In recent years, the accounting rules for certain balance sheet items have transitioned from historical cost to “fair value measurements.” Examples of assets that may currently be reported at fair value are asset retirement obligations, derivatives, and intangible assets acquired in a business combination. Though it may better align your company’s financial statements with today’s market values, estimating fair value may require subjective judgment.
Gaap Definition of Fair Value
Under U.S. Generally Accepted Accounting Principles (GAAP), it is “the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date.” Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures, explains how companies should estimate the fair value of assets and liabilities using available, quantifiable market-based data.
Does Fair Value Differ From Fair Market Value?
Although fair value is similar to fair market value, the terms aren’t synonymous. The most common definition of fair market value is in IRS Revenue Ruling 59-60. The IRS defines fair market value as “[T]he price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
The Financial Accounting Standards Board (FASB) chose the term “fair value” to prevent companies from applying IRS regulations or guidance and U.S. Tax Court precedent when valuing assets and liabilities for financial reporting purposes. The use of this term also shouldn’t be confused with its use in certain legal situations — for example, when valuing a business for a divorce or a shareholder buyout. Statutory definitions of fair value typically differ from the definition provided under GAAP.
Measuring Fair Value
The FASB recognizes three valuation approaches: cost, income, and market. It also provides the following hierarchy for valuation inputs, listed in order from most important to least important:
- Quoted prices in active markets for identical assets and liabilities,
- Observable inputs, including quoted market prices for similar items in active markets, quoted prices for identical or similar items in active markets, and other market data, and
- Unobservable inputs, such as cash-flow projections or other internal data.
Valuation specialists are often used to estimate value. But ultimately, management can’t outsource responsibility for fair value estimates. Management has an obligation to understand the valuator’s assumptions, methods, and models. It also must implement adequate internal controls over fair value measurements, impairment charges, and disclosures.
External auditors evaluate accounting estimates as part of their standard audit procedures. Auditing standards generally require them to select one or a combination of the following approaches to test measurements substantively:
- Test management’s process.
Auditors evaluate the reasonableness and consistency of management’s assumptions and test whether the underlying data is complete, accurate, and relevant.
- Develop an independent estimate.
Using management’s assumptions (or alternate assumptions), auditors develop an estimate to compare to what’s reported on the internally prepared financial statements.
- Review subsequent events or transactions.
The reasonableness of fair value estimates can be gauged by looking at events or transactions that happen after the balance sheet date but before the date of the auditor’s report.
Measuring fair value is outside the comfort zone of most in-house accounting personnel. Fortunately, an outside valuation expert can provide objective, market-based evidence to support the value of assets and liabilities. Contact us for more information.