Fair value accounting is the practice of measuring assets and liabilities at their current fair value—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. Fair value is a market-based measurement, reflecting the views of market participants, not the entity’s own views. Its use has expanded significantly in recent decades, particularly for financial instruments, investment properties, and certain non-financial assets. However, fair value accounting is also controversial, with debates about its reliability, volatility, and relevance.

1. The Definition and Purpose of Fair Value:
Under IFRS 13 and ASC 820 (Fair Value Measurement), fair value is defined 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 is an exit price (selling price), not an entry price (purchase price). It is a market-based measurement, meaning it is based on the assumptions that market participants would use. The purpose of fair value accounting is to provide more relevant and timely information about the current value of assets and liabilities, reflecting market conditions at the measurement date.

2. The Fair Value Hierarchy:
To ensure consistency and transparency, IFRS 13 and ASC 820 establish a fair value hierarchy that prioritizes the inputs used in valuation:

Level 1 (Highest Priority): Quoted Prices in Active Markets:

• Observable, quoted prices in active markets for identical assets or liabilities.

• Example: The share price of a publicly traded company.

• This is the most reliable fair value measurement, as it is directly observable and objective.

Level 2: Observable Inputs Other Than Level 1:

• Inputs other than quoted prices that are directly or indirectly observable.

• Examples: Quoted prices for similar assets, interest rates, yield curves, and credit spreads.

• These inputs are based on market data, but some adjustments may be required.

Level 3 (Lowest Priority): Unobservable Inputs:

• Inputs that are not observable in the market. They are based on the entity’s own assumptions about what market participants would use.

• Examples: Projected cash flows, discount rates, and growth rates.

• This is the least reliable fair value measurement, as it involves significant judgment and subjectivity.

3. Valuation Techniques:
When there is no active market, entities use valuation techniques to estimate fair value:

A. Market Approach:

• Uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.

• Example: Using the sale price of comparable properties to value a property.

B. Cost Approach:

• Based on the amount that would be required to replace the service capacity of an asset (current replacement cost).

• Example: Using replacement cost to value a specialized piece of equipment.

C. Income Approach:

• Converts future amounts (cash flows) to a single present value.

• Example: Discounted cash flow (DCF) analysis to value a business.

4. Application of Fair Value:
Fair value is used in various areas:

• Financial Instruments: Financial assets (e.g., investments in equity securities, derivatives) and financial liabilities are often measured at fair value.

• Investment Property: Under IAS 40, investment property (property held for rental or capital appreciation) may be measured at fair value.

• Biological Assets: Under IAS 41, biological assets (e.g., livestock, crops) are measured at fair value less costs to sell.

• Business Combinations: In a business combination, the acquired assets and liabilities are measured at fair value at the acquisition date.

• Impairment Testing: Recoverable amounts in impairment testing are often based on fair value.

5. The Advantages of Fair Value Accounting:

• Relevance: Fair value provides more relevant information than historical cost, reflecting current market conditions.

• Timeliness: Fair value reflects changes in value in the period in which they occur, providing timely information.

• Comparability: Fair value can enhance comparability between entities that use different measurement bases.

• Reflects Economic Reality: Fair value reflects the economic reality of the entity’s financial position.

6. The Disadvantages and Criticisms of Fair Value Accounting:

• Volatility: Fair value can cause significant volatility in reported profits and equity, reflecting market fluctuations that may not be relevant to the entity’s long-term prospects.

• Subjectivity: When Level 3 inputs are used, fair value involves significant judgment and subjectivity, reducing reliability and comparability.

• Procyclicality: During financial crises, fair value can exacerbate market downturns by forcing asset sales at low prices, creating a “fire sale” spiral (this is a common criticism).

• Costly: Determining fair value can be costly and complex, particularly for Level 3 measurements.

• Lack of Market Depth: In illiquid markets, fair value measurements may not be reliable.

7. Fair Value and the Financial Crisis:
The 2008 financial crisis sparked significant debate about fair value accounting. Critics argued that fair value contributed to the crisis by forcing banks to write down assets to distressed market prices, leading to capital losses and further distress. Proponents argued that fair value simply exposed the underlying problems and that moving to historical cost would have hidden the losses and delayed the crisis. The debate led to refinements in fair value guidance, including more emphasis on the use of orderly transaction assumptions and additional disclosures.

8. Disclosure Requirements:
IFRS 13 and ASC 820 require extensive disclosures about fair value, including:

• The fair value hierarchy level for assets and liabilities measured at fair value.

• Significant unobservable inputs (Level 3) and the sensitivity of fair value measurements to changes in those inputs.

• Valuation techniques used.

9. The Public Sector Context:
Fair value is less commonly used in the public sector than in the private sector, as public sector entities are often long-term, not-for-profit, and focused on service delivery rather than market value. However, fair value is relevant for:

• Investment Properties: Government-owned investment properties.

• Financial Instruments: Government investments and derivatives.

• Public-Private Partnerships: Valuing assets and liabilities under PPPs.

• IPSAS Adoption: IPSAS is aligned with IFRS on fair value.