Fair Value Accounting

Definition

The financial accounting term fair value accounting refers to the estimating of prices that would be received if an asset were traded or a liability transferred.  Fair value accounting can be used to estimate the value of an asset or liability appearing in a company's financial statements.  Generally, these estimates are grouped into three levels, which are characterized by the availability of market information.

Note:  The term fair value can also refer to the equilibrium price for a futures contract.

Explanation

If a company has reason to believe an asset's value may be impaired, it's required to perform a formal estimate of its recoverable amount.  This approach is similar to the concept of lower of cost or market value, which applies to inventory.  Determining an asset's or liability's fair value less it's cost of disposal is one approach to determining its recoverable amount.

Accounting guidance on this topic is provided in FASB Accounting Standards Codification (ASC) Topic 820 - Fair Value Measurement, which breaks down estimates of fair value into three levels as explained below:

  • Level  One:  includes valuations based on quoted prices, for identical assets or liabilities, in active markets.  For example, this classification would include the common stock of a large corporation, whose shares are actively traded on the stock market and the price per share is certain.
  • Level Two:  includes valuations based on what are termed market observables.  This category consists of less actively traded markets.  For example, assets and liabilities that are similar, but not identical to those being valued; assets or liabilities or those that are similar, but not exactly the same, as one traded in an active market; as well as those that are not actively traded but sufficient market data is available to derive a fair value.  Assets and liabilities that fall into this level require the accountant-analyst to document their assumptions when deriving a fair value.
  • Level Three:  includes valuations that are unobservable in the marketplace and require estimates based on a valuation technique.  Since observable market information is not available to derive the fair value of the asset or liability, the value will be based on internally derived information.  Once again, assets and liabilities that fall into this level require the accountant-analyst to document their assumptions when deriving a fair value.

Related Terms

conservatism constraint, holding gains and losses, value-in-use, recoverable amount, lower of cost or market, weighted average cost of capital, cost of disposal