Fair Value

Fair value is the price that can be agreed on in current market conditions when selling an asset or can be paid when transferring a liability. In other words, it is the amount for which one party agrees to sell an asset and the other party— to buy it, provided that the seller and the buyer are not related to each other in any way or their relationships don't affect the pricing. 

The term “fair value” can also be used in accounting. It is defined as the estimated value of a business assets and liabilities included in financial statements. 

Fair Value explained 

The fair value of an asset is determined based on the current market prices or data on recent transactions with similar assets (liabilities). The utility that it will bring to the owner, the supply and demand for it are also taken into account. It should be kept in mind that there is a difference between market value and fair value. The market value is the value of an object in an abstract market, while the fair value is defined as the value estimated for a specific person. If the market for similar objects is well developed, then the values will not be significantly different.

Calculation or determination of the fair value of securities is carried out in public marketplaces. If shares of the company are listed for trade on a stock exchange, a market maker creates and maintains the liquidity level of financial instruments so that other market participants have the opportunity to make transactions. The market maker on the stock exchange plays the role of a custodian of assets. They set bid and ask quotes (buying and selling prices). Investors who want to sell a security get the bid price that will be slightly lower than its actual price. If an investor wants to buy a security, he can purchase it at the ask price that is set slightly above the market price. It is clear that the bid and the ask on a stock is influenced by the investor demand, and that’s why the public market place is a secure method to find the fair value of the asset. 

Derivatives should be measured at fair value. The basis of the value of any derivative is the change in the value of the underlying asset— the one on which the derivative financial instrument is based upon. If an investor purchases a 50 call option on a stock, it would give him the right to buy 100 shares of the same stock at $50 per share at any time. If the market price of the stock increases, this directly affects the value of the option itself.

For futures contracts, the equilibrium price— the price on the market at which the number of goods and services that consumers are ready to consume absolutely corresponds to the number of goods and services that companies bring to the market— plays a great role. It helps to decide on the face value of the futures contracts. In this case, the resulting price is the same in value as the spot price. 

Fair Value in accounting

In accounting, the fair value refers to the value (the corresponding price) at which the transfer of ownership of an asset can be carried out between independent parties who are aware of the subject of the transaction and are ready to make a deal. The valuation of the firm’s assets must be confirmed and all values should be included on the books. 

If there is no possibility to reliably estimate the value, the federal accounting standards highlight the rules of determining the original cost by which the value of assets can be calculated.

If there is no active market for an asset, its fair value is equal to the amount that the company would have paid for the asset at the purchase date, when conducting a commercial transaction between independent and well-informed participants based on the best available information. When determining this amount, the company takes into account the result of recent transactions with similar assets.

Companies that regularly buy and sell assets usually use alternative methods of estimating the fair value. They can calculate fair value based on discounted cash flows, market share, etc.

In addition to this, the assets and liabilities of the enterprise should also be consolidated at their fair value. The consolidation method consists of "adding" the financial statements of the subsidiary to the reports of the parent company.