WallStreetMojo

WallStreetMojo

WallStreetMojo

MENUMENU
  • Free Tutorials
  • Certification Courses
  • 250+ Courses All In One Bundle
  • Login
Home » Accounting Tutorials » Accounting Fundamentals » Fair Value Accounting

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.

Characteristics

Fair Value Accounting - Characteristics

#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 flows 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.

Popular Course in this category
Sale
All in One Financial Analyst Bundle (250+ Courses, 40+ Projects)
4.9 (1,067 ratings)
250+ Courses | 40+ Projects | 1000+ Hours | Full Lifetime Access | Certificate of Completion
View Course

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

  • Year 1 – Present Value 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

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 loss 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

  • 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 market and the value that is shown in statements remains fixed.
  • Fair Value accounting makes the Balance Sheet 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

Advantages

  • Fair value accounting reflects the current prices of the items 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

Disadvantages

  • 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 statements which are not liked by many investors. Investors prefer a stable balance sheet which they may trust.

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

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 –

  • Social Accounting
  • Historical Cost vs Fair Value
  • Fair Value vs Market Value
  • Accounting for Fair Value Hedges
  • Mark to Market Accounting
8 Shares
Share
Tweet
Share
Primary Sidebar
Footer
COMPANY
About
Reviews
Contact
Privacy
Terms of Service
RESOURCES
Blog
Free Courses
Free Tutorials
Investment Banking Tutorials
Financial Modeling Tutorials
Excel Tutorials
Accounting Tutorials
Financial Statement Analysis
COURSES
All Courses
Financial Analyst All in One Course
Investment Banking Course
Financial Modeling Course
Private Equity Course
Venture Capital Course
Excel All in One Course

Copyright © 2021. CFA Institute Does Not Endorse, Promote, Or Warrant The Accuracy Or Quality Of WallStreetMojo. CFA® And Chartered Financial Analyst® Are Registered Trademarks Owned By CFA Institute.
Return to top

WallStreetMojo

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

* Please provide your correct email id. Login details for this Free course will be emailed to you

Book Your One Instructor : One Learner Free Class
Let’s Get Started
Please select the batch
Saturday - Sunday 9 am IST to 5 pm IST
Saturday - Sunday 9 am IST to 5 pm IST

This website or its third-party tools use cookies, which are necessary to its functioning and required to achieve the purposes illustrated in the cookie policy. By closing this banner, scrolling this page, clicking a link or continuing to browse otherwise, you agree to our Privacy Policy

Login

Forgot Password?

WallStreetMojo

Free Accounting Course

You will Learn Basics of Accounting in Just 1 Hour, Guaranteed!

* Please provide your correct email id. Login details for this Free course will be emailed to you

WallStreetMojo

Download Fair Value Accounting Excel Template

New Year Offer - All in One Financial Analyst Bundle (250+ Courses, 40+ Projects) View More