Over the past decade, the accounting industry has seen many rule changes that affect reporting of certain items on balance sheets. One such change is the guidance that certain items be reported at “fair value.” Read on to learn more about this new reporting standard and how to measure it accurately.
What is fair value?
The U.S. Generally Accepted Accounting Principles (GAAP) defines fair value as a "price that would be received to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date.” Buyers and sellers within the principal market of the item are "market participants," but the market itself can vary according to the specific entity being measured.
The purpose of estimating fair value is to report assets, including:
- Nonpublic entity securities
- Derivatives
- Acquired goodwill
- Specific long-lived assets
- Other intangibles not listed here
However, entity-specific considerations such as transaction costs are specifically excluded from these estimates.
Fair value vs. fair market value
While fair value and fair market value are similar, they are not interchangeable. The IRS Revenue Ruling 59-60 provides the most widely accepted definition of market value: “[T]he price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
The Financial Accounting Standards Board (FASB) chose the term "fair value" to deter businesses from using IRS regulations and precedents from the U.S. Tax Court when determining their assets and liabilities for required financial reporting. You should also avoid confusing the term with some of its uses in a legal context, such as conducting a business valuation for a shareholder buyout or divorce. When used in a statutory context, definitions by the GAAP for fair value are different.
Measuring fair value
There are three different valuation methods that the FASB recognizes: cost, income, and market. The FASB has also put in place a hierarchy for valuation inputs, starting at the highest priority and descending to the lowest:
- Quoted pricing for liabilities and assets which are identical in active markets
- Observable inputs including active market pricing for similar items in quoted markets, quoted prices for identical or similar items in active markets, and related market data
- Unobservable inputs involving projections of cash flow or related internal metrics
It's not uncommon to hire a valuation specialist to estimate fair value. Still, those in management roles can't delegate their personal responsibility for these estimates. Leadership is obligated to understand a valuator’s assumptions, models, and methods, including implementation of adequate internal controls over the measurement process, impairment charges, and disclosures.
How auditors assess fair value
It's part of an external auditor's standard audit procedure to evaluate accounting estimates. This could entail inquiring about any underlying assumptions used to determine an input's estimated completeness, accuracy, and relevance.
Auditors will try to recreate these estimated assumptions by management whenever possible. If their determination comes to a substantially different conclusion than reported financial statement data, management will have to explain this discrepancy. Requests for additional supporting documentation of your estimations or questions related to your processes aren't unusual and are a normal part of today's uncertain marketplace.
Find out more
Contact us with any additional questions you may have about fair value measurements. We can help ensure that you’re meeting your financial reporting responsibilities.
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