Define fair value in accounting

Fair value in accounting refers to the estimated market value of an asset or liability, which reflects the price at which it could be sold or settled in an orderly transaction between knowledgeable and willing parties at the measurement date. It is a concept used to provide a realistic valuation of assets and liabilities, ensuring that financial statements present an accurate and unbiased picture of a company's financial position.

Key Characteristics of Fair Value

1. Market-Based Measurement: Fair value is determined based on market conditions, not on the intrinsic or historical cost of the asset or liability.
2. Orderly Transaction: The valuation assumes a transaction that is conducted in a normal, orderly manner, rather than a forced or liquidation sale.
3. Knowledgeable and Willing Parties: The parties involved in the transaction are assumed to have a reasonable understanding of the asset or liability and are willing participants, not under compulsion.

Fair Value Measurement Hierarchy

The fair value measurement approach follows a hierarchy that prioritizes the inputs used to determine fair value. This hierarchy is divided into three levels:

1. Level 1 Inputs: Quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. These are the most reliable evidence of fair value.

   • Example: Stock prices listed on an exchange.

2. Level 2 Inputs: Observable inputs other than quoted prices included within Level 1, such as quoted prices for similar assets or liabilities in active markets, or quoted prices for identical or similar assets or liabilities in markets that are not active.

   • Example: Prices of similar properties in the same area for real estate valuation.

3. Level 3 Inputs: Unobservable inputs for the asset or liability, relying on the entity's own assumptions about what market participants would consider in pricing the asset or liability.

   • Example: Valuation techniques like discounted cash flow models for unique assets.

Application of Fair Value

Fair value is used in various areas of accounting, including:

• Investment Valuation: Determining the fair value of marketable securities and financial instruments.
• Asset Impairment: Assessing whether the carrying amount of an asset exceeds its recoverable amount.
• Business Combinations: Measuring assets acquired and liabilities assumed at their fair values on the acquisition date.
• Fair Value Hedging: Accounting for derivatives and hedging activities.

Fair value provides a consistent and transparent basis for measuring and reporting financial instruments and other assets and liabilities, enhancing the relevance and reliability of financial statements.