Fair Value

Refers to the price at which a buyer and seller agree to sell an asset

The term "fair value" has numeroInvestmentn the financial sector. In investment, it refers to the price at which a buyer and seller agree to sell an asset, provided that both sides are knowledgeable and eager to engage in the deal. 

Fair value

FV (fair value) is a term used in accounting to describe the estimated worth of various assets and liabilities that must be recorded on a company's books. Securities, for example, have an FV that is decided by the market where they are exchanged. 

The actual value of an asset, i.e., a product, stock, or security – that is agreed upon by both the seller and the buyer is known as fair value.

A product's fair worth is determined when it is sold or traded in the market where it belongs or under normal conditions - not when it is liquidated. It is determined in order to arrive at a fair amount of value for the buyer without placing the seller at a disadvantage.

For example, Company A sells its stock to Company B for $30 per share. The owner of Company B believes that once he has acquired the stock, he can sell it for $50 a share, so he chooses to buy a million shares at the original price. 

Despite Company B's enormous profit potential, the sale is considered fair because both parties agreed upon the price and gained from the transaction.

To summarize,

  • It is used in investing to describe the price of an asset as determined by a willing seller and buyer and is frequently established in the marketplace.
  • It is a comprehensive measure of an asset's worth that differs from market value, which refers to the market price of an object.
  • It is a term used in accounting to refer to the estimated worth of a company's assets and liabilities as reported on its financial statement.

Understanding

FV, in the broadest economic sense, is the possible price, or the value attributed to an item or service, based on its utility, supply and demand, and the level of competition for it. 

Understanding the process

Although it indicates a free market, it differs from market value, which merely refers to the price of an object in the marketplace (not intrinsic worth).

In the investment sector, listing security or assets on a publicly-traded marketplace, such as a stock exchange, is a popular technique to assess their fair worth. Daily, market makers provide a bid and ask price for shares of business XYZ that trade on an exchange. 

An investor can sell the stock to the market maker at the bid price and acquire it at the asking price from the market maker. 

Because the bid and ask prices are determined mainly by investor demand for the stock, the exchange is a dependable technique for determining a stock's fair value.

The value of an underlying asset is used to assess the fair value of a derivative. 
 

Bid and ask prices

When you acquire a $50 call option on XYZ stock, you purchase the right to buy 100 shares of XYZ stock at $50 per share for a set period. When the market price of XYZ stock rises, so does the value of the stock option.

It is the equilibrium price for a futures contract in the futures market-the point when supply and demand are equal. 

This is the spot price adjusted for compounding interest (as well as dividends missed because the investor owns the futures contract rather than the underlying stock) over some time.

Example

Applying this value in accounting can be challenging, and it has been used in corporate fraud cases. One of the most well-known is Enron Corporation. In the 1990s, senior management at the massive energy trading and utility company used fair-value accounting to inflate the value of its energy-delivery contracts and, thus, revenues.

Fair-value accounting is a set of principles for determining the "market" value of assets in which there is no trading and thus no market.

FV and Financial Statement

The International Accounting Standards Board defines it as the price paid to sell an asset or the price paid to transfer a liability in an orderly transaction between market participants on a specific date, usually for use on financial statements over time.

Financial statement

A company's assets and liabilities must be listed on the books at their FV in a mark-to-market valuation. In most circumstances, the original cost is utilized to appraise assets.

In some circumstances, determining the fair value of an asset might be difficult if there is no active market for it. However, this is frequently an issue when accountants perform a firm value. For example, let's say an accountant cannot estimate the fair market value of a unique piece of equipment. 

To determine, the accountant can use the asset's discounted cash flows. The accountant in this scenario utilizes the cash outflow to purchase the equipment and the cash inflows generated by utilizing the equipment over its useful life. 

The Fair Value of an asset is the sum of discounted cash flows.

Discounted cash flows

When the financial accounts of a subsidiary firm are integrated or consolidated with those of a parent company, this value is employed. For example, when a parent company buys a stake in a subsidiary, the assets and liabilities of the subsidiary are valued at fair market value for each account. 

The result of combining the accounting records of both firms is a consolidated financial statement, which is a collection of financial statements that displays a parent company and a subsidiary as if they were one company.

Difference Between FV and Others

The differences are:

1) Fair value vs. market value

Market value is simply the price of an item in the marketplace as defined by the rules of demand and supply. FV is a wide estimate of an asset's intrinsic worth. 

Market value

As a result, this value is frequently utilized to determine an asset's genuine worth. Furthermore, the FV of an asset, especially in the context of financial statements, tends to be more stable, whereas its market value is subject to market forces.

In addition, the market value differs in the following ways:

FV varies more than market value.

It could be based on an asset's most current pricing or quotation. For example, if the value of a share in Company A was $30 three months ago and was $20 on the most recent appraisal, the share's market value is $20.

The market value of an asset is determined by supply and demand in the market where it is bought and sold. 

For example, the price of a house to be sold will be determined by current market conditions in the area.

If an owner attempts to sell a property for $200,000 during a period of low demand in the real estate market, the property may not sell. However, if it is offered for $500,000 at a peak, it may sell for that amount.

2) Fair value vs. carrying value

The terms "fair value" and "carrying value" are not interchangeable. Take into account the following:

Carrying value

The real selling value of an item agreed to be paid by the buyer and set by the seller is known as FV. The sale benefits both parties. Profit margins, projected growth rates, and risk concerns are considered when determining this value.

The amount or worth of an asset as it shows on the balance sheet is referred to as carrying value, also known as book value

It is calculated by subtracting the asset's accumulated depreciation and impairment expenses from the asset's original purchase price, as shown on the balance sheet.

The carrying value of an asset does not reflect the asset's original purchase price but rather its current value after several years.

3) Fair value vs. future price

This value is frequently displayed on financial news networks and online before the equity markets open for trading. The value can provide insight into market sentiment.

Future price

Because of the short-term influences of supply and demand for the futures contract, the futures price may differ from the FV. It always refers to the front-month futures contract rather than a contract further out.

This disparity between the FV result and the current S&P 500 futures price could represent an arbitrage opportunity for those who believe the futures price will eventually revert to the value price.

A trader can profit from a price imbalance by purchasing and selling an asset through arbitrage. The trade takes advantage of price differences between identical or similar financial instruments traded on different markets or in different forms.
 

Arbitrage

Throughout the trading day, the FV and futures prices will fluctuate. Futures contracts are traded on the Chicago Mercantile Exchange, while individual stocks that comprise the S&P 500 are traded on various stock exchanges across the country. 

As a result, there are frequent discrepancies between the two.

Determining fair values of derivatives and futures

Derivatives

  • Derivative

The FV of a derivative is determined in part by the underlying asset's value. 

When you purchase a 50-call option on XYZ stock, you are purchasing the right to buy 100 shares of XYZ stock at $50 per share for a set period. If the market price of XYZ stock rises, so does the option's value on the stock.

The fair value of OTC derivatives ("present value" or "theoretical price") is equal to the sum of the instrument's future cash flows, discounted at the measurement date.

These derivatives are valued using methods recognized by international financial markets, such as the "net present value" (NPV) method, option price calculation models, and so on.

  • Future contract

In the futures market is the equilibrium price for a futures contract-that is, the point at which supply and demand are equal. 

This is the spot price after compounded interest (and dividends lost because the investor owns the futures contract rather than the physical stocks) over a specified period.

Futures contracts

The sale price agreed upon by a willing buyer and seller is referred to as FV. A stock's FV is determined by the market in which it is traded. 

When the financial statements of a subsidiary company are consolidated with the financial statements of a parent company, the value represents the value of a company's assets and liabilities.

In particular, it is the theoretical calculation of how a futures stock index contract should be valued in light of the current index value, dividends paid on index stocks, days until the futures contract expires, and current interest rates.

Benefits of FV Accounting

Presently, businesses can choose from a variety of financial reporting approaches. 

The FV accounting method, for example, allows for the measurement and reporting of liabilities and assets based on their estimated or actual fair market value. Because assets and liabilities change over time, there may be unrealized gains or losses in assets held. 

This accounting method can assist in measuring and charting those gains. The actual or estimated value of an asset is measured using FV accounting. It is one of the most widely used financial accounting methods due to the benefits it provides, which include:

Benefits

1. Valuation accuracy

Valuations are more accurate with this accounting, so they can track when prices rise or fall.

2. Actual income measurement

With this accounting, total asset value reflects a company's actual income. It does not rely on a profit and loss statement but actual value.

3. Adaptable to various asset types

This method can value all types of assets, which is preferable to using historical cost value, which can change over time.

4. Assists businesses in surviving

Its accounting allows businesses to survive financially difficult times by allowing asset reduction (or the act of declaring that the value of an asset that is included in a sale was overestimated).

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Researched and authored by Ruxue Bai | LinkedIn

Reviewed and edited by Sakshi Uradi | LinkedIn

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