What is fair value accounting?

Definition and Examples of Fair Value Accounting

Fair value is the highest price that an asset can be sold for in the open market based on its current market value. Fair value refers to the amount that can be obtained for assets such as products, stocks, securities, real estate, or settling a liability at a fair price for both the buyer and the seller.

How Does Fair Value Accounting Work?

Fair value represents obtaining market data at the measurement date instead of historical prices. Calculating fair value also involves analyzing profit margins, future growth rates, and risk factors. The way in which this calculation is carried out depends on the type of data and the accounting method used in the calculation. Although input data and accounting methods may change, some fundamental characteristics of fair value remain unchanged.

Types of Fair Value Accounting Methods

According to the Financial Accounting Standards Board (FASB), there are three valuation techniques that can be used to estimate the fair value of an asset or liability:

Market Approach: The market approach uses the prices of similar or identical assets or liabilities sold to infer fair value. Although this method relies on third-party data, adjustments can be made to account for differences or unique circumstances.

Income Approach: The income approach uses an estimate of the expected cash flows or earnings that the asset is anticipated to generate over its lifetime to calculate the fair value of a tangible or intangible asset, liability, or entity (such as a business). Future earnings are converted to a present amount using a discount rate that reflects risk and the time value of money. The discount rate compensates for the risks of not achieving the expected future cash flows.

Cost Approach: The cost approach uses the estimated cost to replace the asset if the buyer were to purchase or build their own version of the asset using identical methods and resources (such as labor, materials, and overhead expenses). The cost approach considers the asset’s depreciation due to being put into service.

Source: https://www.thebalancemoney.com/what-is-fair-value-accounting-5204601