Fair Market Value

Definition

Fair market value is the price that an asset or service would sell for on the open market between a willing buyer and a willing seller, where both parties are knowledgeable, and neither is under any compulsion to act. It is the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm's length transaction, after proper marketing, and where the parties had each acted knowledgeably, prudently, and without compulsion.

5 Must Know Facts For Your Next Test

1. Fair market value is the price that a willing buyer and a willing seller would agree on in an open and competitive market, where both parties have full knowledge of the relevant facts.
2. Fair market value is often used as a basis for taxation, financial reporting, and valuation of assets and liabilities in various contexts.
3. Determining fair market value can be challenging, as it requires considering a range of factors, such as the asset's condition, location, demand, and any restrictions or encumbrances.
4. Fair market value is different from intrinsic value, which is the inherent worth of an asset based on its underlying characteristics and potential future benefits.
5. The concept of fair market value is closely related to the principle of arm's length transactions, where the parties involved are independent and acting in their own self-interest.

Review Questions

• Explain the role of fair market value in the Statement of Owner's Equity.
  • The Statement of Owner's Equity is a financial statement that tracks changes in a company's equity over an accounting period. Fair market value is relevant in this statement because it is used to determine the value of assets and liabilities that are contributed to or withdrawn from the business by the owner. For example, if an owner contributes an asset to the business, the fair market value of that asset would be recorded as an increase in the company's equity. Similarly, if an owner withdraws an asset from the business, the fair market value of that asset would be recorded as a decrease in the company's equity.
• Analyze how the concept of fair market value is applied in the valuation of assets and liabilities on the Statement of Owner's Equity.
  • The Statement of Owner's Equity requires the use of fair market value to properly account for changes in a company's equity. When an owner contributes an asset to the business, the fair market value of that asset is recorded as an increase in equity. Conversely, when an owner withdraws an asset from the business, the fair market value of that asset is recorded as a decrease in equity. Additionally, if the company issues new shares of stock, the fair market value of those shares would be recorded as an increase in equity. The use of fair market value ensures that the Statement of Owner's Equity accurately reflects the true economic value of the owner's interest in the business.
• Evaluate the importance of fair market value in the preparation and interpretation of the Statement of Owner's Equity, and explain how it impacts the overall financial reporting of the business.
  • Fair market value is a critical concept in the preparation and interpretation of the Statement of Owner's Equity because it provides an objective and reliable measure of the value of assets, liabilities, and equity transactions. By using fair market value, the Statement of Owner's Equity accurately reflects the changes in the owner's equity, which is essential for understanding the financial health and performance of the business. The use of fair market value also ensures consistency and comparability in financial reporting, as it provides a standardized basis for valuing assets and liabilities across different companies and time periods. Furthermore, the information presented in the Statement of Owner's Equity, based on fair market value, is crucial for decision-making by both internal and external stakeholders, such as investors, creditors, and regulatory authorities.

Related terms

Market Value: The price at which an asset would trade in a competitive market, based on what informed buyers and sellers would agree is a fair price.

Intrinsic Value: The true or inherent value of an asset, based on an evaluation of relevant quantitative and qualitative factors, rather than its market price.

Arm's Length Transaction: A transaction between two unrelated and unaffiliated parties who are acting in their own self-interest and are not subject to any pressure or duress from the other party.