In fair value accounting, people would use current market values (Also see Are Market Value and Book Value the Same?) to recognize certain liabilities and assets. Fair value is defined as the predicted price that one can sell an asset or settle a liability to a third party in an orderly transaction based on current conditions of the market. This comprises of the concepts below:
- Current market conditions.Fair value should derive according to market conditions on that measurement date, instead of a transaction which happened earlier.
- Intent. There is no relationship between the intention of someone who holds an asset or a liability to keep on holding it and fair value measurement. If this condition is not achieved, this type of intent may cause a change in the fair value measurement. As an instance, if there is an intent of selling an asset immediately, this may cause a rushed sale to happen, and hence, the sale price would be lower.
- Orderly transaction. One should derive the fair value according to an orderly transaction, which concludes a transaction that does not have excessive pressure of selling it. A corporate liquidation is not an orderly transaction as there is undue pressure.
- Third party. One should derive fair value according to an assumed sale to an entity which is totally unrelated to the seller or not a corporate insider. If not, there will be a related-party transaction, and this may affect the price paid.
Determining fair value by referring to the prices people would offer in active markets is the best way. An active market is a market with an adequate high number of transactions to give current information on the pricing. Besides, the market that one derives the fair value from ought to be the principal market for a particular asset or liability, as we may assume that the massive transaction volume that such market possesses should bring to the ideal prices for the sellers. A business should suppose the market that it will usually sell its assets or settle its liabilities as its principal market.
According to fair value accounting, one can use a few general approaches to derive fair values:
- Market approach. One should use the prices related to real market transactions for the same or similar assets as well as liabilities in deriving fair values. For instance, one can acquire the prices of securities they hold from a national exchange that people would always buy and sell these securities.
- Income approach. One should use predicted earnings or cash flows in the future and adjust it by a calculating a discount rate which stands for the risk of not achieving the assumed cash flow, as well as the time value of money to derive a deducted current value. Another way of incorporating risk into this approach is by developing a probability-weighted average feasible cash flows in the future.
- Cost approach. One should use the predicted price to substitute an asset, and he should adjust for the obsolescence of that current asset.
Generally, the International Financial Reporting Standards (IFRS) (Also see What are IFRS and GAAP?) has provided a grading of information resources which range from Level 1 to Level 3, which is from the best to the worst. Generally, the purpose of providing these levels is to guide the accountants (Also see How an Accountant and a Financial Planner Differs) through a set of alternatives in valuation, where solutions that are nearer to Level 3 are less preferred when compared to Level 1. The three levels have the following traits:
- Level 1. It is a quoted price for the same thing in active markets on a particular measurement date. Among other approaches of deriving fair values, this way is the most reliable and one should use this when this information exists. Whenever a bid-ask spread is present, one should use the price that can represent the asset’s or liability’s fair value the most. This indicates that one should use bid prices for asset valuations and ask prices for liabilities. If you adjust a quoted price in Level 1, you are shifting the result to a lower level.
- Level 2. Apart from quoted prices, these are inputs that can be observed whether directly or indirectly. An instance of input in Level 2 is a valuation by using the multiple approaches for a business unit which is according to the sale of similar entities. This includes assets’ or liabilities’ prices which are
- For comparable objects in an active market; or
- For similar or the same objects in an inactive market; or
- For inputs apart from quoted prices, for example, default rates; or
- For inputs that one derives from correlation with noticeable information in the market.
- Level 3. It is an input that one cannot observe. It can comprise of the data of the firm, adjusted for other fairly accessible data. An instance of input in Level 3 is the financial predictions that a company has made internally.
People would call these three levels as the fair value hierarchy. Keep in mind that you should only use these three levels to choose inputs to valuation approaches. You should not use these levels to generate fair values for liabilities and assets directly. Accounting for fair value is not easy to understand. Hence, if you need help in the accounting-related tasks in your business, do not hesitate to engage an accounting firm in Johor Bahru to help you out.