Introduction to Fair Value Measurement
Fair value measurement is a foundational concept in financial reporting under ASC 820 (U.S. GAAP) and IFRS 13 (International Standards). It establishes a consistent framework for determining the current value of assets and liabilities based on market conditions. Instead of relying on historical cost, fair value reflects what the market would pay or accept today.
Fair value is defined 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. This definition ensures that valuation is objective, market-based, and time-specific.
Understanding the Core Components of Fair Value
Breaking down the definition:
Exit price focuses on selling price, not purchase price
Orderly transaction excludes forced or distressed sales
Market participants are independent and informed buyers and sellers
Measurement date ensures valuation reflects current conditions
This makes fair value a market-driven measurement, not influenced by internal preferences or intentions.
Step 1: Identify the Asset or Liability (Unit of Account)
The first step is identifying exactly what is being measured. This determines whether valuation applies to a single asset, a group of assets, or a liability.
Example
A company holds a financial investment in corporate bonds worth multiple units. The unit of account is each bond, unless another standard requires portfolio-level valuation.
Step 2: Determine the Principal or Most Advantageous Market
The principal market is the market with the highest activity and volume. If none exists, the most advantageous market is used, which provides the best net outcome after transaction and transport costs.
Important rule:
Transaction costs are not included in fair value, but they are considered when identifying the market.
Example
Market A price = $1,200 with $100 transaction cost
Market B price = $1,150 with $20 transaction cost
Net proceeds:
Market A = $1,100
Market B = $1,130
Market B is more advantageous, but fair value remains based on $1,150.
Step 3: Consider Market Participant Assumptions
Fair value reflects assumptions that typical market participants would make regarding risk, expected returns, and economic conditions.
Example
A building used by a company for internal operations may have higher value if converted into commercial rental space. Fair value reflects what the market would consider, not internal usage preferences.
Step 4: Select the Appropriate Valuation Technique
Three approaches are used:
Market Approach
Uses observable prices from active markets.
Income Approach
Discounts future cash flows to present value.
Cost Approach
Estimates replacement cost adjusted for depreciation.
Step 5: Apply the Fair Value Hierarchy
Inputs are categorized into:
Level 1: quoted prices in active markets
Level 2: observable inputs (e.g., market yields)
Level 3: unobservable inputs (internal estimates)
The goal is to maximize observable inputs.
Step 6: Highest and Best Use (Nonfinancial Assets)
For nonfinancial assets, valuation reflects the most profitable use that is:
physically possible, legally permissible, and financially feasible.
Step 7: Incorporate Risk Adjustments
Fair value includes risk such as credit risk, liquidity risk, and uncertainty.
Comprehensive Step-by-Step Solved Example (All Concepts Combined)
Scenario
A company owns a commercial property that generates rental income but could also be redeveloped into a shopping complex. There is no active market price available, so valuation must be performed using the income approach and market assumptions.
Step 1: Identify the Asset
The asset is a commercial building currently generating rental income.
Step 2: Determine the Market
No direct active market exists, but comparable properties are traded in a regional real estate market. This becomes the principal market.
Step 3: Assess Market Participant Assumptions
Market participants would evaluate:
Expected rental income
Future appreciation
Risk associated with tenants
Alternative use (redevelopment potential)
Assume market participants expect redevelopment in 5 years.
Step 4: Select Valuation Technique
The income approach (Discounted Cash Flow method) is most appropriate.
Step 5: Estimate Future Cash Flows
Rental income expected:
Year 1 = $50,000
Year 2 = $55,000
Year 3 = $60,000
Year 4 = $65,000
Year 5 = $70,000
Expected sale value at end of Year 5 (redevelopment value) = $500,000
Step 6: Select Discount Rate
Based on market risk, discount rate = 10%
Step 7: Calculate Present Value of Cash Flows
Year 1:
50,000 / 1.10 = 45,455
Year 2:
55,000 / (1.10)^2 = 45,455
Year 3:
60,000 / (1.10)^3 = 45,079
Year 4:
65,000 / (1.10)^4 = 44,392
Year 5:
70,000 / (1.10)^5 = 43,483
Step 8: Calculate Present Value of Terminal Value
Terminal value = 500,000
PV = 500,000 / (1.10)^5 = 310,460
Step 9: Total Fair Value Calculation
Sum of rental cash flows:
45,455 + 45,455 + 45,079 + 44,392 + 43,483 = 223,864
Add terminal value:
223,864 + 310,460 = $534,324
Step 10: Determine Fair Value Hierarchy Level
Since valuation uses projected cash flows and assumptions:
→ Classified as Level 3 input
Step 11: Consider Highest and Best Use
If redevelopment yields higher value than rental use, fair value reflects redevelopment potential, as long as:
It is legally allowed
Financially feasible
Physically possible
In this case, redevelopment is already included in terminal value.
Step 12: Risk Consideration
Discount rate already includes:
Market risk
Tenant default risk
Economic uncertainty
Thus, risk is embedded in valuation.
Step 13: Final Fair Value
The fair value of the property = $534,324
Additional Mini Example (Market Approach)
If a similar property is recently sold for $550,000:
That observable input may adjust valuation or support it.
Key Takeaways
Fair value under ASC 820 and IFRS 13 is an exit price based on current market conditions rather than historical cost
The valuation process begins by clearly identifying the asset or liability and determining the relevant market
Market participant assumptions play a critical role and must reflect objective expectations rather than internal preferences
Three valuation approaches are used: market, income, and cost approach, depending on data availability
The fair value hierarchy ensures transparency by classifying inputs into Level 1, Level 2, and Level 3
Nonfinancial assets are valued based on their highest and best use, which maximizes economic benefit
Risk factors such as credit risk and uncertainty are incorporated into valuation, typically through discount rates
When observable market data is unavailable, discounted cash flow techniques provide a structured way to estimate fair value
A complete fair value measurement integrates all steps—market identification, assumptions, valuation method, and hierarchy classification—to produce a consistent and comparable financial value