Economic fair value

What Is Economic Fair Value?

Economic fair value refers to the theoretical price at which an asset or liability would be exchanged between willing and knowledgeable parties in an orderly transaction, under current market conditions. It is a market-based measurement, reflecting the perspective of Market Participants rather than the reporting entity. This concept is central to Valuation within finance and Accounting Standards, aiming to provide a realistic and unbiased assessment of an item's worth at a specific measurement date. The intent of the holder is irrelevant when calculating fair value; for example, a rushed sale would not reflect fair value.²⁵ An orderly transaction implies no pressure on the seller to sell, ensuring the valuation is not skewed by forced liquidation.²⁴

History and Origin

The concept of fair value has been a standard in Financial Reporting for decades, with the Financial Accounting Standards Board (FASB) issuing numerous statements that incorporate it as a measurement of value.²³ A significant milestone in the adoption and standardization of economic fair value was the introduction of Statement of Financial Accounting Standards (SFAS) 157 in September 2006 by the FASB, now codified as Accounting Standards Codification (ASC) 820, Fair Value Measurement.²¹, ²² This standard was established to clearly define fair value, provide a consistent framework for its measurement, and expand disclosures regarding fair value measurements.¹⁸, ¹⁹, ²⁰ It sought to improve consistency, reliability, and comparability in financial reporting by providing a structured approach for valuing assets and liabilities.¹⁷ ASC 820 applies to a wide range of items, including Intangible Assets, long-lived assets, and Financial Instruments.¹⁶

The FASB continues to clarify and update guidance related to fair value measurement, for instance, through Accounting Standards Updates (ASU) like ASU 2022-03, which clarifies principles for measuring the fair value of equity securities subject to contractual sale restrictions.¹⁴, ¹⁵ The FASB provides detailed guidance on Topic 820 through its official codification.¹³

Key Takeaways

• Economic fair value represents the hypothetical price an asset or liability would trade for in an orderly, arm's-length transaction.
• It is a market-based measurement, focusing on exit price rather than acquisition cost.
• Fair value measurement is governed by specific Accounting Standards, notably ASC 820 in the United States.
• The determination of fair value can involve various valuation techniques and a hierarchy of inputs based on their observability.
• It provides a more current assessment of an entity's financial position compared to methods based solely on Historical Cost.

Formula and Calculation

Economic fair value is not determined by a single universal formula but rather through various valuation techniques, which depend on the nature of the asset or liability being measured and the availability of market data. The primary approaches include:

• Market Approach: This approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. This often involves using observable prices from active markets, such as quoted prices for identical assets in active markets (Level 1 inputs in the fair value hierarchy).
• Income Approach: This approach converts future amounts (e.g., cash flows or earnings) to a single current (Present Value) amount. Examples include the Discounted Cash Flow (DCF) method, where future expected cash flows are discounted to their present value.
• Cost Approach: This approach reflects the amount that would be required to replace the service capacity of an asset (current replacement cost).

When using the income approach, the formula for a basic present value calculation, which underpins many fair value estimations, can be expressed as:

Where:

• (PV) = Present Value (or fair value estimate)
• (CF_t) = Cash flow at time (t)
• (r) = Discount rate reflecting the risks inherent in the cash flows
• (t) = Time period
• (n) = Total number of periods

The determination of the discount rate and the projected cash flows requires significant judgment and analysis of market conditions and asset-specific characteristics.

Interpreting the Economic Fair Value

Interpreting economic fair value involves understanding the context of the valuation and the inputs used. For assets and liabilities measured at fair value, Accounting Standards typically mandate a fair value hierarchy, categorizing inputs into three levels based on their observability:

• Level 1 Inputs: Quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. These are considered the most reliable inputs and result in a highly objective fair value.
• 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, quoted prices for identical or similar assets or liabilities in inactive markets, interest rates, and yield curves.
• Level 3 Inputs: Unobservable inputs for the asset or Liability. These are used when observable inputs are unavailable and require significant judgment and assumptions by the reporting entity. Examples include financial models that rely on proprietary data or assumptions about future market conditions.

The level at which a fair value measurement is categorized in its entirety depends on the lowest level (least reliable) significant input used.¹² Understanding this hierarchy is crucial for users of financial statements to gauge the reliability and subjectivity of the reported fair value.

Hypothetical Example

Consider a private company, "Tech Innovations Inc.," which is being acquired. As part of the Mergers and Acquisitions process, its assets and liabilities must be valued at fair value. One of its key assets is a proprietary software patent, an Intangible Assets for which there is no active market.

To determine the fair value of this patent, an independent valuation firm employs an income approach, specifically a Discounted Cash Flow model.

1. Project Future Cash Flows: The firm estimates the incremental revenue and cost savings the patent is expected to generate over its useful life. For simplicity, let's assume the patent is expected to generate net cash flows of $2 million per year for the next 5 years.
2. Determine Discount Rate: Based on the risk profile of the technology and comparable ventures, a discount rate of 10% is determined.
3. Calculate Present Value:
   • Year 1: (\frac{$2,000,000}{(1 + 0.10)^1} = $1,818,181.82)
   • Year 2: (\frac{$2,000,000}{(1 + 0.10)^2} = $1,652,892.56)
   • Year 3: (\frac{$2,000,000}{(1 + 0.10)^3} = $1,502,629.60)
   • Year 4: (\frac{$2,000,000}{(1 + 0.10)^4} = $1,366,026.91)
   • Year 5: (\frac{$2,000,000}{(1 + 0.10)^5} = $1,241,842.64)
4. Sum Present Values: The sum of these present values is approximately $7,581,573.53.

Therefore, the economic fair value of the software patent is estimated to be approximately $7.58 million. This valuation would be categorized as a Level 3 fair value measurement due to the use of unobservable inputs and significant management judgment in projecting future cash flows and determining the discount rate.

Practical Applications

Economic fair value is widely applied across various aspects of finance, accounting, and business operations:

• Financial Reporting: Companies use fair value to measure and disclose certain assets and liabilities on their Balance Sheet, such as investment properties, derivatives, and available-for-sale securities. This provides users of financial statements with more current and relevant information about the company's financial position than historical cost alone.
• Mergers and Acquisitions (M&A): In M&A transactions, fair value accounting is critical for purchase price allocation. The assets and liabilities of the acquired company are recorded at their fair values at the acquisition date to reflect their current market worth, which provides valuable information for investors and management.¹¹ The Securities and Exchange Commission (SEC) has specific disclosure requirements concerning fair value in business acquisitions and dispositions to improve information quality for investors.⁹, ¹⁰
• Asset Valuation and Impairment Testing: Fair value is used to assess the value of assets for various purposes, including testing for impairment. If an asset's carrying amount exceeds its fair value, an impairment loss may need to be recognized on the Income Statement.
• Regulatory Compliance: Regulatory bodies often mandate fair value measurement for specific financial instruments and disclosures to ensure transparency and consistency in financial markets. For instance, the FASB's ASC 820 provides guidance on fair value measurement to ensure reliable and comparable financial information.⁷, ⁸

Limitations and Criticisms

While economic fair value offers enhanced transparency and relevance in Financial Reporting, it faces several limitations and criticisms:

• Subjectivity of Inputs: For assets or liabilities without active markets (Level 2 and Level 3 inputs), determining fair value requires significant management judgment and the use of unobservable inputs. This can introduce subjectivity and potential for bias into financial statements, making them less verifiable than measurements based on Historical Cost.⁶
• Procyclicality: Critics argued that fair value accounting exacerbated the 2008 Financial Crisis, especially in illiquid markets. During downturns, declining market prices forced companies, particularly financial institutions, to record significant write-downs on assets, which could further depress market confidence and asset values in a downward spiral.⁴, ⁵ However, research suggests it is unlikely that fair value accounting significantly added to the severity of the 2008 financial crisis, or that it was merely a scoreboard reflecting underlying problems rather than causing them.³ Proponents argue that fair value accounting provides clarity and reveals the true state of affairs, preventing investors from being kept in the dark about bad decisions.²
• Volatility of Earnings: Fair value changes, particularly for Financial Instruments, can lead to increased volatility in a company's reported earnings, even if the underlying asset has not been sold. This volatility may not always reflect the true operational performance of the business.
• Complexity and Cost: Implementing fair value accounting requires sophisticated valuation models and significant expertise, which can be complex and costly for companies, particularly those with a large number of illiquid or complex assets.

Economic Fair Value vs. Market Value

Economic fair value and Market Value are closely related concepts often used interchangeably, but there are subtle distinctions, particularly in the context of Accounting Standards.

Economic Fair Value is a broad concept defined as the price an asset or liability would be sold or transferred for in an orderly transaction between willing and knowledgeable parties at the measurement date. It is an "exit price" and assumes an orderly transaction, meaning there's no pressure on either party to buy or sell. This definition is central to accounting standards like ASC 820.

Market Value typically refers to the current price at which an asset or liability is trading in an active, liquid market. It is the price observed directly from market transactions. While market value can often be the best indicator of economic fair value (especially for actively traded securities, which fall under Level 1 fair value inputs), it is not always synonymous. In illiquid markets or distressed situations, the observed market price might not represent an "orderly transaction" or may be influenced by factors like forced sales, which would lead to a divergence from true economic fair value. Therefore, economic fair value attempts to derive an unbiased, theoretical price even when market conditions are imperfect.

FAQs

Why is economic fair value important?

Economic fair value is important because it provides a more relevant and timely representation of a company's assets and liabilities than historical cost. It helps investors and other stakeholders understand the current economic reality and financial health of an entity, particularly for Financial Instruments and other assets subject to market fluctuations.

How does fair value differ from historical cost?

Historical Cost values assets and liabilities at their original purchase or transaction price. In contrast, economic fair value assesses them at their current market value, reflecting prevailing economic conditions.¹ While historical cost is objective and verifiable, fair value aims for relevance by providing a more up-to-date valuation.

What are Level 1, Level 2, and Level 3 inputs?

These refer to the fair value hierarchy used in Accounting Standards. Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities (most reliable). Level 2 inputs are observable inputs other than Level 1 quoted prices. Level 3 inputs are unobservable inputs, requiring significant judgment and assumptions, used when observable data is unavailable.

Is fair value accounting always mandatory?

No, the application of fair value accounting depends on the specific Accounting Standards and the type of asset or Liability. While some items must be measured at fair value, for others, fair value measurement may be permitted but not required, or historical cost may be the primary basis.