# Fair Value – Definition, Features & Calculations

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## Meaning of Fair Value

Fair value is a term that in the investment sphere refers to the agreed sale price. This, provided that the participants act freely and are informed about the details of the transaction.

That is to say, in the financial world, the fair value of an operation is that agreed between two parties, without coercion in between.

We can cite several examples of this type of value. One of them is the price paid by an investor in the stock market for the purchase of the shares of a company.

It should be noted that the financial market is characterized by immediately reflecting changes in demand, that is, in the mood of investors. Therefore, the market price is a good indicator of fair value.

### Fair Value of Accounting

On the other hand, for accounting, the fair value is the one with which the assets and liabilities of the company must be recorded.

For example, imagine that a firm purchases a new machine for its factory. Said asset will lose utility over time (depreciation). Therefore, in each period its value in the accounting books will be reduced.

That is, if one year the valuation of the machine was 18,000 euros, for the next period it can drop to 14,400 euros, due to its wear and tear. That way, it is close to fair value.

### Derivatives and Futures of Fair Value

Returning to the stock market, the fair value of a financial derivative is mainly determined by its underlying asset.

For example, imagine that an investor has a gold call option, which gives him the right to acquire the gold metal within a certain period of time.

So if the price of gold rises, so will the price of the derivative. Thus, the investor could sell his option at a higher price than he paid to buy the instrument.

### How to Calculate Fair Value?

The fair value is for which a financial asset can be bought or a financial liability settled on a specific date between two parties (buyer and seller) who are independent from each other and are experts in the field and who know how to act freely and prudently under conditions. market.

Its implementation responds to the principle of true image that should govern the accounting activity.

To calculate it we must go to the market value.

For financial assets that do not have an active market, there are valuation models and techniques to find it.

If we cannot use the market value or the aforementioned techniques, the fair value will be determined by its book value less its depreciation or its acquisition price or its production costs.

In our traditional accounting regulations, the value of any fixed asset was its acquisition value less the depreciation made on it.

However, Spanish commercial and accounting regulations have been reformed, since the beginning of the century, to bring them closer to the rules that generally govern the European Union.

Here, in Spain, the fair value appears.

European Regulation : It is collected, fundamentally, in art. 8 of Directive 2013/34 / EU

1. Member States should allow and even require all types of companies to measure financial assets (including derivatives) at fair value.
Likewise, the valuation of other assets with reference to fair value will be allowed or required.

This may be limited to the consolidated financial statements.

In any case, this will apply to instruments that are part of a trading portfolio and to derivatives. It will not apply:

• To financial instruments that are not derivatives and that are held until maturity.
• Loans and receivables issued by the company that are not used to negotiate.
• Debts of subsidiaries, associates, in participation or group of companies or any other financial instrument that, due to its peculiarities, is accounted for differently.
2. Contracts on commodities that allow contracting parties to settle them in cash or through other financial instruments will also be considered derivative financial instruments with the following exceptions:
• That have been previously held under other regulations and continue to be complied with.
• They are conceived as commodity contracts from the start.
• They are expected to be settled through the delivery of the basic product.
3. In any case, the valuation of any asset or liability, in whole or in part, that may be instruments hedged at fair value may be allowed.
4. Fair value is determined with reference to:
• Market Value when it can be easily determined in a reliable market. If it cannot be easily determined but its components or other similar financial product can be used this value.
• If it cannot be easily determined, generally accepted valuation techniques and models will be applied if they guarantee a reasonable approximation to the market value.
• If it is not possible to determine the fair value for any of the previous assumptions, the valuation will be made with the acquisition price or production cost if possible.
5. Once the fair value has been applied to a financial product, any variation in said value will be recorded in the profit and loss account. As an exception to this, they will not go to profit and loss but to a reserve “for fair value” in two cases:
• That the affected financial instrument is hedged according to a hedge accounting system where it is permitted not to record all changes in value in Profit and Loss.
• That the difference in value is due to a difference in the exchange rate in which the product is originally valued.
6. It may be allowed or required for realizable financial assets that are not derivatives, if the variation in value is included in a reserve for realizable value.
7. National laws may also allow or require that other non-financial assets be valued at fair value.

Spanish regulations and doctrine : First of all, the General Accounting Plans (both the general [RD 1514/2007] and the others applicable such as the Small and Medium-Sized Companies [RD 1515/2007], insurance entities, non-profit entities , etc.) implement and regulate the application, for the financial assets that proceeds, of the fair value.

Its definition and implementation respond to what is explained above in this article.

Very interesting is the technical auditing standard on “fair value” . resolution of the accounting and auditing institute ( ICAC ), of October 7, 2010 (the ICAC is a body dependent on the Ministry of Finance that makes this type of opinion that must be followed in the accounting preparation).

According to this standard, companies are empowered to apply fair value to their accounts (that is, it is not strictly mandatory) for which they will adopt the necessary means and procedures.

Sometimes it is easy to calculate it, for example in the case of financial instruments that are listed on a market, but in other cases it is not at all easy and the necessary calculations and checks must be made.

In this sense, the auditor must be able to make, through accounting and knowledge of the reality of the business, the identification of how the information has been produced and calculated as well as the internal control standards, that the estimates in different areas are reasonable , the reasonableness of the statements made by management as well as the adequacy of the accounting principles and standards adopted.

The auditor cannot always be absolutely certain of the information he sees, so he must, in these cases, use the verification and verification tools of the information provided for this purpose.

In this sense, the auditor is responsible, as regards fair value, for the correctness of its implementation, which must be explained in the report and respond to the principle of true image.

For their part, the administrators are responsible for the veracity and correctness of the preparation of the annual accounts of their company, complying, for this purpose, with all the rules and instruments that exist for this.

Specifically, the auditor must know what procedure has been used to determine the fair value for its reflection in the annual accounts and the risk control and evaluation activities (of errors and irregularities) referred to in the terms provided by the technical regulations. audit.

For this, the following will be taken into account:

• The controls used in the fair value valuation, which include information such as the distribution of functions among those responsible for carrying out the accounting information and the calculation of fair value.
• Regarding said responsible persons, their aptitude and experience.
• How computer processes are used.
• The nature and class of the assets (financial instruments or transactions).
• If the accounting is prepared by an external company, the auditor will take into account the planning of their work and compliance with the regulations.
• If the entity has hired experts to determine valuations and disclosures for calculating fair value.
• The relevant assumptions that management has used in calculating fair value.
• The documentation that supports these calculations.
• The methods for developing and applying management hypotheses.
• The control of changes, which must be authorized and properly executed, if there are security procedures and information systems, including in their approval procedure.
• Control of timeliness, reliability and consistency of the data used.
• How management has managed the uncertainties that arise in the fair value estimation process.

In light of all this, the auditor will make a general image taking into account all this information and others such as the criteria of the previous year, the adaptation to the general regulations and the company’s own standards, the attitude and aptitude of the management in the implementation of their own plans, etc. All this to avoid errors or irregularities in the calculation of fair value.

In this sense, for the calculation of reasonable values, the following must be evaluated:

• Adequacy of the valuation method.
• Reasonableness of the hypotheses used.
• The data that has been used for the calculation.
• If the valuation method is uniform in all cases and with previous years.
• The adequacy and veracity of the data used for the calculation.

The auditor can make his own estimate of the fair value for which he must take into account, in addition to all the above information, the subsequent events that support or not the calculation made by accounting.

Likewise, the audit may require the management of the company to state, in writing, on the methods, reasons, breakdowns and subsequent events.