Fair value - What is fair value?
Fair value is calculated for financial statements. However, if you are looking to sell an asset, it would be beneficial to read about market value.
Fair value measures the sale value of an asset that is fair to both the buyer and the seller. It is essentially the ‘potential price’ of an asset or liability, rather than the historical cost or market value.
How to calculate fair value
To calculate fair value of an asset or liability, you will need to do some research into the same or similar products that have recently sold or are currently listed. From there, you can calculate the average current value of the asset or liability.
Fair value example
As an example, let’s say your company owns a piece of machinery that was purchased for £10,000 two years ago. To calculate the fair value of this machine, you will need to research recent sales or listings of similar machines to calculate the estimated value.
You notice that a few companies are selling the same machine on their websites. One company is selling for £6,000, another for £7000, and another for £6,800. You will then calculate the average sale price by adding them together and dividing by 3.
From your calculations, this machine has a fair value of £6,600 and this will be inputted on your financial statement.
Fair value vs. market value
Market value is the actual price a buyer is willing to pay for an asset based on the current supply and demand.
Fair value, on the other hand, does not take into account the arrangement based on an actual sale, but makes estimates from other similar listings.
Market value fluctuates often based on the supply and demand of the asset, whereas fair value does not fluctuate as often.
For instance, let’s say a company own’s a car. They list the car to sell at £5,000. No buyers are interested in purchasing the car for that price but one buyer offers £4,000. This is the market price - what a buyer is willing to pay at that time.
If the company isn’t looking to sell the car, but calculate the fair value, they would research recent listings of the same or similar car. They would find the average price and this would be inputted as the estimated fair value of the asset on their reports.
Fair value vs. historical cost
Historical cost is the price you paid when you purchased the asset, whereas fair value is the estimated current cost of the asset.
Let’s say your business purchased an office space 10 years ago for £500,000, but it is now worth approximately £1,000,000 based on other similar offices in your neighbourhood that have recently sold. The historical cost is £500,000 and the fair value is £1,000,000.
When it comes time to record your assets on the balance sheet, you can choose if you would like to record the historical cost or the fair value estimate, but you must be consistent in which process you choose (i.e. all assets must be recorded as either the historical cost or fair value, you cannot mix the two).
Fair value and International Financial Reporting Standards (IFRS)
Fair value accounting practices have a damaged reputation for being used as tools for corporation fraud. In the past, some companies inflated its estimates which ultimately inflated their revenues and caused them much bigger issues.
IFRS released a fair value measurement framework which can be used to determine the fair value of an asset or liability.
The framework outlines 3 levels of input value, level 1 being the most accurate, and level 3 the least accurate and only to be used if there is no existing market. You should always input level 1 values on your reports, but can input level 2 and 3 values if the others are not available.
- Level 1: quoted prices for the same asset or liability in the current, active market
- Level 2: If you cannot find the information from level 1, level 2 includes assets or liabilities similar to yours being sold in an active market
- Level 3: If you cannot find the values for levels 1 and 2, level 3 uses valuation techniques to estimate the fair value when there is no market or information on similar assets or liabilities available