How to Account for Fair Market Value

Use valuation approaches to account for a company's fair market value.

Fair market value is defined in Internal Revenue Service Revenue Ruling 59-60. The Revenue Ruling states that "fair market value is the amount at which property would change hands between a willing buyer and a willing seller, each having reasonable knowledge of the relevant facts and neither being under any compulsion to buy or sell." This concept of value has also been the subject of numerous court decisions. Business owners often employ the services of professionals accredited in business valuation to determine fair market value.

Things You'll Need

• Business tax returns
• Business financial statements
• Business books and records

Instructions

1. Review the business's tax returns, financial statements and books and records. Books and records include general ledgers, bank statements and reconciliations, payroll reports and related tax returns, sales tax returns and rental agreements. Business valuation professionals generally review documents for a period of three to five years prior to the date of valuation.

2. Consider the factors enumerated in IRS Revenue Ruling 59-60 as they relate to the business being valued. Factors to consider include the economic and industry outlook, the history of the company and earning capacity, the existence of intangible assets such as goodwill or customer lists, the business's book value and the market price of comparable businesses that are actively traded on a stock exchange.

3. Prepare a financial and ratio analysis of the business and conclude if normalization adjustments are warranted. A common balance sheet adjustment is the elimination of bad debt from accounts receivable. Common income statement adjustments include the elimination of excess owner's compensation and perquisites and the addback of non-cash expenses such as depreciation and amortization.

4. Determine which valuation approaches are appropriate to value the business. Use the income approach for a company that exhibits stable earnings and cash flow. Use the cost approach when a company has numerous assets, ie: real estate or machinery and equipment. Use a market approach when sufficient market data exists for the sale of businesses comparable to the company being valued.

5. Prepare a reconciliation of values from each approach. This step requires the use of professional judgment, but a good starting point is the calculation of an average or weighted average of calculated values.

6. Determine if valuation premiums or discounts should be applied. Control premiums, discount for lack of marketability, minority discounts and keyman discounts are commonly used. The value of the premium or discount to be applied is heavily dependent on the business being valued, the valuation approaches used and professional judgment. The value determined after applying premiums and discounts is fair market value.

Tips & Warnings

• Fair market value is not synonymous with book value. Book value encompasses the historical costs reported on the company's balance sheet.

References

• CPA2Biz: Valuation of the Stock of a Closely-Held Business