Fair value accounting measures the value of a company's assets based on its future cash flows. This formula includes aspects like considering future profit margins, growth rates, and risk factors. The exact formula depends on the type of data used and the method of accounting. However, some aspects of fair value are constant over time.
Fair value accounting is an essential technique for companies to ensure that their financials reflect the current market value of their assets. It improves transparency, which benefits vendors, investors, and lenders. It also gives companies unbiased financial data. After all, people want to know what their assets are worth, and fair value accounting allows you to show them that.
Let’s know how it works with quick information in this guide!
Did You Know?
The control variables that can affect when you use the fair value are size and length of operation. If we talk about the accuracy rate of the entire prediction model, it’s 85.8%.
Fair Value Accounting Based On Current Market Conditions
Fair value accounting estimates an asset or liability based on current market conditions, and it doesn't rely on a historical transaction. As long as the quoted price is available in an active market, it is the most accurate proof of fair value.
However, you must note that the bid-ask spread should be used to choose the best indicative price. But be warned, fair value accounting has its drawbacks, and it's crucial to understand how it works before relying on it. Following are some of them:
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Orderly Transaction
If the seller was under pressure to settle liabilities, this could lead to an undervaluation of the asset. To avoid this problem, fair value accounting requires completing the sale orderly, with no undue pressure on the seller.
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Intention of Holder
The motives of the owner could alter the fair value. For example, if the owner plans to sell an asset in a hurry, this could result in an unplanned sale. Also, it will further lower the value of selling the asset. If the seller intended to sell the asset quickly, this would have led to a lower price.
Also Read: What is Enterprise Value, and How can You Calculate it?
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Third-Party
You can calculate the Fair Value by selling the asset to an unrelated (third) person. A person who is a related party, such as an insider of a company or any other person associated with the seller. It will help in altering the amount paid for the asset.
How Do You Determine Fair Value?
Now that you know what fair value means let’s understand how to determine fair value in accounting? This question can be tricky at times, particularly if there are few buyers or sellers. Moreover, management may try to change the price by presenting an unexpected gain. It will not last during the sale.
Make sure you do your homework when determining fair value to avoid this. Here are some guidelines to consider. Read further to learn how to determine fair value in accounting with level-wise steps.
Level 1
The quoted price of the identical item on the date of measurement. The level one value is generally the best fair value’s evidence. Level one is useful for assets and liabilities when there’s a bid-ask cost spread. Using the Level 1 adjustment shifts automatically the result to the lower level. However, this adjustment is only appropriate for inputs derived from correlation with observable market data.
Level 2
Level 2 inputs are the information you can observe for the same items active/non-active in the mark. For example, two grocery stores located in the same spot.
Level 3
Talking about calculating fair value, if the values for levels 1 and 2 are not available, you can calculate the fair value using valuation methods. Level 3 input is necessary that you must use when markets aren't available, or you’re out of the investment.
Fair market value is extremely subjective, and companies can include their adjusted data to include other readily available data. Estimating fair Value requires considerable judgement. If you want to know the fair value, it includes identifying the type of transaction and determining the perspective of a market participant. Then, the fair value of an asset is determined and disclosed by accounting principles.
However, determining the fair value of an asset depends on many factors. Fair value is the exit price in the principal market. It is important to consider all these factors when determining the fair value of an asset.
Advantages of Fair Value Accounting
Fair value accounting is a method of measuring the estimated or actual value of an investment. It is among the most popular accounting methods for financial purposes because of its benefits that include:
- A true measurement of income: With fair value accounting, the entire asset value shows the actual earnings. It does not depend on reports of profits and losses but instead examines the real value.
- Accuracy of valuation: Valuations are more precise by accounting for fair value. It means that valuations will follow price changes when they go up or down.
- Helps businesses survive: Fair value accounting allows businesses to thrive during a difficult financial time. It permits the reduction of assets.
- Flexible to various types of assets: The method used can calculate valuations for all kinds of assets that are more accurate than using historical cost values that may fluctuate over the course.
Also, you can learn the basics of accounting to understand the calculations and formulas in a better way.
What Are Fair Value vs Market Value Calculations?
Now that you know the definition of fair value let’s see the difference between it and market value. Market value can also differ from fair value for the following reasons:
- It could be based on an asset's most recent price or quote. For example, if in the last three months the market value of a share in company "A" was ₹300. Then, in the most recent appraisal, the value was reduced to ₹200. It means the market value of that share is ₹200.
- Market value fluctuates over the fair value.
- The supply and demand influence market value in the marketplace in which the asset is purchased and sold. For example, a home sold will have its cost determined by the current conditions of the market within the area. If the owner attempts to sell a house at a price of ₹30 lacs in a slow period on the real estate and it cannot sell because there isn't much demand. It could be sold if it's offered at ₹50 lacs in a peak period.
Also Read: What Is Goodwill in Accounting?
How Does Fair Value Differ From Carrying Value?
You can understand carrying value and fair value as two distinct things. Think about the following:
- Carrying value is also famous for the name “book value.” This is the Value or amount of an asset in the way shown on the balance sheet. You can calculate it by subtracting the depreciation accumulated on the asset. Also, you must impair costs from the initial price, as shown in the balance sheet.
- The fair value refers to the real value of an asset set that the purchaser will pay according to the price mentioned in the contract between the sellers. Both parties profit from the deal. If you want to determine the fair value, it is necessary to analyse the future growth rates, the risk factors, and profit margins.
- The asset's value is not the initial purchase value of the asset. But, it's the value it has attained over time.
Conclusion
Generally, the fair value represents the highest price an asset could sell for in the free market. Fair Value would indicate a free market as long as the seller and buyer are knowledgeable and willing to sell.
This is different from market value, which is based on actual market prices and reflects the intrinsic worth of an asset. Most companies assess their fair Value by listing their securities on a publicly-traded exchange.
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