Fair value is the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between knowledgeable, willing market participants at the measurement date. It represents the market’s assessment of what something is worth, rather than what the business originally paid for it.
Fair value measurement is used in specific circumstances under both FRS 102 and IFRS. It plays a particularly important role in the accounting for financial instruments, investment property, biological assets and certain business combinations. Understanding when and how to apply fair value is essential for accurate financial accounting.
Fair value vs historical cost
Most items in UK financial statements are initially measured at historical cost – the amount paid to acquire the asset or the amount received when the liability was incurred. Fair value measurement provides an alternative that reflects current market conditions.
| Feature | Historical cost | Fair value |
|---|---|---|
| Based on | Original transaction price | Current market price or estimate |
| Objectivity | Highly objective (documented) | Can require significant estimation |
| Relevance | Becomes less relevant over time | Reflects current economic reality |
| Volatility in accounts | Stable | Can introduce period-to-period fluctuations |
| Audit evidence | Invoices, contracts | Market data, valuations, models |
Neither approach is universally superior. Historical cost provides reliability and simplicity; fair value provides relevance and timeliness. UK accounting standards specify which measurement basis to use for each category of asset or liability.
Fair value under FRS 102
FRS 102 uses fair value measurement in several areas but does not adopt it as pervasively as IFRS.
Financial instruments (Sections 11 and 12)
FRS 102 classifies financial instruments into basic (Section 11) and other (Section 12):
| Classification | Measurement | Examples |
|---|---|---|
| Basic financial instruments | Amortised cost (generally) | Trade debtors, trade creditors, bank loans, simple bonds |
| Other financial instruments | Fair value through profit or loss | Derivatives, options, complex debt instruments, forward contracts |
Basic instruments are measured at amortised cost because their cash flows are straightforward. Other instruments must be measured at fair value because their returns depend on market variables that amortised cost cannot capture.
Investment property (Section 16)
Entities holding investment property can choose between the cost model and the fair value model. Under the fair value model, investment property is remeasured to fair value at each reporting date, with changes recognised in profit or loss.
The fair value model is popular among property companies because it keeps the balance sheet aligned with current property market values, providing more relevant information to investors and lenders.
Business combinations (Section 19)
When one company acquires another, FRS 102 requires the identifiable assets and liabilities of the acquired entity to be measured at their fair values at the acquisition date. The difference between the purchase price and the fair value of net assets acquired is recognised as goodwill.
Other areas
Fair value measurement also appears in FRS 102 in relation to:
- Biological assets and agricultural produce (Section 34)
- Share-based payment transactions (Section 26)
- Revaluation of property, plant and equipment (Section 17, where the revaluation model is chosen)
Determining fair value
The fair value hierarchy
Although FRS 102 does not formally prescribe a three-level hierarchy like IFRS 13, the underlying logic is similar. The most reliable estimate of fair value comes from observable market data:
| Level | Input type | Example |
|---|---|---|
| Level 1 | Quoted prices in active markets | Listed share price, commodity price |
| Level 2 | Observable inputs other than quoted prices | Interest rate curves, comparable property transactions |
| Level 3 | Unobservable inputs (entity’s own estimates) | Discounted cash flow models, management assumptions |
Level 1 inputs provide the strongest evidence and require the least judgement. Level 3 inputs involve significant estimation and are subject to greater scrutiny from auditors.
Valuation techniques
When quoted market prices are not available, entities use valuation techniques to estimate fair value:
- Market approach – using prices and information from comparable market transactions
- Income approach – converting future cash flows or earnings into a present value (discounted cash flow analysis)
- Cost approach – estimating the cost to replace the asset’s service capacity
The chosen technique should maximise the use of observable market data and minimise reliance on the entity’s own assumptions.
Fair value under IFRS
IFRS applies fair value more extensively than FRS 102. Key differences include:
| Area | FRS 102 | IFRS |
|---|---|---|
| Financial instruments | Basic at amortised cost; other at fair value | IFRS 9: more categories; fair value option available |
| Leases | Finance/operating distinction | IFRS 16: right-of-use assets, some at fair value |
| Revenue | Risks and rewards model | IFRS 15: fair value of consideration features |
| Goodwill | Amortised | Not amortised; impairment tested (fair value basis) |
| Measurement standard | General guidance in FRS 102 | IFRS 13: dedicated fair value measurement standard |
IFRS 13 provides a comprehensive framework for fair value measurement, including the formal three-level hierarchy, detailed guidance on valuation techniques and extensive disclosure requirements.
Gains and losses from fair value changes
When an asset or liability is remeasured to fair value, the resulting gain or loss must be recognised somewhere in the financial statements. FRS 102 specifies two possible locations:
| Where recognised | When used |
|---|---|
| Profit or loss | Investment property (fair value model), other financial instruments, biological assets |
| Other comprehensive income | Revaluation of property, plant and equipment; certain hedging gains/losses |
The distinction matters because gains and losses recognised in profit or loss affect the reported profit for the period and may influence distributable reserves and tax. Those recognised in other comprehensive income are reported separately and may be recycled to profit or loss in a later period.
Practical challenges
Subjectivity
Fair value measurements, particularly at Level 3, involve significant management judgement. Assumptions about discount rates, growth rates, market conditions and comparable transactions can all materially affect the reported value. This creates an inherent risk of bias, whether intentional or unconscious.
Volatility
Fair value accounting can introduce significant fluctuations in reported profit and equity from period to period, particularly for entities with large portfolios of financial instruments or investment property. These fluctuations may not reflect the underlying operating performance of the business.
Cost of measurement
Obtaining reliable fair value estimates can be expensive. Independent property valuations, derivative pricing models and specialist reports all add to the cost of preparing financial statements. For smaller entities, this cost may outweigh the benefits, which is one reason FRS 105 prohibits fair value measurement entirely.
Illiquid markets
When markets are illiquid or inactive, quoted prices may not represent fair value. The price at which a distressed seller disposes of an asset may be well below what a willing buyer would pay in an orderly transaction. Determining what constitutes an orderly transaction in these conditions requires careful judgement.
Fair value and tax
For UK tax purposes, profits are generally calculated on an historical cost basis, regardless of the accounting standard used. This means that fair value gains and losses recognised in the accounts may not be taxable or deductible until the asset is actually disposed of.
The divergence between accounting fair values and tax values creates temporary differences that give rise to deferred tax. Entities must track these differences and recognise deferred tax assets or liabilities as appropriate under FRS 102 Section 29.
Disclosure requirements
When fair value is used, FRS 102 requires disclosure of the methods and significant assumptions used, whether values are based on market prices or valuation techniques, and the gains and losses recognised. These disclosures help users assess the reliability of fair value measurements.