Fair value measurements represent a value placed on items that is indicative of their current value rather than historical cost. National accounting standards require the use of fair values for items such as financial instruments, impaired assets, and stock options,. The basic concept behind fair value measurements is that a seller should value an asset at the price it would receive when selling in an open market. Or, a company should value assets at the current replacement cost.
Many companies use the historical cost basis for recording assets. The value retained in the general ledger represents the original cost paid plus any freight charges or installation costs. The problem with this figure is the value is often higher than the asset’s current value. This can inflate the company’s balance sheet and make it look financially healthier than it would be using fair value measurements. National accounting standards often call an asset’s historical value the entry value method.
Three methods exist for making current value measurements on assets or liabilities. The first is to receive a quoted price for an identical asset or liability. The company must have access to the market, and the information must be in real dollars, not a theoretical price. A significant drawback to this method is that markets rarely exist for the assets used by companies. Open market prices are therefore difficult to obtain, especially when a caveat exists that a company must have access to the market.
The second measurements process allows a company to make some assumptions regarding the current value of its assets. The company can use a market where similar assets or liabilities are available for sale. The company can then estimate what its asset might sell for in this market. The market may be active or less active. For liabilities, companies may be able to estimate the future cash flows for each item and then compare this figure to the open market to determine a fair value.
A third fair value measurements process is necessary where no markets exist for the assets owned by a company. If no active or less active markets exist, it makes it impossible to obtain a real dollar figure for the asset or liability. In absence of this data, the company can use its own information and that probably used by other companies looking for a similar asset to gauge the fair value. This should be a rare occasion for companies as this scenario provides the least reliable fair value for assets and liabilities.