Fair value may also be called the justified or unbiased price. It is applied in both Economics and Accounting. Fair value accounting refers to the rational or unbiased estimate for the possible good’s, service’s and asset’s market price. Fair value in Accounting is aimed at presenting financial data in the most utilizable way possible. Financial statements will therefore represent the true and reasonable view of the financial information relating to any financial entity. Stakeholders will hence be able to make their investment and relationship decisions based on Accounts statements that have utilized the Fair Value Accounting principle.
Fair value in Accounting considers objective factors like;
The acquiring, producing or distributing costs, replacing and costs for the closest substitutes, the exact utility for a particular level of social productive capacity development is of importance and the supply against the demand for any particular good, service or asset.
Subjective factors to be considered include;
Characteristics of risk, cost for and return or benefits on capital and the individual utility perception.
Fair value accounting is essential in estimating the market value for assets or liabilities whose true value may not be determined due to lack of a sincere established asset’s or liability’s market.
(Stephen, 2008 p.3-18)
As per the Generally Accepted Accounting Principles (GAAP), Financial Accounting Standards (FAS) 157 dictates that, fair value is the sum of money for which assets can be purchased at a current transaction with willing parties or moved to an equal or equivalent party, in a situation other than a liquidation case. All the direct and indirect production and operational expenses will be given consideration when trying to determine the most reasonable price for both the buyer and the purchaser. Traders will be expected to have all the information that is necessary for their transaction to be clear to all the related parties.
(James, 2009 p.6-13)
Fair value accounting is applicable to assets with a carrying value that is determined by market to another market valuation. For assets recorded at historical cost, the asset’s fair value may not be applicable. An example would be a university store whose cost of four million dollars was constructed ten years ago. In case the management was to give a fair value measure on the store, it will be a subjective measurement due to lack of an active market for this particular asset or assets that are close to this one.
A different example would be, incase DEF Ltd bought a go down in nineteen ninety, for two million dollars, the financial statement in respect to historical cost will record the go down at two million dollars on its balance sheet. If GHI Ltd bought a similar go down in two thousand and ten for four million dollars, then the GHI Ltd will report the go down at four million dollars. Although the two assets are similar, DEF Ltd will report the asset at half the GHI’s asset value.
Historical cost can not identify the two assets being similar. This issue is compounded incase similar assets or liabilities are recorded historically, resulting in an undervalued balance sheet. Although if both DEF and GHI Ltd recorded the financial information as per fair value accounting the two would record the asset of four million dollars.
(Gerald, 2009 p.24-31)
The idea in fair value accounting is to represent the figures in the financial statements at amounts that they would fetch just in case an entity was to purchase them afresh. This is exactly that willing buyers are able to pay for the acquisition of such commodities. Adjustments made in determining fair values should consider the depreciation charge that the assets would attract. The disposable value is always of great interest in accounting at fair values.
Fair value accounting produces information to investors whose interest is on the assets’ or liabilities’ current value but not their historical cost. It is known that stakeholders in a company use financial statements to make decisions as to whether their investments in the enterprise are worthwhile or not.
Unbiased figures represented on the financial statements help investors predict their expected returns on their shares. Such reasonable figures will be helpful in determining the expected company’s growth and how their shares may increase in value in future. It will also be of use to investors to determine the extent of their rewards in case a company goes into liquidation or a receivership in future. The making of both short term and long-term decisions is made easy by the use of the true and fair view represented on the trial balance and balance sheet.
Courtney from Study Moose