Question

Discuss the issues associated with the measurement and use of fair values and the need for an accounting standard on fair value measurement. Give at least one real life example within the last three years.

Answer 1

What is Fair Value?

It is a market based value rather than an entity specific prices and this price should be received to sell an asset or piad to transfer a liability in a normal transaction. Fair value is an exit price and not a price at which an Asset/ liability sells /purchases otherwise.

What re the objectives of fair value measurement?

• To estimate the price
• At which an orderly transaction to sell the asset or to transfer the liability would take place
• Between market participants
• At the measurement date
• Under current market conditions

(i.e. an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability)

The various elemts related to fair Value measurement are discussed below:

1. THE TRANSACTION: A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transafer the liability at the measurement date under current market conditions.

A fair value measurement assumes that the transation to sell the asset or traansfer the liability takes place either:

(a) in the principal maket for the asset or liability; or

(b) in the absence of a principal market . in the most advantageous market for the asset or liability.

2. PRINCIPAL MARKET
Market which is normallly the place in which the assets/liabilities are being transacted with highest volume with high level of acivities coparing with any other market avaialble for similar trnsactions.

3. MOST ADVANTAGEOUS MARKET

• This is the market which either maximizes the amount that would be received when an entity sells an asset or minimize the amount that is to be paid while transferring the liability .
• In the absence of pricipal market, this market is ussed for Fair Calcuation of the Assets/Liabilities. In many cases Principal market $ most advantageous market will be same.
• The market will be assessed based on net proceeds from the sale which will deduct expenses associated with such sale in most advantageous market.

Example: Diamond (a commodity) has got a domestic market where the prices are lesse comparing to the prices available for export of similar diamonds.The normal activities of diamond are being done at domestic Market (90%) and balance 10% only can be sold via export.
Therefore highest level of activities with highest volume is being done at domestic market. Henxe principal market for diamond would be domestic market. Export prices are more than the prices in the principal market and it would give highest return comparing to the domestic market. Therefore, the export market would be considered as most advantageous market.

4. MARKET PARTICIPANTS

An entity shall measure the fair value of an asset or a liability using the assumptions that market participants would use when pricing the asset or liability, assuming that market participants and in their economic best interest.

Who are Market Participants?

The parties which eventually transact the assets'liabilities either in principal market or most advantageous market in their best economic interest i.e.

• They should be independent and not a related party. However if related parties have done similar transaction on arm's length price, then it can be between related parties as well.
• The parties should not be under any stress or force to enter into these transactions.
• All parties should have reasonable and sufficient information about the same.

5. PRiCE

Fair Price is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal or most advantageous market at the measurement date under current market conditions (i.e. an exit price) regardless of whether the price is directly observable or estimated using another valuation technique.

THE VALUATION TECHNIQUES TO MEASURE FAIR VALUE:

1. Market Approach: The market approach uses price and other relevant information generated by market trnsactions involving identcal or comparable (i.e. similar) assets, liabilities or a froup of assets and liabilitie, such as a business.

2. Income Approach: The income approach converts future amounts (e.g. cash fliows or incomes and expenses) tona single current (i.e. discounted) amount. When the income approach is used , the fair value measurement reflects current market expectations about those future amounts.

3. Cost Approach: This method descibes how much cost is required to replace existing asset/laibility in order to make it in a working condition. All related costs will be its fair value. It actually considers replacement cost of the asset/liability for which we need to find fair value.