Fair Value

Definition

Fair value is 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. It is a market-based measurement that reflects the current value of an asset or liability, rather than its historical cost or some other accounting-based valuation.

5 Must Know Facts For Your Next Test

1. Fair value is the primary basis for measuring assets and liabilities in financial reporting, as it provides more relevant and useful information to financial statement users.
2. The fair value hierarchy establishes a framework for measuring fair value, with Level 1 inputs being the most reliable (quoted prices in active markets) and Level 3 inputs being the least reliable (unobservable inputs).
3. Fair value accounting can be used to manage earnings, as changes in fair value can impact net income and the balance sheet.
4. Intangible assets, such as patents, trademarks, and customer relationships, are often measured at fair value upon acquisition and subsequently tested for impairment.
5. The fair value of a tangible asset, such as property, plant, and equipment, may be used to determine its recoverable amount for impairment testing purposes.

Review Questions

• Explain how fair value accounting can be used in the context of earnings management through the accounting for receivables.
  • Fair value accounting can be used in earnings management through the accounting for receivables. Managers may manipulate the fair value of accounts receivable by adjusting the allowance for doubtful accounts, which impacts the net realizable value of the receivables reported on the balance sheet. By overestimating or underestimating the allowance, managers can either increase or decrease the reported value of accounts receivable, thereby affecting the company's net income and financial ratios.
• Distinguish between the accounting for tangible and intangible assets with respect to the use of fair value.
  • The accounting for tangible and intangible assets differs in the use of fair value. Tangible assets, such as property, plant, and equipment, are typically measured at historical cost and tested for impairment, with fair value being used to determine the recoverable amount. Intangible assets, on the other hand, are often measured at fair value upon acquisition and subsequently tested for impairment. The fair value of intangible assets, such as patents, trademarks, and customer relationships, is determined using various valuation techniques, including the market approach, income approach, and cost approach.
• Describe the role of fair value accounting in the recording of transactions related to intangible assets.
  • Fair value accounting plays a crucial role in the recording of transactions related to intangible assets. When an intangible asset is acquired, either separately or as part of a business combination, it is typically recorded at its fair value. This fair value becomes the new cost basis for the asset, which is then amortized or tested for impairment over its useful life. Additionally, subsequent changes in the fair value of intangible assets, such as those resulting from impairment tests, are recognized in the financial statements, impacting the company's net income and financial position.

Related terms

Market Approach: A valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.

Income Approach: A valuation technique that converts future amounts (e.g., cash flows or income and expenses) to a single current (discounted) amount.

Cost Approach: A valuation technique that reflects the amount that would be required currently to replace the service capacity of an asset.