Before providing the formal definition of fair value, let us try to understand the intuitive meaning of this term. Broadly, fair value means market value. The terminology of “fair value” was coined (instead of merely using “market value”) because even if a primary market does not exist for an asset or liability from which market prices could be readily determined, one could still estimate its “fair value” by reference to secondary markets or through the use of valuation techniques. The idea behind fair value, however, is to get as close to market value as possible. Therefore, conceptually, fair value is no different from market value because it reflects current market participant (e.g., investor) assumptions about the present value of expected future cash inflows or outflows arising from an asset or a liability.
Formally, SFAS 157 defines fair value as exchange price, that is, the price that would be received from selling an asset (or paid to transfer a liability) in an orderly transaction between market participants on the measurement date. There are five aspects of thisdefinition that need to be noted:
On the measurement date. The asset or liability’s fair value is determined as of the measurement date that is, the date of the balance sheet rather than the date when the asset was originally purchased (or the liability originally assumed).
Formally, SFAS 157 defines fair value as exchange price, that is, the price that would be received from selling an asset (or paid to transfer a liability) in an orderly transaction between market participants on the measurement date. There are five aspects of thisdefinition that need to be noted:
On the measurement date. The asset or liability’s fair value is determined as of the measurement date that is, the date of the balance sheet rather than the date when the asset was originally purchased (or the liability originally assumed).
Hypothetical transaction. The transaction that forms the basis of valuation is hypothetical. No actual sale of the asset (or transfer of liability) needs to occur. In other words, fair values are determined “as if ” the asset were sold on the measurement date.
Orderly transaction. The notion of an “orderly” transaction eliminates exchanges occurring under unusual circumstances, such as under duress. This ensures that the fair value represents the exchange price under normal circumstances, such as the market price in an active (i.e., frequently traded) market.
Market-based measurement. Fair values are market-based measurements, not entity-specific measurements. What does this mean? This means that fair value of an asset should reflect the price that market participants would pay for the asset (or demand for the liability), rather than the value generated through unique use of the asset in a specific business.To illustrate, consider a highly lucrative cab company that owns a single automobile. Because of excellent business prospects, the present value of future net receipts from the use of this automobile over its estimated life is expected to be $65,000. However, the market value of the automobile (based on its blue-book price) is just $15,000. The fair value of the automobile is $15,000 (i.e., its market-based exchange price) and not $65,000 (i.e., its entity-specific unique value).'
Exit prices. The fair value of an asset is the hypothetical price at which a business can sell the asset (exit price). It is not the price that needs to be paid to buy the asset (entry price). Similarly, for a liability, fair value is the price at which a business can transfer the liability to a third party, not the price it will get to assume the liability.
Hierarchy of Inputs
Note that fair value can be estimated for assets (or liabilities) even when active primary markets do not exist from which prices can be directly ascertained. Obviously fair value estimates that are not derived from direct market prices are less reliable. Realizing this, standard setters have established a hierarchy of fair value inputs (i.e., assumptions that form the basis for deriving fair value estimates). At the outset, two types of inputs are recognized: (1) observable inputs, where market prices are obtainable from sources independent of the reporting company for example, from quoted market prices of traded securities and (2) unobservable inputs, where fair values are determined through assumptions provided by the reporting company because the asset or liability is not traded. Observable inputs are further classified based on whether the prices are from primary or secondary markets. This gives rise to the following three-step hierarchy of inputs (see Exhibit 2.9):
Level 1 inputs. These inputs are quoted prices in active markets for the exact asset or liability that is being valued, preferably available on the measurement date. These are the most reliable inputs and should be used in determining fair value whenever they are available.
Level 2 inputs. These inputs are either (1) quoted prices from active markets for similar, but not identical, assets or liabilities, or (2) quoted prices for identical assets or liabilities from markets that are not active (i.e., not frequently traded). Therefore, while these inputs are indeed market prices, the prices may be for assets (or liabilities) that are not identical to those being valued or the quotes may not be for current prices because of infrequent trading.
Level 3 inputs. These are unobservable inputs and are used when the asset or liability is not traded or when traded substitutes cannot be identified. Level 3 inputs reflect manager’s own assumptions regarding valuation, including internal data from within the company.
The hierarchy of inputs is extremely important. As the pyramid in Exhibit 2.9 suggests, Level 1 inputs must be most commonly used and Level 3 inputs must be used sparingly. Also, SFAS 157 prescribes footnote disclosures where information about the level of inputs used for determining fair values must be reported. An analyst can use this information to evaluate the reliability of the fair value amounts recognized. Finally, it must be.
Orderly transaction. The notion of an “orderly” transaction eliminates exchanges occurring under unusual circumstances, such as under duress. This ensures that the fair value represents the exchange price under normal circumstances, such as the market price in an active (i.e., frequently traded) market.
Market-based measurement. Fair values are market-based measurements, not entity-specific measurements. What does this mean? This means that fair value of an asset should reflect the price that market participants would pay for the asset (or demand for the liability), rather than the value generated through unique use of the asset in a specific business.To illustrate, consider a highly lucrative cab company that owns a single automobile. Because of excellent business prospects, the present value of future net receipts from the use of this automobile over its estimated life is expected to be $65,000. However, the market value of the automobile (based on its blue-book price) is just $15,000. The fair value of the automobile is $15,000 (i.e., its market-based exchange price) and not $65,000 (i.e., its entity-specific unique value).'
Exit prices. The fair value of an asset is the hypothetical price at which a business can sell the asset (exit price). It is not the price that needs to be paid to buy the asset (entry price). Similarly, for a liability, fair value is the price at which a business can transfer the liability to a third party, not the price it will get to assume the liability.
Hierarchy of Inputs
Note that fair value can be estimated for assets (or liabilities) even when active primary markets do not exist from which prices can be directly ascertained. Obviously fair value estimates that are not derived from direct market prices are less reliable. Realizing this, standard setters have established a hierarchy of fair value inputs (i.e., assumptions that form the basis for deriving fair value estimates). At the outset, two types of inputs are recognized: (1) observable inputs, where market prices are obtainable from sources independent of the reporting company for example, from quoted market prices of traded securities and (2) unobservable inputs, where fair values are determined through assumptions provided by the reporting company because the asset or liability is not traded. Observable inputs are further classified based on whether the prices are from primary or secondary markets. This gives rise to the following three-step hierarchy of inputs (see Exhibit 2.9):
Level 1 inputs. These inputs are quoted prices in active markets for the exact asset or liability that is being valued, preferably available on the measurement date. These are the most reliable inputs and should be used in determining fair value whenever they are available.
Level 2 inputs. These inputs are either (1) quoted prices from active markets for similar, but not identical, assets or liabilities, or (2) quoted prices for identical assets or liabilities from markets that are not active (i.e., not frequently traded). Therefore, while these inputs are indeed market prices, the prices may be for assets (or liabilities) that are not identical to those being valued or the quotes may not be for current prices because of infrequent trading.
Level 3 inputs. These are unobservable inputs and are used when the asset or liability is not traded or when traded substitutes cannot be identified. Level 3 inputs reflect manager’s own assumptions regarding valuation, including internal data from within the company.
The hierarchy of inputs is extremely important. As the pyramid in Exhibit 2.9 suggests, Level 1 inputs must be most commonly used and Level 3 inputs must be used sparingly. Also, SFAS 157 prescribes footnote disclosures where information about the level of inputs used for determining fair values must be reported. An analyst can use this information to evaluate the reliability of the fair value amounts recognized. Finally, it must be.
appreciated that while Level 1 and Level 2 inputs will be available for valuing financial assets and liabilities, most operating assets and liabilities may need to use Level 3 inputs.
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