Fair Value in Accounting – Background

Fair value is defined by IFRS 13 and ASC 820 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

While the rule-based US Generally Accepted Accounting Principles (US GAAP) do not widely adopt fair value as a measurement basis, this is not the case with the International Financial Reporting Standards (IFRSs). The latter currently use fair value quite extensively, both for measurement and disclosure purposes, with one of the key differences lying in the revaluation of investment property and property, plant & equipment (PPE) allowed only under IFRS.

However, fair value as a measurement basis is a relatively new accounting concept, at least from a historical perspective. Interestingly, the Framework for the Preparation and Presentation of Financial Statements (for IASs), originally published in 1989, made no mention of the term. It did mention several other possible measurement bases, such as historical cost, present value, current cost, and realizable value. However, the conceptual difference, if any, between the various measurement bases – other than historical cost – was not clearly explained.

Over the years, the International Accounting Standards (IASs) underwent significant changes, with one of the most important presumably being the growing use of fair value as a measurement basis. Fair value also sometimes doubles as an acceptable basis for disclosure. However, prior to the formulation of IFRS 13 – Fair Value Measurement, other IASs offered no unified definition of this measurement basis, nor did they provide a consistent framework for its estimation. Consequently, certain IASs which made use of fair value, as well as the related practice, were not always consistent in applying the measurement principles and even in its basic definition. In addition, some of the standards, such as IAS 39Financial Instruments: Recognition and Measurement, which was later superseded by IFRS 9Financial Instruments, included a relatively detailed set of guidelines regarding the measurement of fair value, while other standards, such as IAS 41Agriculture, only included limited guidelines.

Originally published in 2000, US GAAP Concepts Statement 7 did discuss the fair value basis of measurement, but a similar phenomenon of multiple definitions and limited guidance was also the case under US GAAP prior to the publication of Statement of Financial Accounting Standards No. 157 – Fair Value Measurements in 2006 (SFAS 157). The US national accounting standard-setter, the Financial Accounting Standards Board (FASB), was the first of the two accounting standard-setters to address this problem, with the publication of SFAS 157. The aim of SFAS 157 was to increase the consistency of fair value measurement and to expand related disclosures. This standard was later codified to become Accounting Standards Codification (ASC) Topic 820, and after further amendments, served as the basis for the current versions of IFRS 13 and ASC 820.

Finalized in 2011, IFRS 13 and the corresponding version of ASC 820 (hereinafter – the “Standards”) were developed jointly by the IASB and FASB. One of the objectives of this joint effort was to unify the meaning of fair value across the world’s two leading financial accounting frameworks. Practically speaking, it can be said that while fair value is not used as often under US GAAP as under IFRS, both standards are very similar, with few minor differences. The Standards share, among other things, their illustrative Examples. However, the FASB separately developed a Basis for Conclusions summarizing its considerations in formulating the current version of ASC 820. SFAS 157 had its own Background Information and Basis for Conclusions.

The purpose of the Standards was to define – in a principled manner – what fair value is, to provide a uniform framework for measuring fair value and to establish the disclosure provisions to be applied when using this measurement basis. The Standards describe how fair value should be measured wherever another IFRS (or US GAAP accounting standard) requires or allows the fair value basis to be used. In other words, they do not specify under which circumstances and to which items fair value should be applied, nor do they address the question of where to recognize changes in fair value from one period to another, as these questions are answered by the relevant standards using the said measurement basis. The Standards establish general principles which apply to both financial and non-financial items. The Standards also includes specific provisions applicable to non-financial items alone. Generally speaking, when IFRS 13 (or SFAS 157) came into force, the specific provisions regarding fair value measurement and related disclosure included in the various other standards were deleted or amended.

It may be said that, as opposed to other accounting measurement bases such as historical cost or value in use, one of the main characteristics of the fair value basis under both IFRS and US GAAP is that it is intended to serve as an objective, market-based measure that is non-specific to a particular reporting entity. Fair value is defined by IFRS 13 and ASC 820 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. Thus, whether or not there are observable transactions for the appraised item, the objective of measuring fair value is to estimate the potential price of the item in an ordinary (hypothetical) transaction between market participants at the measurement date, under existing market conditions. Thus, for example, the reporting entity’s intention to hold the asset (rather than sell it) is irrelevant to the measurement. It is also important to note that, at times, estimating the fair value of specific items (such as the fair value of investments in start-up companies) may require considerable judgment, and may also be subject to significant uncertainty and a relatively wide range of possibilities.