The approach of fair value accounting is the measurement of assets and liabilities at their current market value. The fair value is the amount of the asset that can be sold or liability paid for a fair value both for the buyer and the seller.
The best way to determine an asset’s fair value is through an exchange listing of security. Fair value accounting is also known as “mark-to-market,” one of the most commonly recognized standards of valuation when it is sold or assets are acquired.
What this article covers:
- How to Account for Fair value?
- How do you value assets with the fair value accounting method?
- Advantages of Fair Value Accounting
- Fair value vs. historical cost accounting
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 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.
How do you value assets with the fair value accounting method?
According to IFRS 13 Fair Value Measurement, there are three levels of data that you can use to determine the value of an asset or liability. These are as follows:
Level 1 – The quoted price of identical items in an active market (a market where liabilities and assets are transacted frequently and at high volumes, giving ongoing pricing information).
Level 2 – Observable information for similar items in active or inactive markets, rather than quoted prices. For example, real estate in similar locations.
Level 3 – Unobservable inputs, only used when markets are non-existent or illiquid. Examples include your company’s own data, such as an internally generated financial forecast.
Remember that these levels are only used to select your inputs to different valuation techniques, not to estimate the fair value of the assets themselves. There are a broad range of different valuation techniques that you may wish to make use of to make the actual valuation, including the market approach, the cost approach, or the income approach. These valuation techniques vary wildly, so the best technique to use for your company’s assets depends on the type of asset you hold.
Advantages of Fair Value Accounting
Fair value accounting measures the actual or estimated value of an asset. It is one of the most commonly used financial accounting methods because of its advantages, which include:
1. Accuracy of valuation
With fair value accounting, valuations are more accurate, such that the valuations can follow when prices go up or down.
2. True measure of income
With fair value accounting, it is the total asset value that reflects the actual income of a company. It doesn’t rely on a report of profits and losses but instead just looks at actual value.
3. Adaptable to different types of assets
Such a method is able to make valuations across all types of assets, which is better than using historical cost value which may change through time.
4. Helps businesses survive
Fair value accounting helps businesses survive during a financially difficult time because it allows asset reduction (or the act of declaring that the value of an asset that is included in a sale was overestimated).
Fair value vs. historical cost accounting
The differences between fair value accounting and historical cost accounting are stark. Essentially, historical cost accounting values assets and liabilities at the initial price they were exchanged for. In other words, it provides you with the cost of the asset. However, fair value accounting values assets at the prevailing market price. This means that it provides you with the expected return that an asset would fetch if you wanted to sell it.
There are a few other distinctions that are worth noting. Whereas fair value can be used to compare assets from different entities, the historical cost cannot (as different methods may have been adopted for depreciation). It’s also worth remembering that the fair value calculation is much more complex than historical cost and requires various assumptions. So, when it comes to fair value vs. historical cost accounting, both accounting methods have virtues, but to assess the current value of an asset, fair value accounting is a more appropriate option.
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