The international standards on accounting define the fair value as “the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction”.
In essence the concept of fair value relates to estimating a rational and unbiased market price or worth of an asset, good, or service. Fair value is an important term and it has been defined and used in many international standards on accounting. From the definition of this term we need to notice several important points. These discussed below.
Fair value is an amount for which an asset can be exchanged or a liability settled. This is the consideration against which an asset can be sold or a liability can be settled.
Fair value is a reliable estimate if the parties involved in the transaction are “knowledgeable”. Parties can be considered knowledgeable if they are aware of the relevant risks and rewards, utility of the asset, supply and demand of asset, market conditions, and other factors.
The parties to the transaction should be willing taking part in the transaction. Fair value is cannot be estimated if the parties are involved in the transaction against their wills. The parties should be participating in transaction without any pressure, duress or threat.
The transaction should be an arm’s length transaction. Arm’s length transaction means that the parties to the transaction are acting in their own interest. A transaction can be arm’s length transaction if the parties act independently and have no relationship to each other.
International financial reporting standards suggest following three methods of determining fair value in order of preference:
- If identical transaction take place in market, the fair value should be determined with reference to these transactions
- If identical transactions do not exist but similar transactions do exist, fair value can be determined by making necessary adjustments and using market-based assumptions.
- If neither of these methods can be used, other methods of valuation can be used; such as present value of future economic benefits from the asset.