The value of “Fair Value”

   The accountants may already be aware of this concept, but for the ones who don’t know what is fair value all about; then read on.

The 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'. The definition has been taken as per IFRS 13 (International Financial Reporting Standard) and is a widely used concept all over the world. The fair value has come into existence to ensure the accountancy world sticks to the conceptual framework and also to bring financial more in line with what investors expect, relevant and a faithful representation of the business.

The fair value is useful in multiple places like valuation of financial assets or liabilities, investment property, pension funds, etc. Therefore the implications of using fair value are widespread.  The standard allows the fair values to be determined

• Market approaches (valuations based on recent sales prices)
• Cost approaches (valuations based on replacement cost)
• Income approaches (valuations based on financial forecasts)

Market approach simply put is the price at which the market participants are ready to exchange the goods and services. Therefore, if one wants to sell a share, the market price will ideally be the share price of that stock that can be found from stock exchanges like BSE or NSE. However, it may not always be the case that the price is readily available to share, for e.g. if the company is not listed or say a start-up. In such cases the cost approach or most likely the income approach can be used. The startups would usually use the income approach because they would probably not even have a huge asset base. Whereas companies that have been around for many years and have built a huge asset base for e.g. a Public Sector company, in their case the sell off may happen due to mismanagement or merely due to govt. policy of privatisation in such cases the asset base valuation is useful.

The standard also provides some level of guidance as to how fix the prices when we look at the market prices. IFRS 13 classifies inputs into valuation techniques into three levels.

1. Level 1 inputs are quoted prices for identical assets in active markets, i.e. markets where same products are bought and sold regularly.
2. Level 2 inputs are observable prices  and may include quoted prices for similar assets in active markets  or quoted prices for identical assets in less active markets or observable inputs that are not priced (such as interest rates).
3. Level 3 inputs are unobservable inputs and may include cash or profit forecasts using an entity’s own data. Therefore if the company forecasts revenue or profits for the business life cycle of the product, these would be discounted back to present value to give the right valuation

 

So as can be seen, the fair value is not an easy topic, however it’s a fundamental requirement in today’s market. Especially with the IFRS (IND AS) standards being implemented in India as well, it is imperative the students and professionals understand the concepts and make the required changes. For more information you can always write to us or visit IFRS.org to get further in-depth details of these standards.