Fair value is the value of an asset or liability in an arms length transaction between unrelated willing and knowledgeable parties. The concept of fair value is used in many accounting standards including the IFRS covering acquisitions, and the valuation of securities, but is not limited to these.
Fair value accounting requires assets to be revalued when the fair value is materially different from the current book value. Assets may need to be revalued (such as when the market value of securities changes), or their purchase price may not be separable from a larger transaction (as happens in an acquisition).
Increases in the value of an asset are added to the revaluation reserve.
Some methods of determining fair value are preferred to others as they are more accurate when they can be used. The methods used are, in IFRS order of preference:
- If there are identical transactions in the market, assets and liabilities should be valued with reference to such transactions — i.e. marked to market.
- If identical transactions do not exist, but similar transactions exist, fair value should be estimated making the necessary adjustments and using market based assumptions
- If either of the above methods cannot be used, other valuation methods may be used — this is what allows marking to model.
Fair value often has a subjective element as so many valuations are likely to use the latter two methods.
Fair value of intangible assets
The value of intangible assets, especially goodwill has a significant effect on reported profits and balance sheets. The common exclusion of goodwill for valuation purposes makes this less important for investors. After the initial recognition of goodwill, it should be tested for impairment annually.
The methods used for valuing intangible assets are categorised (by an IFRS) into market methods (the first two above) and the income method (the third of the above).
Fair value of securities
IFRSs require use of the following methods, in order of preference:
- Quoted market prices should be used if available.
- The price should be estimated using market data and with reference to the current market value of a similar instrument.
- Where the above methods cannot be used, a company should use cost less impairment.