Fair value

In accounting, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset. Under the converged guidance of IFRS 13 and US GAAP (ASC 820), it is specifically defined as the "exit price": 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. ^[1]

History and Criticism

The current framework was largely driven by the 2008 financial crisis. During periods of market illiquidity, "mark-to-market" accounting was criticized for forcing "fire-sale" valuations. In response, both the FASB and IASB issued guidance in 2008 clarifying how to determine fair value when markets become inactive. ^[2]

Economic and Valuation Perspectives

Market Price vs. Fair Value

Economically, the relation between market price and fair value is debated:

• The efficient-market hypothesis suggests market prices generally reflect fair value as investors incorporate all available information.
• Behavioral finance argues that cognitive biases cause prices to diverge from fair value in unpredictable ways.

The International Valuation Standards (IVS) distinguishes "Fair Value" (or Equitable Value) from "Market Value." While Market Value is the estimated amount for which an asset should exchange on the open market, Fair Value may incorporate "Special Value"—synergies or advantages specific to two identified parties in a transaction. ^[3]

Measurement Framework

To increase consistency, accounting standards establish a converged framework for measuring fair value based on a hierarchy of inputs and three primary valuation approaches.

The Fair Value Hierarchy

The hierarchy prioritizes the inputs used in valuation techniques into three levels: ^[4]

• Level 1 inputs: Unadjusted quoted prices in active markets for identical assets or liabilities (e.g., NYSE stock prices). These are the most reliable.
• Level 2 inputs: Observable market data for similar (but not identical) assets, or identical assets in markets that are not active. This includes interest rates, yield curves, and implied volatility.
• Level 3 inputs: Unobservable inputs based on the entity's own assumptions about how market participants would price the asset (often called "mark-to-management").

Valuation Techniques

Standard setters outline three approaches for measurement: ^[5]

1. Market approach: Uses prices generated by market transactions for identical or comparable assets.
2. Cost approach: Reflects the current replacement cost required to replace the service capacity of an asset.
3. Income approach: Converts future cash flows or income into a single discounted present value (e.g., Discounted cash flow).

Comparison: IFRS vs. US GAAP

While the measurement guidance is converged, the application differs significantly regarding which assets must or may be measured at fair value:

Asset Type	IFRS Treatment	US GAAP Treatment
Financial Instruments	Classified as Amortized Cost, FVOCI, or FVTPL (IFRS 9).	Generally similar, with specific "Fair Value Options."
Property, Plant & Equipment	Choice between Cost Model and Revaluation Model (IAS 16).	Cost Model only; revaluation to fair value is prohibited.
Investment Property	Requirement to measure at fair value; changes recognized in P&L (IAS 40).	Generally carried at historical cost.

Illustrative Accoutning Example: Decommissioning an Oil Platform

As an illustrative disclosure for IFRS 13.B23–B30, this example demonstrates the fair value measurement of a decommissioning liability for an offshore oil platform. Under IFRS 13.IE35–IE39, the entity estimates the price a market participant would demand to assume the obligation.

The technical basis includes:

• Risk and Profit: Inclusion of a profit margin and risk premium reflects compensation for uncertainty (IFRS 13.B31; BC162).
• Inflation and Time Value: Cash flows are adjusted for future price increases (IFRS 13.B35) and discounted (IFRS 13.BC165).
• Non-performance Risk: The 8.5% discount rate incorporates the entity's own credit risk (IFRS 13.42; BC103). ^[6]
  

Probability Assessment of Labour Costs (IFRS 13.IE38)

Cash flow estimate (CU)	Probability assessment	Expected cash flows (CU)
100,000	25%	25,000
125,000	50%	62,500
175,000	25%	43,750
Total expected labour costs		131,250

Fair Value Measurement Calculation (IFRS 13.IE39)

Component	1 January 20X1 (CU)
Expected labour costs	131,250
Allocated overhead and equipment costs (0.80 × CU131,250)	105,000
Contractor’s profit mark-up [0.20 × (CU131,250 + CU105,000)]	47,250
Expected cash flows before inflation adjustment	283,500
Inflation factor (4% for 10 years)	1.4802
Expected cash flows adjusted for inflation	419,637
Market risk premium (0.05 × CU419,637)	20,982
Expected cash flows adjusted for market risk	440,619
Expected present value using discount rate of 8.5% for 10 years	194,879

See also

• Fair value accounting
• Mark-to-market accounting
• Valuation risk

References

1. IFRS 13.9; ASC 820-10-20.
2. FASB Staff Position No. 157-3.
3. IVS 2017; Exposure Draft IVS 2 (2006).
4. IFRS 13.72; ASC 820-10-35-37.
5. IFRS 13.62; ASC 820-10-35-24A.
6. See: IFRS 13.42; IFRS 13.B23–B35; IFRS 13.BC103; IFRS 13.BC162–165; IFRS 13.IE35–39.