What it means
Historical cost is objective but stale; a building bought in 1995 is recorded at its 1995 price. Fair value updates the figure to today, which is more relevant to a reader but requires estimation and can move up and down with the market.
Accounting standards use a mixed model: most operating assets stay at cost less depreciation, while items whose value is readily observable or whose current value is essential to understanding the business are measured at fair value. The definition has several deliberate features.
It is an exit price, what you would get for selling, not what you would pay to buy or replace. It assumes an orderly transaction, not a forced sale or liquidation.
It assumes market participants, so a buyer's special synergies do not count. And it is measured at a specific date, so the same asset can have different fair values on different days.
Because not every asset trades in a liquid market, standards set out a hierarchy of inputs. Level 1 uses quoted prices in active markets for identical items, such as listed shares; it is the most reliable.
Level 2 uses observable inputs other than quoted prices for the identical item, such as quoted prices for similar assets, interest rate curves or recent transactions in comparable property. Level 3 uses unobservable inputs, the entity's own assumptions in a valuation model, such as projected cash flows for an unlisted company or an illiquid derivative.
Level 3 values carry the most judgement and require the most disclosure, and analysts scrutinise them closely. Fair value gains and losses are recognised either in profit or loss or in other comprehensive income, depending on the item and the standard.
A bank's trading book, an insurer's investment portfolio and a property company's buildings can all swing reported results substantially from year to year with no change in the underlying business, which is why readers need to separate fair value movements from operating performance.
In practice
Real-world examples.
Example
An investment property company revalues its office buildings each year using independent valuers and recognises the gains and losses in profit, so its reported profit rises and falls with the property market.
Example
An acquirer measures the fair value of every asset and liability of the company it has bought, including brands and customer lists that the target never recorded, and the excess purchase price becomes goodwill.
Example
A bank carries its derivatives at fair value, mostly Level 2, and discloses that $400 million of complex structured products are Level 3 with model-based values.
Think of it
“Fair value is like the price your car would sell for today if you put it on the market, not what you originally paid.
Formula
Calculation
Fair value is a measurement objective rather than a formula, but each level of the hierarchy has typical techniques.
Level 1: Fair Value = Quoted market price x Quantity held
Level 2: Fair Value = Adjusted comparable price, or Present value of contractual cash flows at observable market rates
Level 3: Fair Value = Discounted cash flow, or comparable multiples applied to the asset's own metrics
Worked example 1, Level 1. A company holds 50,000 shares of a listed company that closed at $23.40 on the balance sheet date. Fair value = 50,000 x $23.40 = $1,170,000. If the shares were bought for $900,000, a gain of $270,000 is recognised.
Worked example 2, Level 3. A company holds a 15% stake in an unlisted software business. It values the stake using a revenue multiple: comparable listed software companies trade at 5 times revenue, the unlisted business has revenue of $8 million, and the company applies a 30% discount for illiquidity and lack of control.
- Enterprise value = 5 x $8,000,000 = $40,000,000
- Less illiquidity discount of 30% = $28,000,000
- Fair value of 15% = $4,200,000
The disclosure must state the multiple used, the discount and how sensitive the value is to each: a multiple of 4 instead of 5 would reduce the fair value to $3,360,000.
Worked example 3, a liability. A company issued a bond with a face value of $10,000,000 at a fixed rate of 5%. Market rates for similar bonds have risen to 7% and four years remain. The fair value is the present value of the remaining coupons and principal at 7%: $500,000 x 3.387 + $10,000,000 x 0.763 = $1,693,500 + $7,630,000 = $9,323,500. The company's liability is worth less than face value because it pays below-market interest.Case study
Seen in the real world.
A private equity fund held a portfolio company at a fair value based on 9 times EBITDA, the multiple at which it had been acquired. Over two years, comparable listed companies had de-rated to 6 times and the portfolio company's own EBITDA had fallen 15%, but the fund kept the valuation unchanged, citing a planned strategic sale. The fund's auditors challenged the Level 3 inputs: the comparable multiple was observable and had moved, the EBITDA was the company's own and had moved, and a hoped-for buyer's price was not a market participant assumption.
The valuation was reduced by 45%, from $180 million to $99 million, and the fund's reported returns for the year turned negative. Investors in the fund complained less about the write-down than about the two years in which the valuation had not moved while the evidence had. The fund adopted a quarterly valuation policy that documented every input, its source and the reason for any departure from observable data.
Watch out
Common mistakes.
- Treating a Level 3 valuation as if it were a market price. It is an estimate resting on assumptions, and the assumptions should be read.
- Confusing fair value with value in use or replacement cost. Fair value is the price market participants would pay, not what the asset is worth to its current owner or what it would cost to rebuild.
- Leaving a fair value unchanged because the underlying asset has not been sold. Fair value is measured at each reporting date whether or not a transaction occurs.
Questions
People also ask.
What is the difference between fair value and market value?
In practice they are close. Fair value is the accounting definition, which specifies an orderly transaction between market participants and excludes buyer-specific synergies.
Why do companies carry some assets at cost and others at fair value?
Because the standards balance relevance against reliability: fair value is required where it is observable or essential, and cost is retained where fair value would be too subjective or not useful.
What is the fair value hierarchy?
A ranking of the inputs used: Level 1 quoted prices for identical items, Level 2 other observable inputs, Level 3 unobservable inputs. It tells readers how reliable each figure is.
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