Fair Value Accounting

If a company has reason to believe an asset's value may be impaired, it's required to perform a formal estimate of its recoverable amount. This approach is similar to the concept of lower of cost or market value, which applies to inventory. Determining an asset's or liability's fair value less it's cost of disposal is one approach to determining its recoverable amount.

Accounting guidance on this topic is provided in FASB Accounting Standards Codification (ASC) Topic 820 - Fair Value Measurement, which breaks down estimates of fair value into three levels as explained below:

• Level One: includes valuations based on quoted prices, for identical assets or liabilities, in active markets. For example, this classification would include the common stock of a large corporation, whose shares are actively traded on the stock market and the price per share is certain.

• Level Two: includes valuations based on what are termed market observables. This category consists of less actively traded markets. For example, assets and liabilities that are similar, but not identical to those being valued; assets or liabilities or those that are similar, but not exactly the same, as one traded in an active market; as well as those that are not actively traded but sufficient market data is available to derive a fair value. Assets and liabilities that fall into this level require the accountant-analyst to document their assumptions when deriving a fair value.

• Level Three: includes valuations that are unobservable in the marketplace and require estimates based on a valuation technique. Since observable market information is not available to derive the fair value of the asset or liability, the value will be based on internally derived information. Once again, assets and liabilities that fall into this level require the accountant-analyst to document their assumptions when deriving a fair value.