Fair value, also called fair price (in a commonplace conflation of the two distinct concepts), is a concept used in finance and economics, defined as a rational and unbiased estimate of the potential market price 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 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 an estimate 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 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 is based on mark-to-market valuations; for assets carried at historical cost, 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 on the kitchen it would be of subjective nature because there is no active market for such items.
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 regards to tradable assets:
- The efficient market hypothesis 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.
- Behavioral finance 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 (IVS 2007) clearly distinguishes between fair value, as defined in the IFRS, and market value, as defined in the IVS:
- 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 in the wider market. In 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.[1]
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 purpose of this guidance is to eliminate the inconsistencies by developing a solid framework to be used in any fair value measurements.
FAS 157 defines fair value as follows: 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".
FAS 157 emphasizes the use of market inputs in valuing an asset or liability. Examples of specific market inputs mentioned include: quoted prices, interest rates, yield curve, credit data, etc. Fair value is, by definition, derived from a current transaction which happens in an active market with knowledgeable and unrelated parties. When fair value is not available due to the lack of an actual transaction, it is logical to use information from an active market. However, sometimes quoted prices might not represent the best estimate of fair value.
The basis of the framework centers on a fair value hierarchy which indicates reliability of inputs used to estimate fair value. The hierarchy is broken down into three levels:
- Level One
- This is for liquid assets with quoted prices. For instance, the price of a listed security. This level requires the use of unadjusted quoted prices from an active market for identical assets or liabilities. To use this level, the entity must have immediate access to the market (could exchange in current condition). 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.
- Level Two
- This is valuation based on market observables. For instance, the price of an option based on Black-Scholes and market implied volatility. 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.
- Level Three
- This is valuation based on non-observable assumptions. 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. 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.
FASB published a staff position brief on October 10, 2008, in order to clarify the provision in case of an illiquid market.[2]
International standards (IFRS)
Fair value accounting is described as option in IAS 39.
See also
References
