Fair value accounting – Basics on fair value accounting and 3 examples

In this post we take a deep dive into fair value accounting. You will learn everyting from what is fair value, metohods to calculate it & formulas.

Fair value accounting

An accurate valuation is paramount during any accounting exercise. Fair value accounting helps to measure assets and liabilities at their current market value. Fair value meaning is the amount at which an asset or liability is sold at a price, that is fair for both the buyer and seller. In this blog, you will learn what does FMV of account means? What is fair value in accounting? And the difference between market value vs. fair value.

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What is fair value?

Let us begin by explaining what is fair value? Fair value definition is as follows, is the agreed price of an asset by the buyer and seller. We assume there is no coercion and both parties are knowledgeable. Fair value is the estimated value of assets and liabilities as written in the company books.

Fair value is the potential price of an asset or liability. You may need to research to find the selling price or listed price of similar products. You can use the information to calculate the price of your asset. You can determine the price of securities in the share market.

What is fair value accounting?

Fair value accounting helps to measure the assets and liabilities stated on the company’s financial statement. Financial Accounting Standard Board implemented the fair value accounting principle to standardize the calculation of different financial instruments. The following concepts are part of fair value accounting.

• Current market conditions – You base it on the market conditions on the measurement date, rather than historical transactions.
• Intention of holder – The intention of the holder might change the measured fair value. E.g. if the owner wants to sell the asset immediately, they may get a lower value. 
• Orderly transaction – Fair value accounting should be from an orderly transaction. There is no unnecessary pressure like business liquidation.
• Third-party – We calculate fair value when the sale is to a third party, rather than an insider or someone related to the seller.

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Fair value formula

The fair value formula is as follows –

Fair Value = Cash × {1+r(x/360)} − Dividends

Where,

Cash = Current S&P Cash Value

r = Current interest rate paid to a broker to buy all stocks in the S&P 500 index

x = Days to the expiration of the futures contract

Dividends = Amount of dividends until contract expiration expressed in terms of points on the S&P contract.

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Fair value vs historical cost

Historical cost is the actual price at which the transaction was done. Fair value is actual value of the asset as on the day. The difference between fair value vs historical cost is as follows. 

Historical costs	Fair Value
Historical costs is the cost at which transaction was done	Fair value is the present market price the commodity will fetch
It is not used to for all assets does not reflect true picture	It is more commonly adopted and tested method
It remains stagnant through the lifetime of the asset	The value fluctuates when compared with other valuation methods
It is permitted under US GAAP and not under IFRS	It is globally accepted and applied making it a more user-friendly method when compare historical cost vs fair value
Used for intangible and fixed assets. Not used for assets like marketable assets.	It refers to the actual worth of the asset and is derived fundamentally and is not determined by the factors of any market forces.
It is not tested for impairment loss	It is tested for impairment annually.

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Fair value vs market value

Fair value is the value at which asset changed hands between two parties. Market value is the value of the company calculated from the current stock market price. The difference between fair value vs market value can be summarized in the table below.

Fair Value	Market Value
Fair value is the actual worth of the asset derived by using methods like discounted cash flow methods. It cannot be determined by market forces.	Market value is determined by market value or by factors like demand and supply.
It is commonly used in stock market for valuation. Fair value will help in accurate valuation of the asset.	It is not commonly used valuation method. Companies use it when they want to use loopholes to hide limitation or shortcomings.
Fair value of an asset remains consistent. It fluctuates less frequently when market value vs fair value methods are compared.	Market value is determined by demand and supply and fluctuates more.
Fair value is globally accepted.	Market value method is not used frequently. It is not a globally accepted method.

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Book value vs fair value

In accounting you need to understand the difference between book value vs fair value. Both are used to describe the valuation of an asset, but have different approaches. The distinction between fair market value vs book value is as follows.

Book Value	Fair value
Book Value is the value of an asset is recognized on the balance sheet.	Fair Value is reasonable and unbiased estimate of the intrinsic value the asset.
It is cost paid for acquiring the asset minus depreciation, amortization, or impairment costs applicable to the asset.	Fair value uses factors like utility, related costs, and supply and demand consideration.
It is based on historical value of the asset.	It is based on the value at the measurable date.

Also read: What is fund accounting, key principles, & responsibilities

Futures vs fair value

Fair and future value has impacts the business but deal with different concepts. Fair value helps to determine the value of assets and liabilities. Future value shows how the value of money changes over time. The difference between future vs fair value can be summarized as-

Future value	Fair value
Future value let us know the value of “today’s dollar” will be in the future.	Fair value defines the price that would be paid for market transaction between buyer and seller.
Future value is used for making business capital decisions. It helps to decide the projects to invest in for growth.	Fair value is used to determine the price of securities.

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Fair value hierarchy levels

Fair value hierarchy categorizes the inputs used in valuation in three levels. The accounting titles hierarchy rules, give the highest priority to level 1 – the quoted price in the active markets for identical assets and liabilities. While we give the lowest priority to level 3 to unobservable inputs. IFRS looks ways to improve the consistency and comparability in fair value measurement and related disclosures through fair value hierarchy levels. here are the fair value hierarchy levels.

• Level 1 inputs – are the quoted price in the active markets for identical assets and liabilities that the entity can access at the measurement date. A quoted market price in the active market provides reliable evidence of fair value and is used without adjustment to measure fair value, with limited exceptions.
• Level 2 inputs – These inputs other than quoted market price include level 1 observable for assets or liability, either directly or indirectly.
• Level 3 inputs – Level 3 inputs are unobservable inputs for other assets or liability. Unobservable inputs are not available.

How to calculate the fair market value of assets?

You may wonder, how to calculate fair market value of assets? We base the fair market value of assets on the assumption that the seller and buyer are knowledgeable and have entered into the transaction willingly. There are three ways for fair value calculations-

• Based on market price – you can determine the value of the asset based on the market price. The prices that are quoted on the stock market are liquid and transparent.
• Use the comparable value of similar assets –To determine the value of the asset, you can use the price of comparable assets. E.g. to determine the price of your house, the price of houses recently sold in your neighborhood will give you a good indication of the valuation of the house.
• Discounted cash flow method – Use discounted cash flow method if you have unique assets that have nothing comparable or similar. You estimate the value of the asset by future cash flow.

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Method to determine the fair market value of derivatives

A derivative is a financial instrument that gets its value from another asset. Fair value tries to put an objective price on a financial instrument instead of current market prices. There are different methods used to determine the fair market value of derivatives.

• Future pricing basics – future contracts are standardized financial contracts that allow the holder to buy or sell an underlying asset or commodity at a certain price in the future. The future contract value is based on the commodity’s cash prize.
• Options pricing basics – Options are common derivative contracts. Options give buyers the right, no obligation to buy or sell the derivatives at a pre-determined price called strike price before the contract expires.

How to calculate the fair value of a futures contract?

In this section, we elaborate on how to calculate fair value.

Fair value = cash price + cost of carry

The fair value of commodities

The cost of carrying is the supplier’s associated cost with fulfilling that contract and need to be taken into account to calculate the fair value of commodities.

• Storage cost
• Insurance cost
• Loss of interest on funds that could have been reinvested if the asset was sold immediately.

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Fair value for financial products

There are no storage costs associated with financial storage.

Fair value = cash price + Interest cost – Dividend payment

The interest costs are based on the Libor interest rate at the time to run until expiry.

Fair value = Cash + [cashx days until Expiry/ (Libor/360)] – Dividend payment

Fair value accounting examples

Fair value accounting example 1

Mr. X is planning to buy a Road Roller. The income from the Road Roller year wise is mentioned below –

• Year 1: $80,000
• Year 2: $50,000
• Year 3: $200,000

The Interest rate running in the market is 5%. The life of the Roller is five years. Calculate the fair value of the asset.

The fair Value of the asset should be its capacity to earn throughout the life after adjustment for the interest rate

Years	Cash Flow	Interest Rate
Year 1	$80,000	5%
Year 2	$50,000	5%
Year 3	$200,000	5%
Total earnings from road roller	$330,000

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Step 2: Calculate the present Value of future cash flow 

Years	Cash Flow	Interest Rate	Discounted Rate	Present cash flow = Cash flow/discounted rate
Year 1	$80,000	5%	1.05%	$76,190
Year 2	$50,000	5%	1.102%	$45,351
Year 3	$200,000	5%	1.158%	$172,768
Total Present value(Fair Value)				$294,309

Total Present Value (Fair Value) = $294,309

Fair value accounting example 2

Mr. Y has bought derived contracts at $100,000 in November 2019. The contract is for three months. The accounting year starts in January. At the end of December, the contract value is $90,000. How will Mr. Y show this change if he is following Fair value accounting?

Solution

According to fair value accounting, Mr. Y will need to reduce the value on the contract by $10,000 to show the loss

November 2019

In Balance sheet – Contract $100,000

January 2020

In Balance Sheet – Contract $90,000

In Profit and Loss Statement = Unrealized Loss $10,000

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Fair value measurement disclosure examples

A firm holds an equity instrument for which sale is restricted for a specific period. The restriction is characteristic of the instrument and will be transferred to market participants. In this, the fair value of the instrument measures on the price of the quoted price of unrestricted equity document of the same issuer in the public market, for the instrument in the specified period. The adjustment will depend on:-

• The nature and duration of the restriction
• The extent to which buyers are limited by the restriction
• Qualitative and quantitative factors specific to instrument and issuer.
• Fair value accounting advantages and disadvantages

Fair value accounting advantages and disadvantages are as follows:-

Advantages

• Accurate valuation – Accounting fair value provides an accurate valuation of assets and liabilities, as per the company’s financial records. The price indicates the price that would be received if it sold an asset or would have to pay to square up a liability.
• True income – Fair value accounting limits the tendency of companies to manipulate their net income. It helps to accurately report the losses and gains from the price change of assets or liability for the period in question.

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Disadvantages

• Value reversal – Fair value accounting can be challenging, especially when the value of assets and liabilities fluctuates and becomes volatile. Even if you reevaluate the valuation in volatile market conditions, there are chances of creating large swings.
• Market information –The fair value method may further affect down market value. Companies when assets are revalued downwards because of current prices it can trigger the selling of assets at more depressed prices.