Fair value


Fair value

Fair value, also called fair price, 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 factors as:
* relative scarcity
* perceived utility (economist's term for subjective value based on personal needs)
* risk characteristics
* replacement costs, or costs of close substitutes
* production/distribution costs, including a cost of capital

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). 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 5 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 IFRSs, and Market Value, as defined in the IVSs:

: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" [ [http://www.ivsc.org/pubs/exp_drafts/ivs2.pdf Exposure Draft of Proposed Revised International Valuation Standard 2 - Bases Other than Market Value, June, 2006] ] .

Fair Value Measurements (US markets):

The Financial Accounting Standards Board (FASB) issued Statement 157 ("Statement 157") in September 2006 to provide guidance about how entities should determine fair value estimations for financial reporting purposes. Statement 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 liablities 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.

Statement 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."

Statement 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, Statement 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.

International standards (IFRS)

Think about the issue related with fair value and historical cost.

References


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