How to Measure Fair Value

Fair value measurement involves some basic assumptions. For one, you can’t have an accurate measurement of fair value unless you figure it based on what the asset is worth or what the liability would transfer for in an appropriate marketplace — in other words, its principal market.

For example, you find out fair value of gold in a precious metal marketplace, such as Monex, not in a marketplace that specializes in pork belly futures, such as the Chicago Mercantile Exchange.

Failing to find a principal market place, the valuation comes from the most advantageous market for the asset or liability.

You also have to quantify the market participants, which are the buyers in the principal or advantageous marketplace. For example, the market participants can’t be related parties, which means they’re somehow associated with the business and have either a real or a perceived vested interest in the outcome of the valuation.

The company also must have a working knowledge of the asset or liability so that it can come up with an accurate valuation. In addition, the company has to be willing to sell or transfer the asset/liability, regardless of the fact that this situation is likely hypothetical.

Fair value also takes into account the specific attributes of the asset or liability at measurement date. These attributes include the condition of the asset and credit risk. For example, fair value measurement of a building takes into consideration the neighborhood in which the building sits and the overall condition of the building.

Except for U.S. Treasury bonds, which are considered risk-free, since they’re backed by the U.S. government, credit risk is generally present in most financial assets. Fair value therefore adjusts based on the risk associated with the asset or liability.

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