Fair Value Accounting

Fair Value Accounting Definition

Fair value accounting is the process of maintaining items in Financial Statements in their current valuation that is the Fair value. Mark to market mechanism is applied at specified periods to change the value of items in financial statements and show them as per their Fair Value in the market. When a particular item is shown in Fair value, then regular unrealized profit/loss is shown in Profit and Loss statement.

Fair Value Accounting

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Characteristics

Characteristics of fair value accounting

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#1 – Market

The change in Fair value is dependent on the overall market, if a particular item is sold at a different price than its fair value, then the item’s fair value doesn’t change due to that transaction. Fair value is decided by the market, so as a whole how much everyone is ready to pay for a particular item

#2 – Holding Period

The fair value is determined when the holder of the item is in no rush to sell the security. During rush, the holder may be ready to sell the item at a discounted price. So Fair value accounting assumes that the fair value is being determined by persons who are prepared to keep the item for a long time

#3 – Future Cash Flows

The Fair value of the asset will be determined based on the present value of all the future cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more that the asset will generate. So this characteristic helps in the neutral pricing of assets.

#4 – Orderly Transaction

The transaction should take place in a public market where everyone can see the trade and can participate. Transactions that happen inside closed doors will not be called for Fair Value pricing. So in Fair Value Pricing, there shouldn’t be any outside factor that affects the price.

#5 – Date Mentioned

Fair Value is always calculated standing on a particular date. So every day, the fair value may change as the market conditions are not stagnant.

Examples of Fair Value Accounting

You can download this Fair Value Accounting Excel Template here – Fair Value Accounting Excel Template

Example #1

Mr. X is planning to buy a Road Roller. The income from the Road Roller year wise is mentioned below –

  • Year 1: $80,000
  • Year 2: $50,000
  • Year 3: $200,000
  • Year 4: $100,000
  • Year 5: $200,000

The Interest rate running in the market is 5%. The life of the Roller is five years. Calculate the fair value of the asset

Solution

The Fair value of the asset should be its capacity to earn a return throughout its life after adjustment of the Interest rate.

Step #1 – Total Earning of the Road Roller

Fair ValueFair Value Accounting Example 1 Accounting
  • = $80,000 + $50,000 + $200,000 + $100,000 + $200,000
  • = $630,000

Step #2 – Calculate the Present Value of Future Cash-Flows

Bring all the payments that you will receive in future to year 0. So discount them cash-flows with the interest rate prevailing in the market.

Example 1.1

Calculation of Total Present Value

Example 1.2
  • = 76,910 + 45,351 + 172,768 + 82,270 + 156,705
  • Total Present Value (Fair Value) = $533,285

So Mr. X should record $533,285 as of the value of the asset in the asset side of the Balance Sheet.

Example #2

Mr. Y has bought a derivative contract at $100,000 in November 2019. The contract is for three months. The accounting year starts in January. At the end of December, the contract value is $90,000. How will Mr. Y show this change if he is following Fair value accounting?

Solution

As Mr. Y is following Fair Value accounting, so he must do mark to market at the end of the financial year. At the end of the year, the contract’s Fair Value is less than what is shown in the Balance Sheet. So Mr. Y will have to record an unrealized lossUnrealized LossUnrealized Gains or Losses refer to the increase or decrease respectively in the paper value of the company's different assets, even when these assets are not yet sold. Once the assets are sold, the company realizes the gains or losses resulting from such disposal.read more of $10,000 in Profit and Loss Statement and must reduce the value of the contract in the balance sheet by $10,000.

November 2019

In Balance sheet – Contract $100,000

January 2020

In Balance Sheet – Contract $90,000

In Profit and Loss Statement = Unrealised Loss $10,000

Fair Value Accounting vs. Historical Cost Accounting

Advantages and Disadvantages

Advantages

Disadvantages

Conclusion

Fair Value Accounting is being accepted by modern accounting, as it shows the real picture of the company. And slowly, the accounting standards are moving towards it. Fair value should be efficiently calculated; there shouldn’t be any manipulation in its calculation.

Recommended Articles

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