accepted Accounting Principles Pricing Real estate valuation Valuation (finance)