In financial reporting, the valuation of assets and liabilities can significantly impact a company's financial statements. While various accounting methods are available, fair value accounting has become increasingly popular due to its accuracy and transparency.
This blog explores the topic in detail, including the fair value definition, how it works, and its advantages.
What is Fair Value?
A fair value is the agreed-upon asset’s value by the buyer and seller for a product, stock, or security. It applies to products sold or traded under normal market conditions and is determined to ensure a fair value for the buyer without putting the seller at a disadvantage.
For instance, if Company A sells its stocks to Company B at INR 300 per share, and Company B believes that it could sell the stock at INR 500 per share, the transaction is considered fair value because both parties benefit from the sale at the agreed-upon price. It fosters transparency and reliability in financial reporting, profiting all stakeholders.
Understanding Fair Value
As stated above, fair value accounting is a way to measure your business's assets and liabilities based on their current market value. In simpler terms, the value of an asset is what a buyer and seller would agree upon as a fair price. Financial Accounting Standards Board introduced this approach to calculate financial instruments more consistently.
Current market conditions are considered rather than historical data to determine fair value. It's important to note that the holder's intention, such as whether they plan to sell the asset, should not affect the valuation as a rushed sale may lead to a lower price.
Fair value accounting applies to transactions under normal market conditions, where the seller is not pressured to sell. As a result, it doesn't apply to companies that are going through liquidation.
Finally, when determining the fair value of an asset, it's important to consider transactions with third parties rather than those with corporate insiders or related parties since the latter may have a conflict of interest, which could skew the asset's value.
Calculating Fair Value
Now that we’ve covered fair value meaning, here’s how the fair value formula works:
Fair Value Formula = Cash [1 + r (x/360)] – Dividends
● “Cash” represents the present value of the security being traded.
● The variable “r” denotes the current interest rate charged by the broker.
● The variable “x” signifies the remaining days until the futures contract expires.
● “Dividends” refers to the number of dividends the investor can expect to receive before the expiration date.
Examples of Fair Value in Practice
Assuming that ABC stock is currently trading at INR 1,895.12 with a 2% interest charge on the sale and a futures contract that expires in 30 days, an investor receives 4.3 dividend points. Here’s how one can calculate the fair value of the stock.
Cash = INR 1,895.12
r = 2%
x = 30 days
Dividends = 4.3 points
Fair Value = Cash [1 + r (x/360)] – Dividends
= 1895.12 [1 + 0.02 (30/360)] – 4.3 = INR 1,898.28
Therefore, based on the calculation, the fair value of ABC stock is INR 1,898.28.
Fair Value vs Carrying Value
Fair value is the actual selling price of an asset agreed upon by the buyer and the seller, which benefits both parties. It is calculated by analysing profit margins, future growth rates, and risk factors.
Alternatively, “carrying value”, also known as book value, refers to the value of an asset as shown on the balance sheet. It is computed by deducting accumulated depreciation and impairment expenses from the asset's original purchase price.
Carrying value represents the asset's actual value after a certain number of years, not its original purchase price. Suppose Company A, a construction firm, purchased a backhoe for INR 30,000 for its operations.
If the backhoe is expected to last for ten years, with a depreciation expense of INR 2,000 per year, then its carrying value after ten years would be INR 10,000.
Carrying Value = INR 30,000 - (INR 2,000 x 10) = INR 10,000
This shows that carrying value reflects the current worth of an asset, whereas fair value indicates the asset's value that could be realised in an open market.
Fair Value vs Market Value
Market value is distinct from fair value in the following ways.
● The market value of an asset can fluctuate more frequently and dramatically than its fair value.
● Market value may be determined based on the most recent transaction or quote for an asset. For example, if a share of Company A was valued at INR 30 over the last three months but is now INR 20, its market value is INR 20.
● An asset's market value depends on supply and demand in the market where it is bought and sold. For instance, the price of a house for sale will be determined by current market conditions in the local area.
If an owner tries to sell a property for INR 200,000 when the market is weak, it may not sell because demand is low. However, if the same property is offered for INR 500,000 during a strong market, it may sell at that price.
Advantages of Fair Value Accounting
Fair value accounting estimates or measures the actual value of an asset. It is widely used for its following benefits.
1. Accurate valuation
Fair value accounting provides more accurate valuations, allowing prices to be adjusted when they fluctuate.
2. Accurate measurement of income
With fair value accounting, a company's total asset value reflects its actual income rather than relying on profit and loss reports.
3. Applicable to different asset types
This method applies to all asset types, making it more versatile than historical cost value, which can change over time.
4. Helps businesses withstand difficult times
Fair value accounting helps businesses survive financially through difficult times by allowing for asset reduction or acknowledging overestimation of the asset’s value.
Factors Affecting Fair Value
Several factors can affect the fair value of an asset or liability.
1. Market conditions: Changes in the supply and demand of an asset or liability can significantly impact its fair value.
2. Economic factors: Economic conditions such as interest rates, inflation rates, and overall economic growth can impact the fair value of an asset or liability.
3. Company-specific factors: An asset or liability's fair value may be impacted by factors unique to a particular company, such as financial performance, market position, and management quality.
4. Legal and regulatory factors: Changes in laws, regulations, and accounting standards can affect the fair value of an asset or liability.
5. Risk and uncertainty: The risk and uncertainty associated with an asset or liability can also impact its fair value, with higher risk generally resulting in a lower fair value.
Ultimately, fair value refers to the price at which knowledgeable and willing parties trade an asset or liability at arm's length. It is influenced by various factors, including market conditions, economic factors, company-specific factors, legal and regulatory factors, and risk and uncertainty. Determining fair value requires careful analysis and judgment.