FAIR VALUE ACCOUNTING: Definition, Example and Advantages

fair value accounting

Accurate valuations are a crucial element of accounting. This brings us to fair value accounting. In this post, we’ll go over all you need to know about the fair value accounting method, including its benefits and drawbacks, as well as the controversy surrounding it. We’ll also see an example of fair value accounting in this article.

What is Fair Value Accounting?

The process of evaluating your company’s liabilities and assets at their current market value is referred to as fair value accounting. In other terms, “fair value” is the amount for which an asset could be sold (or an obligation paid) that is fair to both buyer and seller. The Financial Accounting Standards Board (FASB) adopted fair value accounting to standardize the computation of financial instruments.

Fundamentals of Fair Value Accounting

You should take note of the following concepts when it comes to fair value accounting:

Current market conditions — Rather than historical transactions, the fair value of an asset is determined by the market conditions on the day of measurement.

Holder’s intention – It’s also worth noting that the holder’s intention should be ignored when assessing fair value. For example, if the holder intends to sell the asset immediately, it may result in a hasty sale, decreasing the asset’s price.

Fair value is also dependent on orderly transactions in which there is no pressure on the seller to sell, which is why fair value accounting does not apply to enterprises in the process of liquidation.

Third-party – Furthermore, fair value is thought to stem from the sale to a third party, rather than a company insider or anyone associated to the seller in some way (as this could skew the value of the asset).

Characteristics of Fair Value Accounting 

#1. Market

The change in fair value is determined by the broader market; if an item is sold at a price lower than its fair value, the item’s fair value does not change as a result of the transaction. The market determines fair value, or how much everyone is willing to pay for a certain thing.

#2. Holding Time

When the item holder is not in a hurry to sell the security, the fair value is calculated. During a rush, the holder may be willing to sell the item at a reduced price. As a result, fair value accounting presupposes that the fair value is set by people who are willing to hold the thing for an extended period of time.

#3. Future Cash Flows

The asset’s fair value will be established by calculating the present value of all future cash flows generated by the asset. As a result, this attribute aids in asset pricing neutrality.

#4. Proper Transaction

The transaction should take place in a public market where everyone can witness and participate in the deal. Transactions conducted behind closed doors will not be subject to Fair Value pricing. So, in Fair Value Pricing, no outside element should influence the price.

#5. Mentioned Date

Fair value is always calculated as of a specific date. As a result, the fair value may alter on a daily basis because market conditions are not static.

How does the fair value accounting method value assets?

Three levels of data can be used to calculate the value of an asset or liability, according to IFRS 13 Fair Value Measurement. They are the following:

Level 1 – The quoted price of identical items in a competitive market (a market where liabilities and assets are transacted frequently and at high volumes, giving ongoing pricing information).

Level 2 – Observable data for comparable items in active or dormant marketplaces, rather than quoted prices. For example, comparable real estate.

Level 3 — Unobservable inputs, utilized only when markets are unavailable or illiquid. Examples include your company’s own data, such as a financial estimate developed internally.

Keep in mind that these levels are just used to pick inputs for various valuation algorithms, not to assess the fair value of the assets themselves. To make the real valuation, you can utilize a variety of different valuation methodologies, such as the market approach, the cost approach, or the income approach. Because these valuation approaches differ greatly, the optimal technique to apply for your company’s assets relies on the type of asset you own.

Historical Cost vs Fair Value Accounting

There are significant variations between fair value accounting and historical cost accounting. In essence, historical cost accounting values assets and liabilities at the time they were acquired. In other words, it tells you how much the asset costs. Fair value accounting, on the other hand, evaluates assets at the current market price. This implies it offers you the expected return on an asset if you were to sell it.

There are a few further distinctions to be made. Unlike fair value, the historical cost cannot be used to compare assets from different corporations (as different methods may have been adopted for depreciation). It’s also important to realize that the fair value estimate is far more complicated than the historical cost calculation and needs a number of assumptions. So, when it comes to fair value vs. historical cost accounting, all accounting methods have advantages, but fair value accounting is a better alternative for determining the current worth of an asset.

Example of Fair Value Accounting Method

In November 2019, Mr. Y purchased a $100,000 derivative contract. The agreement is for three months. The fiscal year begins in January. The contract value is $90,000 as of the end of December. If Mr. Y uses fair value accounting, how will he demonstrate this change?

Solution

Mr. Y must mark the market at the conclusion of the fiscal year since he uses Fair Value accounting. The contract’s fair value is less than what is represented on the Balance Sheet at the end of the year. As a result, Mr. Y must report an unrealized loss of $10,000 in the Profit and Loss Statement and reduce the contract’s value in the balance sheet by $10,000.

In November of 2019,

In the balance sheet – a $100,000 contract for January 2020

Contract $90,000 on the balance sheet Unrealised Loss in the profit and loss statement $10,000

The Benefits and Drawbacks of the Fair Value Accounting Method

Benefits

  • Fair value accounting reflects the current pricing of balance-sheet items. As a result, the balance sheet is constantly updated and reflects the true picture of the company.
  • As unrealized gains/losses are marked under this method, regular market marking assists stakeholders in obtaining an accurate profit/loss picture.
  • Because Fair Value is employed, management cannot manipulate pricing, and the auditor can simply verify the prices.

Drawbacks

  • Fair value determination might be difficult at times. When there aren’t enough buyers and sellers, determining Fair Value might be difficult.
  • Management may manipulate the profit by displaying an unrealized gain that may not be sustained at the asset’s actual sale.
  • Fair Value introduces volatility into financial statements, which many investors dislike. Investors prefer a reliable financial sheet they can rely on.

Controversy Over Fair Value Accounting

On October 8, 2008, investors were desperate to figure out why equities were plummeting and banks had stopped lending. The financial crisis was at its peak. That day, William Isaac, a former chair of the Federal Deposit Insurance Corporation, appeared on television and blamed bankers’ accountants. “The Securities and Exchange Commission has destroyed $500 billion of bank capital through its stupid marking to market of these assets that have no marking to market,” he said. “This has wiped out $5 trillion in bank lending.” In other words, the federal government’s accounting regulations were at the heart of the then-developing financial disaster. Many bankers and investors agreed with Isaac.

Government accountants, overseen by the Governmental Accounting Standards Board (GASB), have embraced these same norms, known as “fair value” accounting, with the same zeal as bankers’ and investors’ accountants. In reality, during the last three years, the people who design state and local accounting rules have made fair value a crucial consideration in how governments manage their pensions, investments, and retiree health care. As strange as it may sound, this is a good thing.

Is Fair Value Really Fair?

How can some people regard fair value as unfair while others regard it as fair? Everything is in the eye of the beholder. If you ask an accountant how much something is worth, you will receive one of two responses. The standard answer is “whatever you paid for it.” If a local government paid $1 million for a piece of land ten years ago, the fair value of the land is $1 million. Accountants refer to this as “historical cost.”

But what if a developer is desperate for the land and is willing to pay three times the original purchase price? Is it a reasonable market value? No, according to the accountant. It’s only a conjecture until someone pays that price. That is why accountants are trusted. They work with real numbers.

Of course, the real and the speculative occasionally collide. The prices of equities traded on the New York Stock Exchange, for example, are updated every second. These are technically estimations, although they are based on millions of actual transactions. As a result, accountants are at ease matching a stock’s offered price to its fair value. The same is true for other sorts of investments that might be “marked to market” since they are purchased and sold in a liquid market.

The Final Controversy on Fair Value Accounting

Banks and other financial organizations routinely mark their investments to market. That’s fantastic when market values are rising. However, if markets dry up, as they did during the financial crisis, the consequences are evident and urgent. This has the potential to damage investor confidence. That is also why, during the crisis, the finance industry exerted great pressure on the Securities and Exchange Commission to halt mark-to-market accounting. They believed that reporting fair market values averaged over time would better reflect “normal” market conditions. Regulators were on the verge of capitulating at the time, but they didn’t. They are now rethinking.

GASB, on the other hand, has boosted its own fair value ante. It limited governments’ capacity to “smooth” the fair value of their investments in its new pension liability rules. That example, rather than reporting a single period in time, the average value of pension investments should be reported across time. With interest rates at historically low levels and the stock market volatility, those assets have underperformed, potentially resulting in increased pension funding expenses and less certainty when budgeting for those costs. The GASB’s revised rules for other post-employment benefits, such as retiree health care, may have the same impact. In addition, the accounting group expanded its own fair value framework for governments.

Many of the GASB’s most important stakeholders have expressed dissatisfaction with its understanding of fair value. However, there is no doubt that they have implemented that term clearly and consistently. To put it another way, they have resisted the temptation to politicize this obscure but critical aspect of accounting. That brings much-needed fairness to fair value.

Conclusion

Modern accounting accepts Fair Value Accounting since it presents the true picture of the organization. Accounting standards are gradually shifting in this direction. Conversely, fair value should be calculated as efficiently as possible, with no manipulation.

Fair Value Accounting FAQs

What is meant by fair value in accounting?

Fair value is a wide measure of an asset’s worth that differs from market value, which refers to an asset’s market price. In accounting, fair value refers to the projected value of a company’s assets and liabilities as shown on its financial statements.

How do you calculate fair value accounting?

You can calculate the fair value of your asset using the average of three sale prices. If three similar trucks are priced at $8,500, $8,100, and $8,000, the average is $8,200.

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