Fair value
Encyclopedia
Fair value, also called fair price (in a commonplace conflation of the two distinct concepts), is a concept used in accounting
Accountancy
Accountancy is the process of communicating financial information about a business entity to users such as shareholders and managers. The communication is generally in the form of financial statements that show in money terms the economic resources under the control of management; the art lies in...

 and economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, defined as a rational and unbiased estimate of the potential market price
Market price
In economics, market price is the economic price for which a good or service is offered in the marketplace. It is of interest mainly in the study of microeconomics...

 of a good, service, or asset, taking into account such objective factors as:
  • acquisition/production/distribution costs, replacement costs, or costs of close substitutes
  • actual utility
    Utility
    In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....

     at a given level of development of social productive capability
  • supply vs. demand


and subjective factors such as
  • risk characteristics
  • cost of and return on capital
  • individually perceived utility


In accounting, fair value is used as a certainty of the market value of an asset (or liability) for which a market price cannot be determined (usually because there is no established market for the asset). Under US GAAP (FAS 157), fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties, or transferred to an equivalent party, other than in a liquidation sale. This is used for assets whose carrying value
Book value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's book value...

 is based on mark-to-market valuations; for assets carried at historical cost
Historical cost
In accounting, historical costs is the original monetary value of an economic item. Historical cost is based on the stable measuring unit assumption. In some circumstances, assets and liabilities may be shown at their historical cost, as if there had been no change in value since the date of...

, the fair value of the asset is not used. One example of where fair value is an issue is a college kitchen with a cost of $2 million which was built five years ago. If the owners wanted to put a fair value measurement on the kitchen it would be a subjective estimate because there is no active market for such items or items similar to this one. In another example, if ABC Corporation purchased a two-acre tract of land in 1980 for $1 million, then a historical-cost financial statement would still record the land at $1 million on ABC’s balance sheet. If XYZ purchased a similar two-acre tract of land in 2005 for $2 million, then XYZ would report an asset of $2 million on its balance sheet. Even if the two pieces of land were virtually identical, ABC would report an asset with one-half the value of XYZ’s land; historical cost is unable to identify that the two items are similar. This problem is compounded when numerous assets and liabilities are reported at historical cost, leading to a balance sheet that may be greatly undervalued. If, however, ABC and XYZ reported financial information using fair-value accounting, then both would report an asset of $2 million. The fair-value balance sheet provides information for investors who are interested in the current value of assets and liabilities, not the historical cost.

Fair value vs market price

There are two schools of thought about the relation between the market price and fair value in any kind of market, but especially with regard to tradable assets:
  • The efficient market hypothesis
    Efficient market hypothesis
    In finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.There are...

     asserts that, in a well organized, reasonably transparent market, the market price is generally equal to or close to the fair value, as investors react quickly to incorporate new information about relative scarcity, utility, or potential returns in their bids; see also Rational pricing
    Rational pricing
    Rational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away"...

    .
  • Behavioral finance
    Behavioral finance
    Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...

     asserts that the market price often diverges from fair value because of various, common cognitive biases among buyers or sellers. However, even proponents of behavioral finance generally acknowledge that behavioral anomalies that may cause such a divergence often do so in ways that are unpredictable, chaotic, or otherwise difficult to capture in a sustainably profitable trading strategy, especially when accounting for transaction costs.

Fair value vs market value

The latest edition of International Valuation Standards
International Valuation Standards Committee
The International Valuation Standards Council is charged with developing robust and transparent procedures for performing international valuations through a single set of globally recognized valuation standards, acceptable to the world’s capital markets organisations market participants and...

 (IVS 2007), clearly distinguishes between fair value, as defined in the IFRS, and market value
Market value
Market value is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value or fair market value, although these terms have distinct definitions in different standards, and may differ in some...

, as defined in the IVS:
So As the term is generally used, Fair Value can be clearly distinguished from Market Value. It requires the assessment of the price that is fair between two specific parties taking into account the respective advantages or disadvantages that each will gain from the transaction. Although Market Value may meet these criteria, this is not necessarily always the case. Fair Value is frequently used when undertaking due diligence in corporate transactions, where particular synergies between the two parties may mean that the price that is fair between them is higher than the price that might be obtainable on the wider market. On other words Special Value may be generated. Market Value requires this element of Special Value to be disregarded, but it forms part of the assessment of Fair Value.

Fair value measurements (US markets)

The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157: Fair Value Measurements ("FAS 157") in September 2006 to provide guidance about how entities should determine fair value estimations for financial reporting purposes. FAS 157 broadly applies to financial and nonfinancial assets and liabilities measured at fair value under other authoritative accounting pronouncements. However, application to nonfinancial assets and liabilities is deferred until 2009. Absence of one single consistent framework for applying fair value measurements and developing a reliable estimate of a fair value in the absence of quoted prices has created inconsistencies and incomparability. The goal of this framework is to eliminate the inconsistencies between balance sheet (historical cost) numbers and income statement (fair value) numbers.

FAS 157 defines fair value as the price received to sell an asset or the price paid to transfer a liability in a transaction taking place in an active market. This is sometimes referred to as "exit value". In the futures market, fair value is the equilibrium price for a futures contract. This is equal to the spot price after taking into account compounded interest (and dividends lost because the investor owns the futures contract rather than the physical stocks) over a certain period of time. On the other side of the balance sheet the fair value of a liability is the amount at which that liability could be incurred or settled in a current transaction.

FAS 157 emphasizes the use of market inputs in estimating the fair value for an asset or liability. Quoted prices, credit data, yield curve
Yield curve
In finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...

, etc. are examples of market inputs described by FAS 157. Quoted prices are the most accurate measurement of fair value; however, many times an active market does not exist so other methods have to be used to estimate the fair value on an asset or liability. FAS 157 emphasizes that assumptions used to estimate fair value should be from the perspective of an unrelated market participant. This necessitates identification of the market in which the asset or liability trades. If more than one market is available, FAS 157 requires the use of the "most advantageous market". Both the price and costs to do the transaction must be considered in determining which market is the most advantageous market.

The framework uses 3-level fair value hierarchy to reflect the level of judgment involved in estimating fair values. The hierarchy is broken down into three levels:

Level One: The preferred inputs to valuation efforts are “quoted prices in active markets for identical assets or liabilities,” with the caveat that the reporting entity must have access to that market. An example would be a stock trade on the New York Stock Exchange. Information at this level is based on direct observations of transactions involving the identical assets or liabilities being valued, not assumptions, and thus offers superior reliability. However, relatively few items, especially physical assets, actually trade in active markets. If available, a quoted market price in an active market for identical assets or liabilities should be used. To use this level, the entity must have access to an active market for the item being valued. In many circumstances, quoted market prices are unavailable. If a quoted market price is not available, preparers should make an estimate of fair value using the best information available in the circumstances. The resulting fair value estimate would then be classified in Level Two or Level Three.

Level Two: This is valuation based on market observables. FASB acknowledged that active markets for identical assets and liabilities are relatively uncommon and, even when they do exist, they may be too thin to provide reliable information. To deal with this shortage of direct data, the board provided a second level of inputs that can be applied in three situations: The first involves less-active markets for identical assets and liabilities; this category is ranked lower because the market consensus about value may not be strong. The second arises when the owned assets and owed liabilities are similar to, but not the same as, those traded in a market. In this case, the reporting company has to make some assumptions about what the fair value of the reported items might be in a market. The third situation exists when no active or less-active markets exist for similar assets and liabilities, but some observable market data is sufficiently applicable to the reported items to allow the fair values to be estimated.

For instance, the price of an option based on Black–Scholes and market implied volatility
Implied volatility
In financial mathematics, the implied volatility of an option contract is the volatility of the price of the underlying security that is implied by the market price of the option based on an option pricing model. In other words, it is the volatility that, when used in a particular pricing model,...

. Within this level, fair value is estimated using a valuation technique. Significant assumptions or inputs used in the valuation technique requires the use of inputs that are observable in the market. Examples of observable market inputs include: quoted prices for similar assets, interest rates, yield curve, credit spreads, prepayment speeds, etc. In addition, assumptions used in estimating fair value must be assumptions that an unrelated party would use in estimating fair value. Notably, FASB indicates that assumptions enter into models that use Level 2 inputs, a condition that reduces the precision of the outputs (estimated fair values), but nonetheless produces reliable numbers that are representationally faithful, verifiable and neutral.

Level Three: The FASB describes Level 3 inputs as “unobservable.” If inputs from levels 1 and 2 are not available, FASB acknowledges that fair value measures of many assets and liabilities are less precise. Within this level, fair value is also estimated using a valuation technique. However, significant assumptions or inputs used in the valuation technique are based upon inputs that are not observable in the market and, therefore, necessitates the use of internal information. This category allows “for situations in which there is little, if any, market activity for the asset or liability at the measurement date.” FASB explains that “observable inputs” are gathered from sources other than the reporting company and that they are expected to reflect assumptions made by market participants.In contrast, “unobservable inputs” are not based on independent sources but on “the reporting entity’s own assumptions about the assumptions market participants would use.” The entity may only rely on internal information if the cost and effort to obtain external information is too high. In addition, financial instruments must have an input that is observable over the entire term of the instrument. While internal inputs are used, the objective remains the same: estimate fair value using assumptions a third party would consider in estimating fair value. Also known as mark to management. Despite being “assumptions about assumptions,” Level 3 inputs can provide useful information about fair values (and thus future cash flows) when they are generated legitimately and with best efforts, without any attempt to bias users’ decisions.

The FASB, after extensive discussions, has concluded that fair value is the most relevant measure for financial instruments. In its deliberations of Statement 133, the FASB revisited that issue and again renewed its commitment to eventually measuring all financial instruments at fair value.

FASB published a staff position brief on October 10, 2008, in order to clarify the provision in case of an illiquid market.
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