Fair value is an accounting method by which companies must value assets under the Financial Accounting Standards Board (FASB) guidelines. FASB issued Financial Accounting Standard (FAS) 157 to help accountants understand the proper valuation of assets against current market conditions. Unfortunately, FAS 157 made it problematic to value assets during an economic downturn, leading to some difficult situations for financial institutions handling specific financial derivatives.
Fair value is the economic concept where one good is transferred for another good where the values of the goods are similar. Additionally, money may be exchanged for a good when the value of the good is equal to the value of the money.
Fair value is not necessarily equal to market value, since one individual may treat a good as having a higher value to him than another individual does.
The concept of fair value in accounting is determining an asset’s value when no readily determinable market value exists. Specialized assets can range from unique construction projects, specific manufacturing equipment and certain financial derivatives.
Historically, fair value was determined by pricing the asset against the related market; once assets became more unique and financial derivatives were created, FASB clarified their definition of fair value.
FASB’s FAS 157 sought to clarify the historical definition of fair value used by accountants. The standard created a fair value hierarchy based on three levels:
Level One: applies to liquid assets that have prices determined by active markets with similar assets. Level Two: an asset’s valuation is based on observable market inputs. These inputs include credit spreads, interest rates and quoted prices for similar assets. Level Three: asset valuation based on unobservable market inputs. Fair value is determined similar to Level Two assets, except that no market information is available. Therefore, the asset’s value is based on internal information.
FAS 157 defines fair value as the price received for an asset between market participants at the date of sale or valuation. This concept creates some difficulty for the seller by introducing the concept of mark-to-market. This concept forces sellers to value their assets on an exit price, that is, when the asset is sold, rather than a historical cost or carrying cost.
Problems with FAS 157
The difficulties arising with FAS 157 are twofold: what happens when an asset's exit price is lower than the value of the asset and what happens when the market value of an asset is zero. The first situation occurred in the U.S. economic downturn of 2008; as financial derivatives based on subprime mortgages begin to fail, the asset value reached extreme lows. Companies were forced to re-value these assets to the market value and face huge losses.
The second situation also applies to financial instruments. In the economic downturn some financial derivatives reached zero value and companies were faced with wholesale losses.