What is fair value?
Fair value is a market-based measure, not the price the business originally paid. IFRS 13 Fair Value Measurement (and ASC 820 under US GAAP) defines it as an "exit price" between willing, informed participants.
The fair value hierarchy
- Level 1: quoted prices in active markets for identical items, such as listed shares.
- Level 2: observable inputs other than quoted prices, such as similar assets or interest rate curves.
- Level 3: unobservable inputs based on the company's own assumptions, such as discounted cash flow models for private companies.
Level 3 measurements need the most disclosure because they involve the most judgement.
Where fair value is used
- Investments in shares and bonds
- Derivatives such as forward contracts
- Investment property (if the fair value model is chosen)
- Assets and liabilities acquired in a business combination
- [Impairment](/glossary/impairment) testing
Fair value vs historical cost
[Historical cost](/glossary/historical-cost) records what was paid and is reliable but can become outdated. Fair value is more current but relies on estimates and can be volatile.
Example
A company bought shares for $10,000. At year-end they trade at $13,500. Measured at fair value, the investment is shown at $13,500 with a $3,500 [unrealised gain](/glossary/unrealized-gain-or-loss).