Fair value accounting is a measurement approach under which certain assets and liabilities are carried in the balance sheet at their current market-based value instead of what was originally paid for them. The value is updated at each reporting date, and the resulting gains and losses are recognised in the financial statements. It is applied mainly to financial instruments, but also to investment property, biological assets, pension plan assets and assets acquired in a business combination.
The approach contrasts with historical cost, which records items at their purchase price less depreciation or impairment. Modern standards use a mixed model, with some items at fair value and others at cost. Both International Financial Reporting Standards and United States generally accepted accounting principles define fair value in almost identical terms, the result of a joint project completed in 2011.
Definition
IFRS 13, effective from 2013, 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. Several features follow from this wording.
- Exit price. Fair value is what the holder would receive on a sale, not what it would cost to buy the asset.
- Market-based. It reflects the assumptions that market participants would use, not the entity's own intentions or its particular advantages.
- Orderly transaction. It assumes normal marketing time, not a forced or distressed sale.
- Principal market. The price is taken from the market with the greatest volume for the item, or failing that the most advantageous market.
IFRS 13 does not itself say when fair value must be used. That is decided by other standards; IFRS 13 says how to measure it and what to disclose. The United States equivalent is Topic 820 of the codification issued by the Financial Accounting Standards Board.
Measurement and the hierarchy
Where a quoted price in an active market exists, it is used without adjustment; this is often called mark-to-market. Where it does not, fair value is estimated with a valuation technique. The standards recognise three families: the market approach, which uses prices of comparable items; the income approach, which discounts expected future cash flows or uses option pricing models; and the cost approach, which estimates current replacement cost.
Inputs to these techniques are ranked in a three-level fair value hierarchy. Level 1 inputs are quoted prices for identical items in active markets. Level 2 inputs are other observable data, such as prices of similar items, yield curves and credit spreads. Level 3 inputs are unobservable and rely on the entity's own assumptions. Entities must maximise observable inputs and disclose more about Level 3 measurements, including sensitivity to changes in assumptions. The IFRS version is described under IFRS fair value hierarchy.
Where fair value is required
Under IFRS 9, a financial asset is measured at fair value through profit or loss unless it qualifies for amortised cost accounting or for fair value through other comprehensive income. Qualification depends on the business model for holding the asset and on whether its cash flows are solely payments of principal and interest. Trading assets, equity investments and all derivatives are at fair value. Gains and losses on items in the middle category are held in equity, in accumulated other comprehensive income, until sale.
Outside financial instruments, IAS 40 lets entities choose a fair value model for investment property, and fair value less costs of disposal is one of the measures used in impairment testing under IAS 36. Assets and liabilities acquired in a business combination are recognised at fair value, which determines the amount of goodwill. Even for items carried at cost, fair value often has to be disclosed in the notes.
Arguments for and against
Supporters argue that current values are more relevant to investors than out-of-date costs, that they make it harder to hide losses or to time sales in order to manage earnings, and that they are the only sensible measure for instruments such as derivatives, which may have no cost at all. Critics argue that fair values are unreliable when markets are thin, that Level 3 valuations give management wide discretion, that unrealised gains may never be received, and that short-term price swings add volatility to earnings and capital that does not reflect a long-term holder's business.
The 2008 crisis and after
The debate sharpened during the 2008 financial crisis. Banks holding mortgage-related securities had to write them down as prices collapsed, and some bankers and politicians claimed that marking to distressed prices forced further sales and deepened the crisis. Standard setters responded with guidance on measuring fair value in inactive markets and, under IFRS, a limited option to reclassify assets out of fair value categories. Later studies generally found that fair value rules played a small role compared with losses on loans, which were not held at fair value.
The episode in 2023 pointed the other way. Silicon Valley Bank held large portfolios of bonds at amortised cost, and the fall in their market value as rates rose appeared only in the notes. When depositors focused on those figures, confidence failed, prompting calls for wider use of fair value for securities and closer attention to unrealised losses on securities portfolios.