Accounting Terms: Understanding Fair Value

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The value of assets is determined through standard measures, or methods and in the accounting world fair value relates to how assets are valued. In essence the rationale behind the method which is supported by the international IFRS accounting standards, is that the value of assets must be based on market value as of the balance sheet date.

The principle is also widely referred to as the mark to market, and alternatively another valuation model is employed in cases where the market value is non existent in the form of the market to model.

In an efficient market, the market price is usually equal or close to the fair value and whenever market price differs from fair value, the reasons are most likely to be as a result of some biases on the part of the buyers or sellers. The introduction of fair value was initially intended to approximate the book value of the market value as a way of facilitating the task of the valuations of companies.

Through the updating of each statement of accounts on assets, fair value more or less leads to a decline in potential capital gains that had not been taken into account in the balance – thus it successfully cuts the volatility of the valuations of companies.

Under the Financial Accounting Standards Board (FASB) standards number FAS 157 fair value is the price obtained to sell an asset or the price paid to transfer a liability in an transaction taking place in an active market, also referred to as “exit value”.

On another level, the futures market regards fair value as the equilibrium price for a futures contract. Fair value can help to read more quickly into the repercussion of financial crises, but also how to absorb them more efficiently. And when applied to the securitized loans such as CDOs, the valuation method outlines the magnitude of impairment of assets.

However, criticism has been leveled at the accounting standard for among other things having resulted in billions of dollars in losses following the sub-prime, crisis owing to its use.

And many bankers and regulators now concur on the issue of limiting its context as regards how the standard is employed. Many experts have voiced their negative views about the application of the valuation of assets by financial institutions. This is because their scope is maintained in the medium to long term, for which the instantaneous value is rendered meaningless.


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