Accounting for fair value means measuring an asset or a liability at the price it would change hands for today between market participants, rather than at what it originally cost. The measurement is an exit price, 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, a definition set out with the entries it produces in mark to market.
The definition is the short part. What makes fair value hard in practice is the framework sitting behind it, because a price is not a number until somebody has said which market it comes from, whose assumptions it uses, and what use of the asset it assumes.
Which Market the Price Comes From
Not the best one available, and this is where people guess wrong first.
A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for it. The principal market is the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity (FASB Statement No. 157, paragraph 8).
The most advantageous market only comes into play when there is no principal one. The standard says so outright: if there is a principal market for the asset or liability, the fair value measurement shall represent the price in that market, whether that price is directly observable or otherwise determined using a valuation technique, even if the price in a different market is potentially more advantageous at the measurement date (FASB Statement No. 157, paragraph 8).
Read that last clause as a prohibition. A dealer who can get a better price on a thin secondary market does not get to use it while a principal market exists.
The market is also judged from the reporting entity’s own position. The principal or most advantageous market, and so the market participants, should be considered from the perspective of the reporting entity, which allows for differences between entities with different activities (FASB Statement No. 157, paragraph 8). Two entities holding the identical asset can therefore be measuring against two different markets, honestly.
What Comes Out of the Price and What Does Not
Two adjustments look alike and are treated in opposite ways.
The price in the principal or most advantageous market shall not be adjusted for transaction costs, which are the incremental direct costs to sell the asset or transfer the liability in that market (FASB Statement No. 157, paragraph 9). Selling costs are an attribute of how an entity transacts rather than of the asset, so they stay out.
Transport is the exception, and it turns on location. Transaction costs do not include the costs that would be incurred to transport the asset or liability to or from its principal market, and where location is an attribute of the asset or liability, as might be the case for a commodity, the price shall be adjusted for the costs, if any, of transporting it to or from that market (FASB Statement No. 157, paragraph 9).
A commodity sitting in the wrong warehouse is therefore worth less than the same commodity at the delivery point, and the standard wants that difference in the number.
Whose Assumptions the Measurement Uses
Not the reporting entity’s. Market participants are buyers and sellers in the principal or most advantageous market who are independent of the reporting entity, knowledgeable, able to transact, and willing to transact, meaning motivated but not forced or otherwise compelled to do so (FASB Statement No. 157, paragraph 10).
That last condition does real work in a distressed period, because a forced seller is not a market participant and a price extracted from one is not, on its own, fair value.
The requirement stops short of naming names. The fair value of the asset or liability shall be determined based on the assumptions market participants would use, and in developing those assumptions the reporting entity need not identify specific market participants but should identify the characteristics that distinguish market participants generally (FASB Statement No. 157, paragraph 11).
Which Use the Measurement Assumes
For a nonfinancial asset the answer can differ from what the owner is actually doing with it.
A fair value measurement assumes the highest and best use of the asset by market participants, considering the use that is physically possible, legally permissible and financially feasible at the measurement date, and highest and best use is determined based on the use of the asset by market participants even if the intended use of the asset by the reporting entity is different (FASB Statement No. 157, paragraph 12).
That use then fixes the valuation premise. Highest and best use is in-use where the asset would provide maximum value to market participants principally through its use in combination with other assets as a group, and in-exchange where it would provide maximum value principally on a standalone basis, and the fair value is measured on whichever premise applies (FASB Statement No. 157, paragraph 13).
Liabilities work from the other side. A fair value measurement assumes that the liability is transferred to a market participant at the measurement date, so the liability to the counterparty continues and is not settled, and that the nonperformance risk relating to it is the same before and after the transfer (FASB Statement No. 157, paragraph 15).
The Technique Is Chosen, Not Assumed
Once those questions are answered the measurement is built with a technique. Valuation techniques consistent with the market approach, the income approach or the cost approach shall be used to measure fair value (FASB Statement No. 157, paragraph 18). What each of those three does, and how the fair value set differs from the set an appraiser uses on a whole business, is worked through in valuation, and the wider notion of obsolescence the cost approach carries is in obsolescence.
What belongs here is the constraint on choosing between them. Valuation techniques that are appropriate in the circumstances and for which sufficient data are available shall be used to measure fair value, and in some cases a single technique will be appropriate, as when an asset is valued using quoted prices in an active market for identical assets, while in other cases multiple techniques will be (FASB Statement No. 157, paragraph 19).
Both halves of that sentence bite. Sufficient data is a condition, so a technique that cannot be fed properly is not available however appropriate it looks, and a single technique on a thinly evidenced asset is the point at which a reviewer should push.
Where the Inputs Get Ranked
The output of all of this is then classified by the quality of what went into it rather than by the technique used, on the three-level hierarchy set out in financial instruments. The one rule to carry across from there is that the level of a measurement in its entirety is decided by the lowest level input significant to it, so one unobservable assumption pulls the whole number down the ranking.
Where a US Firm Meets It
In the workpaper, and the questions are the four the framework asks.
Which market the price came from, and whether it is the principal one for this client rather than the one the price was easiest to find in. Whose assumptions the number rests on, which for a client-supplied valuation usually means asking what the preparer of it assumed rather than accepting the total. Which use is assumed for a nonfinancial asset, since a client’s own plan for a property is not the test. And which approach was used, because a single technique on an asset with sparse data is the point where a reviewer should push.
The tax side runs on its own regimes and does not follow this framework, a separation worked through in mark to market.
Common Questions
Not quite. Fair value is a defined exit price measured in a specific market, using market participant assumptions and, for a nonfinancial asset, the highest and best use (FASB Statement No. 157, paragraphs 8, 10 and 12). Market value is a general term without those constraints, and the two diverge most where an entity’s own intended use differs from what market participants would do with the asset.
No. The price used shall not be adjusted for transaction costs (FASB Statement No. 157, paragraph 9). Transport costs are different, and are adjusted for where location is an attribute of the asset.
The market participants’, not the reporting entity’s. They are independent, knowledgeable, able and willing buyers and sellers in the principal or most advantageous market, motivated but not forced or otherwise compelled to transact (FASB Statement No. 157, paragraph 10). The entity does not have to name specific participants, only the characteristics that distinguish them generally (FASB Statement No. 157, paragraph 11).
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms under layered review, and a trial task lets a firm’s own reviewer grade a real block of close and workpaper preparation before any client file depends on it.
