Finding an accurate value for your company or asset holdings is critical for businesses to function well. Strong financial decisions come from reliable assessments. They also factor in many different data sources. Fair value accounting is one such tool used to find the equitable value of an asset between both buyer and seller.
What Is Fair Value Accounting?
Fair value accounting is a process in which an accountant determines the fair price of an asset for both the buyer and seller. The fair value is calculated across several unbiased and rational factors.
Fair value accounting was established and implemented by the Financial Accounting Standards Board in 2006. Fair value itself is intended as an unbiased process by which someone generates an estimate of a good or asset. The calculation is made based on many factors, both objective and subjective.
These are some of the facets of the fair value assessment:
- Market Conditions: While other evaluation techniques rely on historical data, fair value accounting looks at current market sentiment to figure out the value
- Holder Intention: How the holder of the asset matters, such as if they are looking to sell quickly or not.
- Uninfluenced Transactions: Fair value comes from a review of unpressured transactions, such as those caused by liquidation or short sale.
- Third-Party Interest: Parties outside of the transaction sum up to help determine fair value, as someone related to the transaction could artificially alter the price.
These factors are combined into a calculation to ultimately find the fair value pricing for the good or asset in question.
How Do You Determine Fair Value?
Determining fair value happens across three levels of data. These levels refer to how close the data is to the asset in question. As you get further away from the asset in question, the higher level of data you are working with.
These levels are defined by the IFRS 13 Fair Value Measurement standard. This standard comes from the International Accounting Standards Board (IASB), which releases and updates these standards as the economic landscape changes over time.
Here is the hierarchy of data as given from IFRS 13:
Level 1
Level 1 data comes from direct quotes of identical assets or liabilities in the active market. The asset in question could be stock prices or commodity volumes pushed through an exchange at the time of evaluation.
The definition of an active market is the marketplace where asset and liability transactions occur at a high enough volume to have ongoing pricing information. Stock exchanges are one example of these marketplaces.
Level 2
In level 2, the data comes from sources indirectly related to the assets or goods in question. This data also comes from related assets in both active and inactive markets, rather than just active markets.
For example, a fair value assessment of real estate could entail looking at pricing for buildings in the same area as the building in question or similar markets in other places in the world.
Level 3
When Level 1 and Level 2 data aren’t available, Level 3 can provide some insight. However, it isn’t the most objective data, relying on valuation techniques to generate the data instead of market direct and indirect market forces. Level 3 data tends to be unobservable because the data is calculated rather than surveyed.
Fair Value and Financial Statements
Fair value assessments help generate accurate financial statements. By determining the value of an asset or liability using fair value accounting, a company can create an accurate financial statement based on current market trends.
This can be difficult to determine when the asset or liability in question is abnormal or outside an active market. Rare equipment or materials could mean that the accountant has to run valuation measures to determine an approximate price for the item in question.
Regardless, fair value accounting can provide unbiased financial statements in an ideal circumstance.
Fair Value vs. Carrying Value
Unlike fair value, the carrying value for an asset is determined by more than just current market sentiment. Carrying value also factors in the costs associated with an asset, such as depreciation and impairment expenses.
In other words, carrying value goes beyond the original purchase price of the asset. However, fair value factors in some prospective factors like growth and profit.
Fair Value vs. Market Value
Market value is a more volatile version of fair value. While fair value has calculations made in finding an asset’s value, market value’s basis is in current pricing for the asset in question. There are no factors of growth or profit made, just what the marketplace is willing to spend at that particular moment.
The factors that determine market value are the age-old factors of supply and demand. An artificial or abnormal swing in one of these factors could wildly swing the market value of an asset low or high. This is what makes market value more volatile than fair value.
Advantages of Fair Value Accounting
Fair value accounting has several benefits that make it a useful tool, such as:
- Accuracy: Fair value accounting tends towards accuracy thanks to its consideration of many factors
- Income Assessment: When using fair value, you can find the true income of a company, rather than relying on only profit and loss reporting
- Adaptability: Fair value accounting works across asset types, making it viable for assessing almost any asset.
- Strength and Utility: Fair value accounting can help a business survive a rough financial period by providing accurate data that implements quickly
Conclusion
Fair value accounting is a worthwhile tool in finding an asset’s worth in the marketplace. By factoring in both current and future market factors, fair value can work as an accurate tool for finding the value of an asset. To have a fair value for your company, contact us to find an accountant that will assist you with your needs