Fair Value

Fair value, also called fair price (in a commonplace conflation of the two distinct concepts), is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account such objective factors as:

  • acquisition/production/distribution costs, replacement costs, or costs of close substitutes
  • actual utility at a given level of development of social productive capability
  • supply vs. demand

and subjective factors such as

  • risk characteristics
  • cost of and return on capital
  • individually perceived utility

In accounting, fair value is used as a certainty of the market value of an asset (or liability) for which a market price cannot be determined (usually because there is no established market for the asset). Under US GAAP (FAS 157), fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties, or transferred to an equivalent party, other than in a liquidation sale. This is used for assets whose carrying value is based on mark-to-market valuations; for assets carried at historical cost, the fair value of the asset is not used. One example of where fair value is an issue is a college kitchen with a cost of $2 million which was built five years ago. If the owners wanted to put a fair value measurement on the kitchen it would be a subjective estimate because there is no active market for such items or items similar to this one. In another example, if ABC Corporation purchased a two-acre tract of land in 1980 for $1 million, then a historical-cost financial statement would still record the land at $1 million on ABC’s balance sheet. If XYZ purchased a similar two-acre tract of land in 2005 for $2 million, then XYZ would report an asset of $2 million on its balance sheet. Even if the two pieces of land were virtually identical, ABC would report an asset with one-half the value of XYZ’s land; historical cost is unable to identify that the two items are similar. This problem is compounded when numerous assets and liabilities are reported at historical cost, leading to a balance sheet that may be greatly undervalued. If, however, ABC and XYZ reported financial information using fair-value accounting, then both would report an asset of $2 million. The fair-value balance sheet provides information for investors who are interested in the current value of assets and liabilities, not the historical cost.

Read more about Fair Value:  Fair Value Vs Market Price, Fair Value Vs Market Value, Fair Value Measurements (US Markets)

Famous quotes containing the word fair:

    What art thou that usurp’st this time of night,
    Together with that fair and warlike form
    In which the majesty of buried Denmark
    Did sometimes march? By heaven I charge thee speak!
    William Shakespeare (1564–1616)