A fair value adjustment is a type of accounting process that makes it possible to reassess the fair value when there is a considerable difference between that figure and the current book value of an asset. Managing this type of adjustment requires taking some time to engage in what is known as revaluing in order to bring the two figures into closer harmony. There are a number of reasons why a fair value adjustment may be necessary, including significant shifts in the market value of the assets involved, or when the assets are involved in a business acquisition.
The exact process of conducting such an adjustment will depend on the type of asset involved and what has occurred to create the wider disparity between the currently identified fair value and the book value of that asset. For example, if the asset involved is a piece of real estate, then the process will require identifying the current market value, based on the increases or decreases in demand for similar properties in the immediate area. This can be compared to both the book value and the current fair market value and taken into account when determining a reasonable and fair amount for the adjustment.
One of the more common approaches with fair value adjustment relies on identifying a similar event or situation for comparison, then making the adjustment accordingly. It is not unusual for several similar situations to be considered, effectively making it possible to utilize the sum total of those events to arrive at an adjustment that is within reason. First priority goes to events that are exactly like the situation cited for readjustment, with similar events being considered when and if there are no exact matches readily available for scrutiny.
While a fair value adjustment is often based on factual information gathered for purposes of ensuring the adjustment is reasonable and logical, there is also some degree of subjectivity that may be present. The idea is to limit the amount of subjectivity that is brought to the task and make efforts to evaluate the available data with the highest degree of objectivity as possible. Doing so helps to minimize the chances of the fair value adjustment not really addressing the underlying reasons for the disparity between the book value and the current fair value, while also increasing the chances that the fair value is more in line with the current market value.
How To Calculate Fair Value Adjustment
Calculating the fair value adjustment is conceptually very simple. It is nothing more than the difference between the current book value of an asset and its fair value on the market. If the fair value is greater than the book value, subtract the latter from the former to calculate the gain. If the reverse is true, subtract the former from the latter to calculate the loss.
However, the key challenge is determining what the fair value of the asset is. For publicly traded securities, such as corporate bonds and stocks, this is fairly simple. You can just look up the most recent closing price to get an accurate fair value. Similarly, if the asset is a commodity, it will have a well-established and publicly available market price.
For other assets, the process can become a little more challenging. You can potentially work off of pricing data for similar assets. For example, if you are trying to determine the fair value of real estate, you can look at recent local property sales prices and adjust according to the relative size of your property. For machinery and other capital assets, you may be able to find data on resale values. In some cases, it may be worthwhile to have an independent appraiser assist with the process. In some cases, an independent appraiser may be legally required to determine the value.
Although it is perfectly legal to make reasonable fair market adjustments to your books to account for gain or loss of value, it is illegal to misrepresent the value of assets to try to defraud others. For example, you can’t claim a huge and unsubstantiated loss of fair value to lower your taxes. Similarly, you can’t claim a baseless increase in value to attract investment.
In short, you should always make sure your fair value adjustments are based on a reasonable assessment of fair market value and that you have the paperwork and data to back up your assertions. If you can demonstrate that a generally accepted process was used to estimate the fair value, you will likely avoid any legal issues, even if there is a disagreement over the value of an asset.
How To Record Fair Value Adjustment
Recording a fair value adjustment is typically simple. However, the correct process depends slightly on the type of asset(s) being adjusted. For example, a change in the value of a portfolio of securities is handled differently than a change in the value of real estate. It is important to note that fair value adjustments are different than the depreciation of carrying value.
You do not necessarily need to include a fair value adjustment in your income or balance sheet. This is typically only done when the change is significant. Otherwise, you can wait until you realize the loss or gain at the point of selling the asset. For certain assets, you may apply standard depreciation during this period.
To record your fair value adjustment, you will need to make a journal entry that affects the balance sheet account of the asset and your income. If the fair value has increased, you would debit the valuation account and credit your income. For losses, you should credit the valuation account and debit your income.
It is a good idea to work with a professional accountant when making fair value adjustments. The rules can vary depending on jurisdiction and elected accounting method.
Are Dividends Accounted in Adjusting to Fair Value Trading SEC?
No, dividends are not directly accounted for in fair value adjustments. They are only reflective of changes in the fair market value of an asset. Any dividends would be recorded separately as income.
Of course, dividends may impact the fair value of an asset. This may have a positive impact because it reflects that the business is profitable and potentially lucrative. However, it may also have a negative impact if there is a perception that a potential investment and subsequent growth was missed due to paying dividends. Thus, the dividends are indirectly accounted for, even if they are not a direct part of the equation.
It is worth noting that fair market adjustments for securities are most commonly used for hold-for-trading securities. These are stocks and bonds that have been purchased with the intention of selling them within a short timeframe (typically a year). Thus, dividends are not typically a major element of the buying or selling decisions. Instead, securities that may be impacted by fair value adjustments are typically those that are expected to be profitable due to changes in value.