Fair value

Fair value is an accounting measurement basis: the price at which an asset (or liability) would be exchanged between knowledgeable, willing parties in a current transaction. It contrasts with historical cost, which is what was actually paid. Most accounting standards require certain assets to be measured at historical cost, but others — particularly financial instruments, investments, and derivatives — must be measured at fair value on each reporting date. Fair value measurement introduces both more current information and more volatility into financial statements. It is governed by specific standards that define the hierarchy of inputs (fair-value-level-1, fair-value-level-2, fair-value-level-3).

Fair value vs. historical cost

Historical cost is what a company paid for an asset. Fair value is what it could sell the asset for today (or what a comparable asset trades for).

Example: A company buys a building for $10 million in 2010. Under historical cost, it remains on the balance sheet at $10 million (less accumulated depreciation). Under fair value, it is marked up or down annually to reflect current market prices.

In rising markets, fair value is higher; in falling markets, it is lower. This reflects economic reality more accurately than historical cost, but it also introduces volatility.

What assets are measured at fair value?

Under GAAP:

• Investments in securities (stocks, bonds) held for trading: fair value
• Derivatives: fair value
• Certain debt at fair value option: fair value
• Intangible assets in goodwill impairment testing: fair value
• Property and equipment in some circumstances: fair value option available (not required)
• Most operating assets: historical cost

The rule is not simple. Some standards mandate fair value; others allow it; others require historical cost.

IFRS has similar but slightly different rules. Investment property can be measured at fair value under IFRS.

The three-level hierarchy

Fair value is determined using a hierarchy of inputs, from most to least reliable:

• Fair-value-level-1: Quoted prices in active markets (e.g., stock price). Most reliable.
• Fair-value-level-2: Observable inputs other than quoted prices (e.g., comparable company prices, broker quotes). Moderate reliability.
• Fair-value-level-3: Unobservable inputs (company’s own assumptions, projections). Least reliable.

Companies must disclose the level of input for each fair-valued asset. Level 3 measurements are often subjective and require careful scrutiny.

Unrealized gains and losses

When an asset is marked to fair value and the price changes, the gain or loss is recorded. This gain or loss is unrealized until the asset is sold.

Where the unrealized gain or loss is recorded depends on the asset type:

• Trading securities: Income statement (affects net income).
• Available-for-sale securities: Accumulated other comprehensive income (does not affect net income, until sold).
• Hedging derivatives: Either income statement or accumulated other comprehensive income depending on hedge type.

This distinction means two companies with identical fair value changes can report different earnings depending on the classification of their assets.

Earnings volatility from fair value

Fair value accounting can create significant earnings volatility. A company with a large portfolio of trading securities or derivatives sees its earnings swing with market prices. In a stock market crash, the fair value of holdings declines, creating a loss on the income statement, even if the company does not sell.

This is why some view fair value accounting as introducing unnecessary volatility. Others argue it provides transparency: assets and liabilities are stated at economic value, not arbitrary historical cost.

Fair value option and balance sheet relevance

GAAP allows companies to elect the “fair value option” for certain assets and liabilities. If elected, those items are measured at fair value with changes in income statement.

This option is used strategically. A company might elect fair value for a liability to offset gains or losses on assets, reducing earnings volatility (a form of economically effective hedging).

Disclosure and footnote requirements

Companies disclose fair value measurements extensively:

• All assets and liabilities measured at fair value.
• The fair value, fair value level, and how it was determined.
• Changes in fair value during the period.
• Sensitivity analysis for level 3 measurements (what if we changed assumptions?).

These footnotes are essential for understanding the reliability of fair value numbers.

See also