In this article, we will discuss the concept of fair value in accounting, how it works, and its different types.
Definition and Examples of Fair Value in Accounting
Fair value in accounting is a term that represents the excess difference between the purchase price and the fair value of a business. Fair value is usually considered during the acquisition process of businesses. The reputation of the company, brand, customer base, and intellectual property can be represented by fair value as an intangible asset on the balance sheet. Companies are required to calculate fair value annually to test for impairment, which occurs as a result of changes in the fair value of the business.
How Fair Value Works in Accounting
To calculate fair value, you will need to understand the formula. Fair value equals the excess difference after subtracting the fair value from the purchase price:
Fair Value = Acquisition Cost – Net Assets Value
You will need to determine the net assets value of the company, which equals the company’s known assets minus liabilities. Subtract this total from the amount paid for the company’s acquisition.
Once the company completes the purchase and acquires another company, the acquisition is recorded on the balance sheet. Fair value is listed as a non-current asset on the balance sheet and is considered an intangible asset because it is not a physical object.
Note: Companies must record fair value as a requirement of Generally Accepted Accounting Principles (GAAP), as defined by the Financial Accounting Standards Board (FASB).
Understanding Impairment in Fair Value
“Impairment” refers to fluctuations in the fair market value of a business. Because fair value can change due to circumstances like changes in customer base or reputation, it must be accurately and correctly reported. Companies must review this annually, as well as when the company is acquired for the first time, as stipulated by FASB.
It is also necessary to perform impairment tests if certain events affect the fair market value of the business, such as mass layoffs, changes in competition, or changes in the general business climate.
Types of Fair Value
Fair value can be divided into different types based on what was acquired and how it was obtained. Generally, fair value can be either purchased or inherent. It can also be subdivided based on industry and can be referred to as business value, practice value, or practice value.
Business Value: Business value represents the excess difference between the price paid for the company’s acquisition and its actual fair market value. Business value is generally used in accounting when acquisitions occur unless the type of business is more specific, such as a practice.
Practice Value: Practice value refers to the specific fair value of practices, such as a law office. Practice value is similar to business value as it considers the overall value of the practice.
Value of Practice: Value of practice refers to fair value concerning a specific line of business practiced, similar to practice value. However, this type of fair value places particular emphasis on the skills, knowledge, and talents of the practitioners.
Purchased Value: Purchased value means that the company simply bought the other company, which is the general concept in business value.
Inherent Value: Inherent value is not purchased and results from within the same company. For example, this value can arise from changes in the company’s reputation, increasing its value.
Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Financial Accounting Standards Board. “Intangibles—Goodwill and Others (Topic 350),” Page 1. Accessed Oct. 27, 2021.
Source:
https://www.thebalancemoney.com/what-does-goodwill-mean-in-accounting-5207391
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