What is Fair Value?

In simple terms, fair value is the realisable value of an asset or liability in an orderly market. According to SFAS 157 (FASB, 2006a) and IFRS 13 (IASB, 2011) fair value is 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. In reality, though, fair value is quite a challenge to define as many factors come into play in determining what fair value is.

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In its purest form, assuming a fully efficient, liquid and perfect market, fair value should equal market value (Level 1). However, in the real world, where markets are not completely liquid for some assets and liabilities, fair value as described by the FASB and the IASB could be estimated from the values of identical assets which are traded in a liquid market (Level 2) or estimated through model valuations (Level 3) where the inputs used are based on as much relevant market information as possible.

It is important to mention that the market value based on the FASB and IASB requirements, considered as fair value, is the “exit price”; i.e. the price at which an asset could be sold on the reporting date (SFAS 157, IFRS 13). Fair value estimates are expected to represent the present value of the expected future cash flows associated with a financial statement item (Barth, 2000:19; Ryan, 2008a:12; Whittington, 2008:157). Furthermore, the present value of the expected cash flows is determined by discounting at the current market rate of return, and it is considered to reflect all available information up to the measurement date (Chisnall, 2001).

Prior to the issue of IFRS 13, the IASB defined fair value differently from SFAS 157. In paragraph 9 of IAS 39, fair value was defined as “the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction”.

Concerning the measurement issues involving fair value estimation, IAS 39 provides three classifications: Active markets for which quoted prices are available, inactive markets for non-equity instruments, and inactive markets for equity instruments. For financial instruments trading in active markets, the appropriate quoted price of an asset held (or liability to be issued) is the current bid price, whereas for assets to be acquired (or liabilities to be held), it is the current ask price. When current bid and ask prices are

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unavailable, the price of the most recent transaction can be used provided that there has not been a significant change in economic circumstances since the time of the transaction. Additionally, quoted prices can be adjusted if the firm can demonstrate it is not fair value (for example, distress sales). In the absence of an active market for a non- equity financial instrument, IAS 39 specifies that the preferred valuation technique must be the most commonly used procedure by market participants to price the instrument (for example, if the valuation technique has been demonstrated to be able to provide reliable estimates of fair value obtained in actual market transactions). The selected valuation technique needs to be consistent with recognized economic methodologies for valuing financial instruments, and the firm needs to calibrate the valuation technique periodically by testing it for validity using prices from any observable current market transactions in the same instrument (or based on any available observable market data). Finally, for equity instruments (and any linked derivatives) that do not have a quoted market price in active markets, IAS 39 requires that these instruments are to be measured at fair values only if the range of reasonable fair value estimates is not significant, and the probabilities of the various estimates can be reasonably assessed. Otherwise, the firm is precluded from measuring these instruments at fair value (IASB, 2003a, Yong, 2010).

The differences between the fair value definitions in SFAS 157 (IFRS 13) and IAS 39 include that SFAS 157’s definition is explicitly based on the concept of an “exit price,” whereas the IAS 39 definition of fair value is based on neither the exit price nor the entry price of a financial statement item. SFAS 157 uses the “market participants” view whereas the IAS 39 definition of fair value uses the concept of a “willing buyer and seller.” In particular, SFAS 157 states that the fair value of a liability is the price that will be paid to transfer a liability, whereas IAS 39 defines the fair value of a liability as

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the amount for which it will ultimately be settled (Yong, 2010). As with SFAS 157, IAS 39 states that fair value estimation is not the amount that a firm would receive or pay in a forced transaction, involuntary liquidation, or distress sale (paragraph A69). Also in tandem with SFAS 157, paragraph 48 of IAS 39 regards the best evidence of fair value as quoted prices in an active market. Finally, while IAS 39 does not unequivocally classify valuation inputs into Level 1, Level 2, and Level 3 categories as specified in SFAS 157, it does stipulate that the chosen valuation technique should make maximum use of market inputs and depend as little as possible, on firm-specific inputs (Yong, 2010).

The adoption of IFRS 13 is significant as it can be seen that the IASB worked together with the FASB on these standards as part of the convergence project on the issue of fair value accounting, especially with regard to accounting for financial instruments, thereby settling the differences between the SFAS 157 and IAS 39 definitions highlighted above.