The balance sheet usually reflects the historic cost of assets and liabilities. But certain items must be reported at “fair value” under U.S. Generally Accepted Accounting Principles (GAAP). Here’s a closer look at what fair value is and which balance sheet accounts it affects.
Fair value vs. fair market value
Accounting Standards Codification (ASC) Topic 820 defines fair value as “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.” This definition is similar in many respects to “fair market value,” which is defined in IRS Revenue Ruling 59-60.
The main difference is that fair market value focuses on the universe of hypothetical buyers and sellers. Conversely, FASB uses the term “market participants,” which refers to buyers and sellers in the asset’s or liability’s principal market. The principal market is entity specific and may vary among companies.
Hierarchy of value
Under ASC Topic 820, fair value is most often associated with business combinations and subsequent accounting for goodwill and other intangibles after the deal closes. Other examples of items that are reported at fair value include:
When measuring fair value, the FASB provides a hierarchy of methods that may not necessarily apply to valuations performed for other purposes. GAAP gives top priority to market-based methods, such as quoted prices in active markets for identical assets or liabilities.
When market data isn’t readily available for a specific company, GAAP looks to quoted prices in active markets for similar assets or liabilities — in other words, comparable public stock prices or sales of controlling interests in comparable companies. The least desirable level of inputs under GAAP is unobservable data, such as cash flow or cost estimates prepared by management (which may be used to estimate value under the income or cost approach).
Changes in value
Decreases in the fair value of an asset (or increases in the fair value of a liability) may result from, say, poor company performance, changes in economic conditions and inaccurate estimates made in the past. Companies aren’t allowed to overstate the value of assets (or understate the value of a liability) under GAAP, so changes in fair value may lead to write-offs or restatements.
Auditors are specifically prohibited from providing valuation services for their public audit clients. Private companies may follow suit to prevent independence issues during audits. So, companies often turn to valuation experts who are independent from their auditors to make fair value estimates — and then their auditors can evaluate whether those estimates appear reasonable. Contact us if you have any questions about fair value, including how it’s estimated or when it applies.