Let’s say you need to come up with a value for something – a company, a hard asset, intellectual property, shares of stock. The measure is often Fair Market Value or Fair Value – two terms that get treated as if they are identical. Except Fair Market Value and Fair Value are not identical and their differences matters. So, let’s answer the question:
What is the difference between Fair Market Value and Fair Value?
Let’s start with the definitions.
|FAIR MARKET VALUE||FAIR VALUE|
|The search for the price at which the property would change hands between a willing buyer and a willing seller under no compulsion to buy.||The search for the price to sell an asset or paid to transfer a liability in an orderly transaction between market participants.|
To my eye, these definitions look identical. But, they are different. And the reason they are different is because of where they come from and how they get used. Fair Market Value is the Internal Revenue Service’s (“IRS”) measure. The IRS has actually defined Fair Market Value in an IRS Revenue Ruling (59-60). Since Fair Market Value is the tax man’s measure, there is an enormous amount of case law analyzing and defining Fair Market Value. Case law and history beget comfort, so appraisers and accountants rely on Fair Market Value as a standard measure for assets and enterprises and real estate.
In contrast, Fair Value is the standard of valuation under Generally Accepted Accounting Principles, which is the sort of official set of accounting rules put out by the Financial Accounting Standards Board (“FASB”) FASB gets its authority from the Securities Exchange Commission, the regulator of stocks and bonds. FASB’s job is to set standards for financial reporting under US GAAP. So, Fair Value is the sort of the publicly-traded stock valuation measure. Fair Value is used in Black Scholes, Lattice Model and other valuation strategies for options. Sometimes, Fair Market Value valuations conducted for tax purposes don’t comply with Fair Value and have to be revalued.
The difference goes beyond source – it also includes inputs. Fair Market Value gets to an objective estimate of what fictional, fungible, fully-informed reasonable and willing buyers and sellers would pay and accept for something. Fair Value aims to show what “two specific parties taking into account the respective advantages or disadvantages that each will gain from the transaction.[i]” Fair Value tries to pull in the idiosyncrasies of the parties while Fair Market Value approaches valuation from a slightly more theoretical position.
There is actually a horse race between Fair Market Value and Fair Value. Though Fair Market Value started in the lead, Fair Value is coming up on the outside, propelled by globalization. If Fair Market Value represents the old economy, market oriented approach, Fair Value has developed into a set of three tiers that starts off by using lofty variables from the market and drills down to take into account hard-to-get information as well as grass roots facts.
Fair Value is picking up steam. In 2009, FASB got its arms around GAAP and reogrnized it into a single collection of rules called the FASB Accounting Standards Codification (“ASC”). FASB claims it didn’t kill GAAP, but it did seem to start to sedate it. GAAP were American rules for accounting – now that America’s financial statements get shared increasingly around the world, our methods of accounting are out of step, sometimes requiring restatement to match International Financial Reporting Standards (“IFRS”). The IFRS are established and maintained by the International Accounting Standards Board (“IASB”). IASB and FASB are right now working together to converge the international and US accounting standards – their report is due during the second half of 2012. Here is the Profit and Laws prediction: the IRS will switch to Fair Value by 2015. You heard it here first. Disagreements welcome.
[i] International Valuation Standards 2007.