Accounting for corporate finance: key concepts: fair value
Measurement of fair value
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. It is not the amount an entity would receive or pay in a forced transaction, involving liquidation or distress sale. However, fair value reflects the credit quality of the instrument. So, for example, a bond issued by a company with an AAA credit rating would normally be expected to have a higher value than an identical bond issued by a lower-rated company.
The best evidence of the fair value of a financial asset at initial recognition is usually the transaction price. Where the price is not paid in cash, it will be the fair value of the consideration given.
Ascertaining fair value
IAS39’s application guidance gives extensive detail and consideration to the various factors governing the interpretation of what constitutes fair value. It provides a hierarchy to be used:
- Quoted marked prices in an active market are the best evidence of fair value and should be used, where they exist, to measure the financial asset:
- If a market for a financial asset is not active, an entity establishes fair value by using a valuation technique that makes maximum use of market inputs. Market inputs include recent arm’s length market transactions, reference to the current fair value of another instrument that is substantially the same, discounted cash flow analysis, and option pricing models. An acceptable valuation techniques incorporates all factors that market participants would consider in setting a price and is consistent with accepted economic methodologies for pricing financial instruments:
- If there is no active market for an equity instrument and the range of reasonable fair values is significant and these estimates cannot be reasonably assessed, then an entity must measure the equity instrument at cost less impairment.