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.
#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. 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
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
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
- = $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.
- Year 1 – Present ValuePresent ValuePresent Value (PV) is the today's value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation. of the Cash Flow $80,000 = 80,000 / 1.05 = 76,190
- Year 2 – Present Value of the Cash Flow $50,000 = 50,000 / (1.05)^ 2 = 45,351
- Year 3 – Present Value of the Cash Flow $200,000 = 200,000 / (1.05)^3 = 172,768
- Year 4 – Present Value of the Cash Flow $100,000 = 100,000 / (1.05)^ 4 = 82,270
- Year 5 – Present Value of the Cash Flow $200,000 = 200,000 / (1.05)^5 = 156,705
Calculation of Total Present Value
- = 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.
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?
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. of $10,000 in Profit and Loss Statement and must reduce the value of the contract in the balance sheet by $10,000.
In Balance sheet – Contract $100,000
In Balance Sheet – Contract $90,000
In Profit and Loss Statement = Unrealised Loss $10,000
Fair Value Accounting vs. Historical Cost Accounting
- Fair Value Accounting is the most unbiased form of accounting and is accepted by modern accounting standards Whereas, Historical Accounting is based on historical prices and was used by accounting standards earlier
- Fair value accounting brings volatility in the Accounting Statements like Balance sheet and Profit and Loss because profit/loss is marked after every period. In contrast, Historical accounting keeps Balance sheet and Profit/Loss stable as there is no mark to marketMark To MarketMarking to market (MTM) is the concept of recording the accounts, i.e., the assets and liabilities at their fair value or at the current market price, which varies with time rather than historical cost. It helps to represent the company's actual financial condition. and the value that is shown in statements remains fixed.
- Fair Value accounting makes the Balance SheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. more realistic as the prices shown in the balance sheet, whereas Historical Cost accounting is stale pricing. The value that is shown in Financial Statements under this accounting can’t be trusted. Under historical accounting, the purchase value remains constant irrespective of its actual price in the market.
Advantages and Disadvantages
- Fair value accounting reflects the current prices of the items in the balance sheetItems In The Balance SheetAssets such as cash, inventories, accounts receivable, investments, prepaid expenses, and fixed assets; liabilities such as long-term debt, short-term debt, Accounts payable, and so on are all included in the balance sheet.. So the Balance sheet is very much updated and reveals the real picture of the entity
- Regular mark to market helps stakeholders to get the actual profit/loss picture as unrealized gains/losses are marked under this system
- As Fair value is used, so management can’t play with the pricing and auditor can easily check the prices
- The determination of fair value is painful at times. If too many buyers and sellers are not available, then the determination of Fair Value is tough.
- Management may play with the profit, by showing an unrealized gain, which may not sustain during the actual sale of the asset.
- Fair Value brings volatility to the financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. which are not liked by many investors. Investors prefer a stable balance sheet which they may trust.
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.
This has been a guide to Fair Value Accounting and its definition. Here we discuss characteristics, examples of fair value accounting along with advantages, disadvantages, and differences. You may refer to the following articles to learn more about finance –