What is Fair Value?

According to the In­ter­na­tion­al Financial Reporting Standard 13, fair value is the “amount at which an asset could be exchanged between know­ledge­able and willing parties in an arm’s length trans­ac­tion.” (The arm’s length principle re­cog­nises that all parties involved in a trans­ac­tion are acting in­de­pend­ently and there is no special re­la­tion­ship between them.) It assumes that the price paid for an asset or to transfer a liability is accurate as of the day the trans­ac­tion takes place. Fur­ther­more, it also assumed that the parties involved are acting in their best economic interests. The idea behind the fair value meas­ure­ment approach is that assets and li­ab­il­it­ies are re-measured peri­od­ic­ally in order to note changes in their value. The resulting change then has an impact either on net income or else on another com­pre­hens­ive income for that par­tic­u­lar period. When it comes to actually figuring out how to determine fair market value, there are certain valuation tech­niques that you should utilise and for which there is plenty of data to refer to. The most widely used of these, the market approach, cost approach, and income approach, can be found in the IFRS 13.62.

The idea behind fair value is to bestow greater ob­jectiv­ity, trans­par­ency, and relevancy to annual balance sheets. Given that it is a com­mer­cial valuation standard, for busi­nesses it remains of no con­sequence according to tax laws. Its biggest plus point is arguably its validity and up-to-date-ness, which comes as a result of the real-time eval­u­ation of assets and li­ab­il­it­ies. His­tor­ic­al details, like ac­quis­i­tion and pro­duc­tion costs, which would otherwise serve as yard­sticks, in this case fail to provide such up-to-date in­form­a­tion. Both for current as well as for future investors or business partners it is the best pos­sib­il­ity of gauging the success potential of such business ventures. Fur­ther­more, fair value eval­u­ations serve as a basis for clas­si­fy­ing future cash flows.

The IASB actually adopted its standards from some of its U.S. coun­ter­parts when it comes to ad­dress­ing some of the problems to do with valuation. A so-called fair value hierarchy has been es­tab­lished for the valuation of assets and li­ab­il­it­ies:

Level 1: Fair values is based on quoted market prices given to identical assets and li­ab­il­it­ies, assuming that the parties involved have immediate access to the market.

Level 2: Fair value is based on market prices that are similar, i.e. not identical, to the assets and li­ab­il­it­ies in question.

Level 3: If it is the case that the values for both level 1 and 2 are un­avail­able, then the fair value should be estimated using certain valuation tech­niques.

Companies are required to provide detailed in­form­a­tion about how they cal­cu­lated the fair value. It should be clear which eval­u­ation method and input para­met­ers have been referred to. It is also necessary to provide basic in­form­a­tion relating to the valued assets, or li­ab­il­it­ies. Ad­di­tion­ally, it should also be outlined, via footnotes or an at­tach­ment, what effect the valu­ations based on the level 3 para­met­ers had on the stated profits/losses.

Fair value acts as an important valuation standard both in any initial or follow-up as­sess­ment. It tells you the value of an asset or the cost of a liability at the time of ac­quis­i­tion, as well as how this value/cost then changes over time, and in terms of how this impacts profits or losses. Fair value as­sess­ments are actually mandatory when it comes to the following assets and li­ab­il­it­ies:

• All assets that are part of planned future assets (company pension schemes)

• Pension pro­vi­sions, insofar as their amount is based on the fair value of se­cur­it­ies and which lies above the guar­an­teed minimum amount.

• Assets, li­ab­il­it­ies, deferred items, and special items that are con­trolled or partly con­trolled by a sub­si­di­ary or sister company – ex­cep­tions would be pro­vi­sions and deferred taxes

• Assets, li­ab­il­it­ies, deferred items, and special items that come as a result of the par­ti­cip­a­tion of external companies (this is limited to the ac­quis­i­tion coasts) – here ex­cep­tions would also be pro­vi­sions and deferred taxes

The first two cases are es­pe­cially important when it comes to follow-up eval­u­ations. In principle, the cal­cu­la­tion of the fair value of in­tan­gible assets only really becomes an option if you can dis­tin­guish between research and de­vel­op­ment.

As we mentioned above, when it comes to cal­cu­lat­ing fair value, there are three ap­proaches that are of par­tic­u­lar sig­ni­fic­ance. While the market approach is geared directly towards the re­spect­ive market and is in­flu­enced by the first and second steps for assessing fair value, both the cost approach and the income approach determine fair value on the basis of the criteria of the third level of the fair value hierarchy. Below we have outlined detailed in­form­a­tion on the various ap­proaches, as well as referring to which situ­ations they are spe­cific­ally suited to: 

Market Approach

As the name suggests, this is a market-ori­ent­ated approach to eval­u­ation. It involves dif­fer­en­ti­at­ing between the use of current market prices and the use of analogies when it comes to defining fair market value. In the first case, the concrete market price serves as a guideline for de­term­in­ing fair value. One pre­con­di­tion is that when we talk about the market we are talking about an active market, for which three re­quire­ments need to be met:

1. The assets or li­ab­il­it­ies in question should be pre­dom­in­antly ho­mo­gen­ous (detached from geo­graph­ic­al or material links to any com­pet­it­ors).
2. Generally, there should be willing buyers and sellers available.
3. The prices of the assets in question should be public in­form­a­tion.

In the second case there is no concrete market price for the asset in question, meaning that the fair value must be de­term­ined using com­par­able assets. In order to do this, the values to be compared are modified ac­cord­ingly – e.g. by making increases or re­duc­tions. Even the use of mul­ti­pli­ers that can be linked to revenue and earnings is possible. The simple trans­par­ency of the market method make it the preferred choice when it comes to cal­cu­lat­ing fair market value. It is often the case, though, that in­suf­fi­cient or in­ad­equate data makes the ap­plic­a­tion of the market method im­possible, as neither the specific market price nor com­par­able value is available.

Income Approach

Also known as the cash value method, the basis of this approach is the dis­count­ing of all relevant cash flows with a risk-equi­val­ent interest rate on the day of valuation. This, in com­bin­a­tion with values for the amount and duration of the cash flows, allows you to calculate the fair value. Here are the following pro­ced­ures for doing so:

• Immediate cash flow method: The value is cal­cu­lated using future profit earnings which can then be assigned to the asset in question. This occurs directly in the form of cash flows.

• Relief from royalty method: Fair value is de­term­ined using the relief from royalty method through future royalty fees that need to be paid to a third party in return for an asset. To do this, the license rate in question is mul­ti­plied by the turnover.

• Residual value method: Central to this method is that the asset to be valued is assigned any income as a residual income. For this it is necessary the cash flows of all other assets (tangible and in­tan­gible) are sub­trac­ted from the overall income.

• Excess earnings method: The excess earnings method involves de­term­in­ing the changes in future cash flows based on cost savings or revenue, which is generated through in­tan­gible assets. In order to determine this, the cash flows of similar companies are consulted wherein the asset to be examined does not exist.

All capital value ap­proaches share a similar problem in that essential para­met­ers for the valuation of any valuable object are open to influence, and even ma­nip­u­la­tion, due to es­tim­a­tions that are ul­ti­mately sub­ject­ive. Above all, when it comes to cash flows, it is the amount and time that can be hard to com­pre­hend and objectify.

Cost Approach

The cost approach involves two ap­proaches to de­term­in­ing fair value – the cost of re­pro­duc­tion and the cost of re­place­ment. The re­pro­duc­tion cost method brings about fair value from a com­bin­a­tion of all costs that are necessary to reproduce an asset one-to-one, if identical resources and measures are used. Likewise, the re­place­ment method is also geared towards the costs that would be incurred in the re­pro­duc­tion of the asset (with identical values as well). Unlike with the re­pro­duc­tion method, here it is assumed that the current resources and methods are being used.

The costs involved in such a valuation are direct costs, or cash flows, as well as overheads and op­por­tun­ity costs and employer’s salary. If the valuable object to be reviewed has already been valued at an earlier stage, then it is still necessary to determine the loss of monetary value that has occurred in the meantime, and then subtract this in order to get the final fair value. The strengths of the cost approach lie in its trans­par­ency and the veri­fi­ab­il­ity of the eval­u­ation criteria, although it must be noted that the re­pro­duc­tion process for many in­tan­gible assets can be difficult to execute. 

There are arguments for and against the whole concept of fair value. The biggest argument in favour of it is that it allows for a more accurate balance sheet and one that better reflects the current value of assets and li­ab­il­it­ies. The value of these assets and li­ab­il­it­ies is in turn re­flect­ive of the market of the business, and therefore provides a very up-to-date insight into the current state of the market. Fair value focuses on a market place’s as­sump­tions and is not specific to any one business or entity. This ensures that it takes into account any as­sump­tions relating to risk.

On the other hand, there are those out there who have iden­ti­fied the downsides of fair value due to the fact that any changes in a fair value causes greater volat­il­ity when it comes to peri­od­ic­ally reported financial per­form­ances. They argue that assets or li­ab­il­it­ies assigned with fair values can be po­ten­tially mis­lead­ing, as it can be quite ir­rel­ev­ant for assets/li­ab­il­it­ies to be held over a longer period. The likes of liquidity problems, investor ir­ra­tion­al­ity, market in­ef­fi­cien­cies, and un­re­li­able com­par­at­ive models can all have a dis­tort­ive effect on fair market value. There are those out there who have even gone so far as to say that the fair value model of ac­count­ing has con­trib­uted to unstable and fluc­tu­at­ing economic markets.

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