What is Fair Value?

Fair value is the estimated price at which an asset or liability could be exchanged in an orderly transaction between market participants at the measurement date. It reflects current market conditions rather than historical cost. Fair value is often determined using market prices, comparable transactions, or valuation models. It is commonly used in financial reporting to provide more relevant and timely information about an entity’s financial position.

How to Account for Fair Value

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 concepts noted below:

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 of the holder. 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.
Sale to a 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.
Active market. 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 this 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.

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Fair Value Accounting

Methods for Deriving Fair Value

Under fair value accounting, there are several general approaches permitted for deriving fair values, which are noted below:

Market approach. The 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. The 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. The cost approach uses the estimated cost to replace an asset, adjusted for the obsolescence of the existing asset.

The Fair Value Hierarchy

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 noted below. 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.

Level 1. These inputs are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. These observable market prices provide the most reliable evidence of fair value and require no adjustments.
Level 2. These inputs are observable inputs other than quoted prices for identical items, such as quoted prices for similar assets, interest rate yield curves, credit spreads, or market-corroborated data. Valuations at this level rely on indirect market data and may require limited adjustments.
Level 3. These inputs are unobservable inputs that reflect the entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability. These measurements typically involve significant judgment, modeling techniques, and extensive disclosure due to their subjectivity.