Lesson 52 - Intermediate Accounting Course 

52. Fair Value Accounting for Financial Instruments

Fair value accounting is a method used to measure and report financial instruments at their current market value rather than their historical cost. This approach ensures that financial statements reflect the most accurate and up-to-date valuation of assets and liabilities, making them more useful for investors, regulators, and analysts.

1️⃣ What Is Fair Value Accounting?

Fair value accounting measures financial instruments—such as stocks, bonds, and derivatives—based on their current market price or an estimated value when no market price is available. The goal is to provide a realistic valuation rather than relying on past purchase costs.

According to IFRS 13 and ASC 820 (GAAP), fair value is defined as:

“The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

This means fair value represents the exit price or the amount an investor would receive if they sold the asset at the reporting date.

2️⃣ Why Use Fair Value Accounting?

✅ More Accurate Financial Reporting – Reflects real-time market conditions.
✅ Better Decision-Making – Investors and analysts get updated valuations.
✅ Transparency – Reduces manipulation of financial statements.
✅ Risk Assessment – Helps companies evaluate their exposure to market fluctuations.

However, fair value accounting can also lead to earnings volatility because prices change frequently.

3️⃣ Fair Value Hierarchy (IFRS & GAAP)

To ensure consistency, financial instruments are classified into three levels based on the reliability of the valuation method used:

The reliability of valuation decreases as you move from Level 1 to Level 3.

4️⃣ Fair Value Accounting for Different Financial Instruments

A. Equity Securities (Stocks & Shares)

✔ Publicly traded stocks use market prices (Level 1).
✔ Private company shares require valuation models (Level 3).
✔ Gains or losses from changes in fair value go to the income statement under IFRS and GAAP.

Example Journal Entry for an Increase in Stock Value:

Investment in Stock     $5,000  

      Unrealized Gain         $5,000 

This recognizes a gain when the investment value increases.

B. Bonds and Fixed-Income Securities

✔ Government bonds are valued based on market quotes (Level 1).
✔ Corporate bonds are often valued using market comparables (Level 2).

C. Derivatives (Options, Swaps, Futures)

✔ These financial instruments must always be recorded at fair value.
✔ Their value is often based on mathematical models (Level 2 or 3).

D. Loans and Receivables

✔ If traded in active markets, loans are recorded at fair value (Level 1 or 2).
✔ If not actively traded, companies estimate values using discounted cash flows (Level 3).

5️⃣ Fair Value vs. Historical Cost Accounting 

Some assets, like land or equipment, are not measured at fair value unless revaluation is allowed under IFRS.

6️⃣ Challenges and Criticism of Fair Value Accounting

❌ Market Volatility – Changes in market prices can lead to large swings in earnings.
❌ Subjectivity in Level 3 Valuations – No active market means reliance on models.
❌ Liquidity Issues – Some assets may not have an easily determinable fair value.

7️⃣ Key Takeaways

✔ Fair value accounting provides real-time valuation of financial instruments.
✔ Three levels of fair value hierarchy ensure transparency and reliability.
✔ Widely used for stocks, bonds, derivatives, and loans but not always for fixed assets.
✔ Provides more relevant information than historical cost but can increase earnings volatility.