Fair value is a broad measure of the actual value of an asset that is agreed upon by both the seller and the buyer. Amongst other things, the asset in question could be a product, service, stock, or a security. More specifically, fair value applies to a product that is sold or traded in the market where it belongs or under normal conditions – NOT one that is being liquidated. The value is determined in order to come up with an amount or value that is fair to the acquirer without putting the seller on the losing end. This distinguishes it from market value which refers to the price of an asset in the marketplace such as a stock market.
In an accounting sense, fair value refers to the estimated worth of a company’s assets and liabilities listed on the company’s financial statement. It is intended to provide a rational and unbiased estimate of the potential market price of a good, service, asset or security. In making the valuation, objective factors such as the costs associated with production or replacement, market conditions and matters of supply and demand are considered. In this regard, the concept of fair value is closely related to precedent transaction analysis as a means of establishing a value of a target firm during a merger or acquisition. Additional subjective factors such as the risk characteristics, the cost of capital & return on capital and individually perceived utility may also be included.
Fair Value Guidelines
FASB Accounting Standards Codification (ASC) Topic 820 (Fair Value Measurement), now defines fair value as
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
This is sometimes referred to as “exit value”. On the other side of the balance sheet the value of a liability is the amount at which that liability could be incurred or settled in a current transaction. Similar to the US GAAP, IFRS 13, Fair Value Measurement, was adopted by the International Accounting Standards Board on May 12, 2011 and defines fair value as
the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). When measuring fair value, an entity uses the assumptions that market participants would use when pricing the asset or the liability under current market conditions, including assumptions about risk.
This more encompassing definition incudes the effects of credit risk when calculating the value.
