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Fair Value

Definition

In accounting and in most Schools of economic thought, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset. It takes into account such objective factors as...

What is 'Fair Value'

Fair value is defined as a sale price agreed to by a willing buyer and seller, assuming both parties enter the transaction freely. Many investments have a fair value determined by a market where the security is traded. Fair value also represents the value of a company’s assets and liabilities when a subsidiary company’s financial statements are consolidated with a parent company.

Explaining 'Fair Value'

The most reliable way to determine an investment’s fair value is to list the security on an exchange. If XYZ stock trades on an exchange, market makers provide a bid and ask price for XYZ stock. An investor can sell the stock at the bid price to the market maker and buy the stock from the marker maker at the ask price. Since investor demand for the stock largely determines bid and ask prices, the exchange is the most reliable method to determine a stock’s fair value.

How a Consolidation Works

Fair value is also used in a consolidation, which is a set of financial statements that presents a parent company and a subsidiary firm as if the two businesses are one company. This accounting treatment is unusual because original cost is used to value assets in most cases. The parent company buys an interest in a subsidiary, and the subsidiary’s assets and liabilities are presented at fair market value for each account. When the accounting records of both companies are consolidated, the subsidiary company’s fair market values are used to generate the combined set of financial statements.

Factoring in a Valuation

In some cases, it may be difficult to determine a fair value for an asset if there is not an active market for trading the asset. This is often an issue when accountants perform a company valuation. Say, for example, an accountant cannot determine a fair value for an unusual piece of equipment. The accountant may use the discounted cash flows generated by the asset to determine a fair value. In this case, the accountant uses the cash outflow to purchase the equipment and the cash inflows generated by using the equipment over its useful life. The value of the discounted cash flows is the fair value of the asset.

Futures Market

In the futures market, fair value is the equilibrium price for a futures contract. This is equal to the spot price after taking into account compounded interest (and dividends lost because the investor owns the futures contract rather than the physical stocks) over a certain period of time.


Further Reading


Fair value accounting, financial economics and the transformation of reliability
www.tandfonline.com [PDF]
This paper addresses the question of how and why the use of fair values in accounting acquired significance prior to 2007 despite widespread opposition. An answer is suggested in terms of four mutually supporting conditions of possibility which gave the proponents of …

Did fair-value accounting contribute to the financial crisis?Did fair-value accounting contribute to the financial crisis?
www.aeaweb.org [PDF]
This paper addresses the question of how and why the use of fair values in accounting acquired significance prior to 2007 despite widespread opposition. An answer is suggested in terms of four mutually supporting conditions of possibility which gave the proponents of …

Financial reporting quality: is fair value a plus or a minus?Financial reporting quality: is fair value a plus or a minus?
www.tandfonline.com [PDF]
This paper addresses the question of how and why the use of fair values in accounting acquired significance prior to 2007 despite widespread opposition. An answer is suggested in terms of four mutually supporting conditions of possibility which gave the proponents of …

Fundamental issues related to using fair value accounting for financial reportingFundamental issues related to using fair value accounting for financial reporting
search.proquest.com [PDF]
This paper addresses the question of how and why the use of fair values in accounting acquired significance prior to 2007 despite widespread opposition. An answer is suggested in terms of four mutually supporting conditions of possibility which gave the proponents of …

The decision usefulness of fair value accounting–a theoretical perspectiveThe decision usefulness of fair value accounting–a theoretical perspective
www.tandfonline.com [PDF]
This paper addresses the question of how and why the use of fair values in accounting acquired significance prior to 2007 despite widespread opposition. An answer is suggested in terms of four mutually supporting conditions of possibility which gave the proponents of …

Assessing the impact of fair value upon financial crisesAssessing the impact of fair value upon financial crises
academic.oup.com [PDF]
This paper addresses the question of how and why the use of fair values in accounting acquired significance prior to 2007 despite widespread opposition. An answer is suggested in terms of four mutually supporting conditions of possibility which gave the proponents of …

Fair value accounting is the wrong scapegoat for this crisisFair value accounting is the wrong scapegoat for this crisis
www.tandfonline.com [PDF]
This paper addresses the question of how and why the use of fair values in accounting acquired significance prior to 2007 despite widespread opposition. An answer is suggested in terms of four mutually supporting conditions of possibility which gave the proponents of …

Fair value accounting for financial instruments: some implications for bank regulationFair value accounting for financial instruments: some implications for bank regulation
papers.ssrn.com [PDF]
This paper addresses the question of how and why the use of fair values in accounting acquired significance prior to 2007 despite widespread opposition. An answer is suggested in terms of four mutually supporting conditions of possibility which gave the proponents of …

The crisis of fair-value accounting: Making sense of the recent debateThe crisis of fair-value accounting: Making sense of the recent debate
www.sciencedirect.com [PDF]
This paper addresses the question of how and why the use of fair values in accounting acquired significance prior to 2007 despite widespread opposition. An answer is suggested in terms of four mutually supporting conditions of possibility which gave the proponents of …

A convenient scapegoat: Fair value accounting by commercial banks during the financial crisisA convenient scapegoat: Fair value accounting by commercial banks during the financial crisis
meridian.allenpress.com [PDF]
This paper addresses the question of how and why the use of fair values in accounting acquired significance prior to 2007 despite widespread opposition. An answer is suggested in terms of four mutually supporting conditions of possibility which gave the proponents of …



Q&A About Fair Value


When would you use consolidated financial statements instead of separate financial statements?

Consolidated financial statements are used when one company owns more than 50% of another company and controls its operations. Consolidated financial statements are also used when two companies merge together into one new business entity. This type of consolidation is called a "merger." In this case, the assets and liabilities from each company are combined into one set of records in order to create one set of financial statements for the newly formed business entity. If only one company owns more than 50% interest in another company but does not control its operations, then separate financial statements must be prepared for each firm even though they operate under common ownership and management.

Why do accountants sometimes have trouble determining asset values if there isn't an active market for trading them?

Assets with little or no active markets often have difficultly being valued accurately because there aren't any current transactions taking place involving those assets at all times that allow accountants to observe what buyers

What determines if a stock has a high or low price on an exchange?

The demand of investors largely determines the stock's price on an exchange.

Is there another way to determine a stock's fair value besides using exchanges?

Yes, you could use other methods such as discounted cash flow analysis or option pricing models. However, these methods are not as reliable as exchanges because they rely heavily on assumptions about future events that may or may not occur.

What is fair value?

Fair value is the sale price agreed to by a willing buyer and seller, assuming both parties enter the transaction freely.

How can you determine an investment's fair value?

You can determine an investment's fair value by listing it on an exchange where market makers provide bid and ask prices for the security.

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