Fair value measurement: Meaning, Criticisms & Real-World Uses

What Is Fair Value Measurement?

Fair value measurement, a cornerstone of modern Financial Reporting, represents the estimated price at which an asset could be sold or a liability transferred in an orderly transaction between market participants at the measurement date. This concept falls under the broader category of [Financial Accounting], aiming to provide a more relevant and timely representation of an entity's financial position compared to historical cost. It is an "exit price" notion, reflecting what would be received upon selling an asset or paid to transfer a liability, rather than an "entry price" for acquiring or incurring it. Fair value measurement requires entities to consider the assumptions that Market Participants would use when pricing an asset or liability under current market conditions, including assumptions about risk.

History and Origin

The evolution of fair value measurement reflects a global shift in [Accounting Standards] toward greater transparency and relevance in financial reporting. Prior to the widespread adoption of fair value principles, many assets and liabilities were recorded at their Historical Cost Accounting, which often did not reflect their current economic value. The push for fair value began gaining significant momentum in the late 20th and early 21st centuries.

In the United States, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157), in 2006, which was later codified as ASC 820. This standard provided a single definition of fair value and a framework for its measurement. Concurrently, the International Accounting Standards Board (IASB) developed IFRS 13, Fair Value Measurement, issued in May 2011. This standard similarly defines fair value and sets out a framework for its measurement and disclosure under IFRS ¹⁶, ¹⁷. These coordinated efforts between major accounting standard-setters aimed to enhance consistency and comparability in fair value measurements globally. For example, IFRS 13 broadly defines fair value as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price)"¹⁵.

Key Takeaways

Fair value measurement is a market-based valuation, representing an exit price.
It is used to report Financial Instruments, assets, and liabilities at their current market value on financial statements.
Key accounting standards, such as ASC 820 (US GAAP) and IFRS 13 (International), provide a framework for its application.
A "fair value hierarchy" categorizes inputs used in the measurement, prioritizing observable market data.
Despite its benefits, fair value measurement can be complex, especially for illiquid assets, and has faced criticism, particularly during financial crises.

Valuation Approaches and Techniques

Fair value measurement does not rely on a single, universal formula but rather on various valuation approaches and techniques appropriate to the asset or liability being measured. ASC 820 and IFRS 13 generally outline three primary valuation approaches:

Market Approach: This approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. It often involves using quoted prices for identical items in active markets (Level 1 Inputs), or quoted prices for similar items, or observable inputs other than quoted prices (Level 2 Inputs).
Income Approach: This approach converts future amounts (e.g., cash flows or income and expenses) to a single current (i.e., discounted) amount. Techniques under this approach include the present value method, option-pricing models, and multi-period excess earnings methods. The fair value measurement is determined based on current market expectations about those future amounts¹⁴.
Cost Approach: This approach reflects the amount that would be required to replace the service capacity of an asset (its current replacement cost). For example, it might involve the cost to construct a similar asset.

Entities must maximize the use of relevant observable inputs and minimize the use of unobservable inputs (Level 3 Inputs) when selecting a valuation technique.

Interpreting Fair Value Measurement

Interpreting fair value measurement involves understanding its context within Financial Statements and the underlying assumptions used. Since fair value is a market-based measure, it aims to reflect the price that would be agreed upon by hypothetical, independent market participants, not necessarily the specific entity's intended use or holding period.

When evaluating a company's financial health, analysts and investors interpret fair value measurements to gauge the current economic reality of its assets and Liabilities. For instance, an increase in the fair value of a company's investment portfolio reflects a real-time gain in wealth, which would not be evident under a purely historical cost model. However, the reliability of the measurement depends heavily on the inputs used, with Level 1 inputs (quoted prices in active markets) being the most reliable, and Level 3 inputs (unobservable inputs based on management assumptions) being the least. Users of financial statements scrutinize disclosures about the fair value hierarchy to assess the subjectivity inherent in the reported values¹³.

Hypothetical Example

Consider "Tech Innovations Inc." which owns a portfolio of publicly traded bonds and a private equity investment in a promising startup.

Publicly Traded Bonds: Tech Innovations Inc. holds 1,000 units of a bond trading on an active exchange. On December 31, the market price for this bond is $105 per unit. The fair value measurement for these bonds would be:
$\text{Fair Value (Bonds)} = \text{Number of Units} \times \text{Market Price Per Unit} \\ \text{Fair Value (Bonds)} = 1,000 \times \$105 = \$105,000$
This is a Level 1 Input because the price is directly observable in an active market.
Private Equity Investment: Tech Innovations Inc.'s private equity investment in "FutureGen Robotics" is not publicly traded. To determine its fair value, the company uses an income approach, specifically a discounted cash flow (DCF) model. The model projects FutureGen's future cash flows and discounts them back to the Present Value using a discount rate that reflects the risks associated with similar private companies. The inputs, such as future growth rates and the discount rate, are largely unobservable and require significant judgment. After performing the DCF analysis, Tech Innovations Inc. determines the fair value of its stake in FutureGen Robotics to be $5,000,000. This fair value measurement would be classified as a Level 3 input due to the unobservable nature of the inputs.

This example illustrates how fair value measurement can range from straightforward calculations based on active market prices to complex estimations using models and subjective assumptions, often falling under the purview of Asset Valuation.

Practical Applications

Fair value measurement is integral across various facets of finance and accounting, providing current economic information.

Investment Companies and Funds: Registered investment companies and business development companies are often required to determine the fair value of their investments, especially those without readily available market quotations. The Securities and Exchange Commission (SEC) provides guidance and rules, such as Rule 2a-5 under the Investment Company Act of 1940, detailing requirements for fair value determinations, including risk assessment, methodology application, and oversight¹¹, ¹².
Derivatives and Financial Instruments: Derivatives, such as options and futures, are almost always carried at fair value on the balance sheet because their value changes rapidly with market conditions. This provides users of financial statements with up-to-date information on the potential risks and rewards these instruments represent.
Mergers and Acquisitions (M&A): In M&A transactions, fair value measurement is crucial for allocating the purchase price to the acquired assets and Liabilities, including intangible assets like patents and customer relationships, which may not have been on the target company's books at historical cost.
Impairment Testing: For certain assets, accounting standards require impairment tests based on fair value. If an asset's carrying amount exceeds its fair value, an impairment loss must be recognized.
Equity Instruments: While not always measured at fair value, certain equity investments (e.g., those held for trading) are typically measured at fair value through profit or loss, providing transparency on market fluctuations.

Limitations and Criticisms

Despite its widespread adoption and benefits, fair value measurement has faced several criticisms, particularly concerning its application during periods of market instability.

One significant criticism emerged during the 2008 financial crisis. Critics argued that fair value accounting, specifically Mark-to-Market Accounting, exacerbated the crisis by forcing banks to value illiquid assets, such as mortgage-backed securities, at "fire-sale" prices¹⁰. This, they claimed, led to a downward spiral: lower valuations reduced regulatory capital, compelling banks to sell more assets, which further depressed prices, creating a pro-cyclical effect⁹. However, other analyses suggest that fair value accounting was more a messenger of the crisis than its cause, accurately reflecting the declining value of assets rather than initiating the decline itself⁷, ⁸. The SEC, in a 2008 study, concluded that fair value accounting did not cause bank failures and recommended improving, rather than suspending, fair value standards⁶.

Another limitation stems from the subjectivity involved, especially when observable market data is scarce (i.e., when Level 3 inputs are predominantly used). Valuations in such cases rely on management's assumptions and complex Valuation Techniques, introducing a higher degree of estimation uncertainty. This can potentially open the door to manipulation or present an incomplete picture, even with required disclosures about the inputs used⁵. Critics argue that this subjectivity undermines the reliability that fair value measurement is supposed to provide, particularly for assets in inactive or distressed markets.

Fair Value Measurement vs. Historical Cost Accounting

Fair value measurement and Historical Cost Accounting represent two fundamentally different approaches to valuing assets and liabilities on a company's balance sheet.

Historical cost accounting records assets and liabilities at their original purchase price or incurred cost, and these values generally remain unchanged over time, except for depreciation or amortization. It offers reliability and verifiability, as the original cost is objectively determined at the time of the transaction. However, its primary drawback is a lack of relevance; the historical cost may bear little resemblance to an asset's current market value, especially for long-lived assets or investments in volatile markets.

In contrast, fair value measurement aims to reflect the current economic value of assets and liabilities, representing the price they would command in an orderly transaction today. It prioritizes relevance, providing users of financial statements with more up-to-date information that can be useful for decision-making. The main point of confusion often arises because fair value can be subjective for assets without active markets. While historical cost provides an undeniable paper trail, fair value provides a more dynamic, albeit sometimes estimated, view of financial position. Most modern Accounting Standards, including GAAP and IFRS, mandate a mix of both, applying fair value to specific assets and liabilities, notably financial instruments and certain investment properties, while retaining historical cost for others.

FAQs

What does "orderly transaction" mean in fair value measurement?

An "orderly transaction" means a transaction that assumes exposure to the market for a period customary for transactions involving such assets or liabilities, ensuring that it is not a forced liquidation or distress sale. It implies that the transaction takes place between willing and knowledgeable parties³, ⁴.

What are the three levels of the fair value hierarchy?

The fair value hierarchy categorizes inputs used in fair value measurement into three levels to increase consistency and comparability:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets.
Level 2: Observable inputs other than Level 1 quoted prices, 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.
Level 3: Unobservable inputs for the asset or liability, based on the entity's own assumptions because there is no market data available².

Why is fair value measurement important for investors?

Fair value measurement provides investors with more relevant and timely information about the current economic value of a company's assets and liabilities. This helps in making more informed investment decisions by reflecting current market conditions rather than just historical costs, enhancing the transparency of Financial Statements ¹.

Does fair value measurement apply to all assets and liabilities?

No, fair value measurement does not apply to all assets and liabilities. Its application is determined by specific Accounting Standards (like ASC 820 or IFRS 13), which specify when fair value is required or permitted for certain types of assets, liabilities, or Equity Instruments. It is most commonly applied to financial instruments, certain investment properties, and assets acquired in business combinations.