What Is the Fair Value Model in Accounting?
Understand the fair value model, a method for valuing assets at current market price, and its effect on financial statement relevance and reliability.
The fair value model is an accounting method for measuring certain assets and liabilities. It uses the current market value, which is the price received for selling an asset or paid for transferring a liability in a transaction between market participants.
The principle of fair value is that it is a market-based measurement, not specific to the entity. The valuation reflects the assumptions that independent buyers and sellers would use, regardless of the entity’s intent to hold an asset. The goal is to determine an “exit price” in the principal market for that asset or liability.
How Fair Value is Measured
To ensure consistency, accounting standards established the fair value hierarchy. This framework prioritizes the inputs used in valuation techniques by categorizing them into three levels. A measurement’s classification in the hierarchy is determined by the lowest level of input that is significant to the entire valuation.
Level 1 Inputs
Level 1 inputs are the highest priority and most reliable. They are unadjusted quoted prices for identical assets or liabilities in active markets, where transactions occur with enough frequency and volume to provide ongoing pricing. A common example is a stock traded on a major public exchange. The price from the principal market, the one with the greatest volume for the item, is used without adjustment. This direct observability makes Level 1 measurements the most objective and transparent form of fair value.
Level 2 Inputs
Level 2 inputs are observable data points other than the quoted prices in Level 1. This category includes quoted prices for similar assets in active markets or for identical items in markets that are not active. Other examples include interest rates, yield curves, and volatility measures observable in the market. The value of certain real estate or corporate bonds, for instance, might be determined using Level 2 inputs by comparing them to similar assets with observable pricing.
Level 3 Inputs
Level 3 inputs are unobservable and used when there is little to no market activity for the asset or liability. As the lowest priority, they rely on an entity’s own assumptions about what market participants would use to price the item, requiring significant judgment. Level 3 inputs are necessary for complex or illiquid assets, such as private equity investments, complex derivatives, or certain intangible assets. Because these valuations are subjective, they require extensive disclosures in financial statements.
Assets Measured at Fair Value
U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) specify which assets and liabilities can be measured at fair value. A primary category is financial instruments, such as derivatives and financial assets classified as “trading securities.” These are bought to be sold in the near term, and their value is tied to market fluctuations.
Another area is investment property, which under IFRS, can be measured at fair value. This is different from property, plant, and equipment used in a company’s operations. Certain biological assets, like livestock or timber, are also measured at fair value less costs to sell.
Companies also have a “fair value option” for certain financial assets and liabilities that would otherwise be measured differently. Available under both U.S. GAAP and IFRS, this irrevocable choice allows a company to measure an item at fair value from its inception. It is often used to prevent accounting mismatches when related assets and liabilities are measured on different bases.
Contrasting the Fair Value and Cost Models
The primary alternative to the fair value model is the cost model, where an asset is recorded at its original purchase price, or historical cost. This cost is then reduced over time through depreciation or amortization and is subject to impairment tests if its value falls significantly.
The difference is the valuation basis: the cost model uses a historical value, while the fair value model uses a current, market-based value. The fair value model can introduce more volatility into financial statements, as reported values fluctuate with market conditions.
This highlights a debate in accounting between relevance and reliability. Fair value proponents argue it provides more relevant, current information. In contrast, the cost model is often seen as more reliable and objective because it is based on a verifiable historical transaction.
Reporting Fair Value in Financial Statements
When an item is measured at fair value, changes in its value between reporting periods are recognized in the financial statements. The treatment depends on the item’s nature. For many assets, like trading securities, these unrealized gains and losses are reported in the income statement, affecting net income.
For other items, changes in fair value are reported in Other Comprehensive Income (OCI). For example, when the fair value option is elected for a financial liability, the portion of the value change from the entity’s own credit risk is recognized in OCI. This prevents a company from reporting a profit because its creditworthiness has declined.
Disclosure is a significant part of fair value reporting. Companies must disclose the fair value for each class of asset and liability, organized by the hierarchy level (Level 1, 2, or 3) used. For Level 3 measurements, disclosures are more extensive, including a description of the valuation techniques and inputs used.