Fair value accounting measures your company’s assets and liabilities at their present value, not at the price you originally agreed to pay. Learn how to calculate fair value in this Ascent guide.
I spent a lot of time watching Antiques tour on PBS, where appraisers sometimes shock ordinary people by sharing sky-high appraisals for dusty heirlooms that seem worthless. It’s incredibly heartwarming to see people fall on a small fortune for things they’ve proudly displayed in their homes for generations.
Fair value accounting may not give you the same warm and fuzzy feeling, but it’s an essential part of understanding the value of your business.
Overview: What is Fair Value Accounting?
Fair value accounting involves measuring your company’s assets and liabilities – everything it owns and owes – at their market value. Instead of valuing your business based on purchase prices, you periodically update values to reflect what they are worth today.
You’re probably most familiar with the historical cost method of accounting, where you record the purchase price of an asset on your financial statements until it’s sold or scrapped. Fair value accounting more accurately values your business, but it takes more effort to maintain.
For example, say a company bought land for $500,000 five years ago and a property appraiser says it is worth $600,000 now. A historical cost statement will value the land at $500,000 until it is sold. The fair value accounting method would adjust the value of the land to $600,000.
For financial reporting purposes, generally accepted accounting principles (GAAP) require the historical cost method for most types of assets, including land. This is good for small businesses because the historical cost approach is simple: record the asset purchase transaction on day one and don’t change it until the asset is sold or disposed of .
Although rare for small businesses, there are two instances where you may need to report the fair value of an asset on your financial statements: impaired assets and certain investments.
If an asset loses significant value, either due to damage or due to market conditions, you are required to depreciate or reduce the value of the asset on your books. Suppose your business land is swallowed up by a sinkhole, causing it to lose 40% of what it is worth. You will need to adjust its value in your books.
You also use the fair value method for investments that are not related to business activities. For example, an ice cream store that owns its land would record the asset on its books at historical cost. If the ice cream shop used its profits to invest in the stock market, the investments would be listed at fair value.
Although you probably won’t use the fair value approach for financial reporting, you may still want to create a fair value balance sheet where all assets are listed at market value. Potential investors and lenders will consider the market value of assets to form a business valuation.
4 fair value accounting concepts
International Financial Reporting Standards (IFRS) and GAAP share a definition of fair value, calling it “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the valuation date”. Let’s break this down.
1. Orderly Transaction
An orderly transaction is one where the seller is in no rush to sell, giving your property time to find the right buyer willing to pay a fair price.
Think of it like selling your house. You might put a lower than market asking price on the house when you need to move quickly. With more time, you can wait for someone to buy it at a fair price.
2. Market players
A fair value transaction occurs between two unrelated parties with a solid understanding of the market in which they operate. It’s not like you sell your friend a discount car because he once helped you move house.
3. Date of measurement
The fair value of an asset or a liability takes into account market conditions on the day of valuation. Your car may be worth $5,000 on a Monday, but after a tree fell on Tuesday, it could be totaled. Investors and lenders often use their own appraisers for big ticket items to ensure that your fair appraisal is accurate and has not changed since the measurement date.
4. Main or most advantageous market
The final concept assumes that you are in an environment that maximizes the sale price of an asset or minimizes the transfer price of a liability.
For example, suppose you sell your old cell phone because you just bought a new one. You can sell it online for $250, but a kiosk at the mall will give you $150. The fair market value of the phone is $250.
How to determine fair value
The fair value of an asset or liability reflects the price at which you can sell or transfer it in the market, but it’s hard to know the exact amount unless you do. Let’s try to find the fair value of a silver 64GB iPhone X today (October 2020).
1. Find comparables
Look for the market where similar assets are sold and liabilities are transferred. Pay attention to assets and liabilities that have recently been sold or transferred, not those that have not yet been sold or transferred. You can put a used iPhone on the market at any price; you only care about the selling price.
Under IFRS and GAAP, the best information you can find is what they call “Level 1” entries: the selling prices of identical assets and liabilities. In our iPhone example, a level one entry would be a list of second-hand, same color, same size iPhone X sales made today.
When level one information is not available, proceed to “level two”, which would be similar but not identical assets and liabilities. An iPhone X of a different color would fall under the Tier Two category.
To calculate the fair market value of an iPhone, you can use websites like Swappa that share detailed pricing information (for a fee). They share limited data for free, such as the recent average selling price of the most popular models. Swappa says an iPhone X with 64GB of storage has sold for an average of $384 over the past few months.
2. Consider Hiring a Professional
When nothing like your asset or liability is in the market, you have to fall back on what the Financial Accounting Standards Board (FASB) and GAAP call “level three” disclosures. Level three information comes from internal data in your accounting software and from professionals who can use their judgment to estimate value.
Professionals can create models that estimate the income your asset will generate in the future – called its future cash flow – to determine fair value. You may be asked to produce metrics such as asset turnover rate to create an accurate fair value.
Even if there are comparables in the market, you could hire an appraiser to determine the fair value of your asset or liability. They may have access to more information than you and can provide a more accurate estimate.
Fair is fair
You will never know the value of an item until you sell it. Fair value accounting is therefore about obtaining the best possible estimate given the information you have. If you’re not confident in your fair valuation calculation, talk to an expert.