Fair value accounting uses current market values as the basis for recognizing certain assets and liabilities. Fair value is the estimated price at which an asset can be sold or a liability settled in an orderly transaction to a third party under current market conditions. This definition includes the following concepts:
- Current market conditions. The derivation of fair value should be based on market conditions on the measurement date, rather than a transaction that occurred at some earlier date.
- Intent. The intention of the holder of an asset or liability to continue to hold it is irrelevant to the measurement of fair value. Such intent might otherwise alter the measured fair value. For example, if the intent is to immediately sell an asset, this could be inferred to trigger a rushed sale, which may result in a lower sale price.
- Orderly transaction. Fair value is to be derived based on an orderly transaction, which infers a transaction where there is no undue pressure to sell, as may be the case in a corporate liquidation.
- Third party. Fair value is to be derived based on a presumed sale to an entity that is not a corporate insider or related in any way to the seller. Otherwise, a related-party transaction might skew the price paid.
The ideal determination of fair value is based on prices offered in an active market. An active market is one in which there is a sufficiently high volume of transactions to provide ongoing pricing information. Also, the market from which a fair value is derived should be the principal market for the asset or liability, since the greater transaction volume associated with such a market should presumably lead to the best prices for the seller. The market in which a business normally sells the asset type in question or settles liabilities is assumed to be the principal market.
Under fair value accounting, there are several general approaches permitted for deriving fair values, which are:
- Market approach. Uses the prices associated with actual market transactions for similar or identical assets and liabilities to derive a fair value. For example, the prices of securities held can be obtained from a national exchange on which these securities are routinely bought and sold.
- Income approach. Uses estimated future cash flows or earnings, adjusted by a discount rate that represents the time value of money and the risk of cash flows not being achieved, to derive a discounted present value. An alternative way to incorporate risk into this approach is to develop a probability-weighted-average set of possible future cash flows.
- Cost approach. Uses the estimated cost to replace an asset, adjusted for the obsolescence of the existing asset.
GAAP provides a hierarchy of information sources that range from Level 1 (best) to Level 3 (worst). The general intent of these levels of information is to step the accountant through a series of valuation alternatives, where solutions closer to Level 1 are preferred over Level 3. The characteristics of the three levels are as follows:
- Level 1. This is a quoted price for an identical item in an active market on the measurement date. This is the most reliable evidence of fair value, and should be used whenever this information is available. When there is a bid-ask price spread, use the price most representative of the fair value of the asset or liability. This may mean using a bid price for an asset valuation and an ask price for a liability. When you adjust a quoted Level 1 price, doing so automatically shifts the result into a lower level.
- Level 2. This is directly or indirectly observable inputs other than quoted prices. An example of a Level 2 input is a valuation multiple for a business unit that is based on the sale of comparable entities. This definition includes prices for assets or liabilities that are (with key items noted in bold):
- For similar items in active markets; or
- For identical or similar items in inactive markets; or
- For inputs other than quoted prices, such as credit risks, default rates, and interest rates; or
- For inputs derived from correlation with observable market data.
- Level 3. This is an unobservable input. It may include the company’s own data, adjusted for other reasonably available information. Examples of a Level 3 input are an internally-generated financial forecast and the prices contained within an offered quote from a distributor.
These three levels are known as the fair value hierarchy. Please note that these three levels are only used to select inputs to valuation techniques (such as the market approach). The levels are not used to directly create fair values for assets or liabilities.