What Are the Characteristics of Fair Value Accounting?

Need to attract potential investors, stay compliant with current accounting standards or sell some of your assets? It all starts with knowing what your company is really worth.

Fair value accounting is one of the ways you can do just that. 

Let’s learn more about what fair value accounting is, how it works and how you can use it to make informed decisions about the future of your company.

What is Fair Value Accounting?

Fair value accounting, also referred to as mark-to-market accounting, is defined as the value that an asset can be sold for, or that a liability can be settled for. This value should be fairly agreed upon by both the seller and the buyer and based on current active market conditions.

It’s one of the most commonly used accounting methods due to its adaptability to all types of assets. It allows individuals or organizations to accurately measure assets and liabilities at current market value. 

That’s why the U.S. Financial Accounting Standards Board (FASB) implemented this approach—to standardize the calculation of how much assets and liabilities are worth.

Are There Any Alternatives to Fair Value Accounting?

The main alternative to fair value accounting is called historical cost accounting, and it varies from fair value accounting in several ways.

The historical cost method records assets based on their original purchase price, rather than how much they are currently worth.

This method is primarily used for inventory and fixed assets, such as property or equipment, and it prevents assets from being overvalued. However, historical cost accounting can be inaccurate, especially as time passes from the original purchase. 

Bear in mind that one valuation method is not necessarily better or more accurate than the other. Their usage largely depends on which assets you’re valuing.

What are the Characteristics of Fair Value Accounting?

To implement fair value accounting properly, take these factors into account:

Current Market Conditions

One of the main characteristics of fair value accounting is its reliance on current market conditions to determine value. The original purchase price of a held asset or liability isn’t considered when using this method.

Instead, you’ll identify what someone would currently be willing to pay for it today and record this value on your financial statements.

Let’s say one of your assets is a piece of specialized equipment, purchased five years ago for $10,000. Based on current market conditions and depreciation over time, its current fair value might be reduced to $7,000.

Stocks are another good example. Their fair value fluctuates daily based on market conditions, and companies holding stocks as investments must regularly adjust their value on financial statements to reflect current prices.

Factors like inflation, appreciation and high market demand may raise the market value of your assets. For instance, property or office space held in an up-and-coming area may be worth more than what you originally purchased it for.

Objective Market Valuation

It doesn’t matter whether you are actually intending to sell an asset when you’re determining its fair value. The price is based on market conditions, not your intentions to sell.

Orderly Transaction

Fair value should be based on orderly transactions, or those in which there is no pressure on the seller to quickly sell off their assets. 

Companies that are being liquidated cannot use fair value accounting for this reason, as they are typically under time pressure to sell every asset off.

Sale to a Third Party

Fair value accounting only takes into account the value of an asset as it is sold to a third party, rather than anyone with any relation to the seller. Inside purchasing may misrepresent the true value of an asset.

Active Market

Whenever possible, fair value should be determined based on active market prices, or a market in which there are frequent, high volume transactions being made. This provides you with plenty of up-to-date and accurate pricing information about how much assets like yours are being purchased and sold for.

Stock exchanges like the NYSE or NASDAQ are classic examples of active markets, providing real-time data to determine fair value.

How Do You Value Assets Fairly?

Fair value accounting follows generally accepted accounting principles (GAAP) to determine how an asset or liability should be valued. 

There is a hierarchy of three levels that determines the reliability of inputs:

• Level 1: The price quoted in active markets. This is the gold standard of valuation. Your asset can be directly matched to an identical one actively traded in the market. That real-time pricing makes it the most fair and accurate way to determine value, so use it whenever possible.
• Level 2: The price derived by using inputs other than quoted prices. Level 2 sources include inputs such as interest rates, items that are similar to your asset but not identical, or identical items found in inactive markets.
• Level 3: The price derived from unobservable inputs. Typically, this is based on a company’s own internal data and assumptions, rather than comparison to external sources or similar assets. While this is the most speculative method and prone to estimation error, it may be necessary if you can’t find observable market data.

What are the Benefits of Fair Value Accounting?

When well-implemented, fair value accounting can be a game-changer, since it offers companies an accurate look at how much their assets and liabilities are worth.

This method requires regular revaluation, typically at the end of every reporting period. Your financial statements will reflect economic conditions in real-time, giving you, your shareholders and potential investors a better picture of how much your company is worth.

This improves the transparency of your financial statements, but remember that external auditors may inquire about how fair values were determined and assumptions or valuation models applied. 

Because of this, make sure to always be able to back up your accounting with numbers, or work with an expert accounting service to ensure accuracy.

Moreover, fair value accounting aligns with International Financial Reporting Standards (IFRS). All U.S. companies should be following GAAP, but if you’re looking to go international, it’s a good idea to comply with international standards too.

What are the Drawbacks to Fair Value Accounting?

While fair value accounting aims to give buyers and sellers an accurate reflection of how much assets are worth, it isn’t a foolproof method.

For starters, this method relies heavily on current market conditions. During highly volatile times when prices are fluctuating rapidly, reported financial performance can be skewed in favor of the company, making it appear more profitable than it truly is.

Furthermore, it can be difficult to assess the true value of unique assets. Accurate valuation may require third-party appraisals or a lot of market research.

Fair Value Accounting and Your Business

Not sure if fair value accounting is the right fit for your business—or how to accurately value your assets and liabilities? 

Finvisor is here to help. Our team of expert accountants takes all the guesswork out of valuation, allowing you more time to make important financial decisions for the future of your company.

Contact us today to schedule an introductory call and learn more about how we can help you with accounting, bookkeeping and compliance.