When it comes to running a small business, accurate accounting plays a vital role. Not having a proper understanding of your assets or liabilities can disrupt your cash flow or make you miss opportunities for expansion because you didn't realize you had the financial opportunity. To successfully run your business, you want to make sure you have a thorough understanding of accurate small business accounting.
One common method of accounting is known as fair value accounting. We'll explore what this accounting system means for your business and how the process of looking at current market value works when evaluating a business's worth. Here's what you need to know.
What Is Fair Value Accounting?
Fair value accounting is a system of bookkeeping that looks at the valuation of market prices of a particular asset or liability when doing the balance sheet for a business. It was established by the
Financial Accounting Standards Board (FASB) and is outlined under U.S. GAAP (generally accepted accounting principles).
This system looks at how much a particular asset could be sold for on the real market to determine its worth to the business. For investments, this can be done by listing shares of the company on a publicly traded exchange; for small companies, the pricing is managed more in-house. Fair value accounting operates differently than historical cost accounting, which uses past financial statements and focuses on the value of an asset when first purchased.
However, when determining the fair market value, businesses must consider a few key concepts. These can help paint a more complete picture of the current value of a particular asset or liability so as to better understand the business's financial situation.
- Current market conditions: For this category, you must examine the current market for the asset or liability. You want to see current quoted prices for particular assets or liabilities rather than looking at how they sold in the past.
- Intent: Accounting rules articulate that the intent of the seller must also be considered. For example, someone interested in quickly selling a particular item might be more inclined to accept a lower price than someone who can take their time when selecting a buyer.
- Orderly transaction: The orderliness of a particular transaction refers to whether there are any outside circumstances that might impact the sale. If the business owner needs to liquidate assets, for example, the sales process will be different than someone who is shifting from producing one type of product to another and wants to see off the remaining inventory of the old product.
- Third party: The third party refers to the person buying the asset. If the market participants are unrelated to the seller, they might respond differently to various price points compared to someone connected to the seller in some way.
As you can see, the four categories demonstrate how market value can be subtly influenced, which need to be accounted for.
How Do You Determine Fair Market Value?
Determining the fair market value of a product is done by following the hierarchy laid out by IFRS 13 Fair Value Measurement. Within this structure, there are three levels that can be used to calculate the fair value for particular financial assets or liabilities. Whenever possible, the first level of data inputs gets prioritized because it provides the clearest comparison with a similar active asset or liability for sale. However, when that information is unavailable, fair market value inputs will be selected from the other levels.
This fair value hierarchy is designed to provide businesses with a guide to select their inputs to different valuation techniques. They don't estimate the market value of a particular asset or liability.
- Level 1: Level one data points look at how similar or even identical assets or liabilities are currently sold on the market. This requires examining only active markets for assets or liabilities of equal value. The stock exchange provides an excellent example of this, as stocks can be constantly evaluated and compared to each other in real time.
- Level 2: Level two data inputs look at similar assets in an active market or an inactive market. Like level one, these are observable inputs to note. Most people become familiar with this level of evaluation when buying and selling a home. Real estate professionals use this level to determine price points based on similar buildings in similar locations.
- Level 3: Level three data inputs can be used if no data is available regarding similar assets or liabilities. These are unobservable inputs. In this situation, subjective information regarding the likely value of the asset or liability is included in the calculation.
Once you have your data inputs, you'll want to utilize a valuation technique to give you an actual usable value. There are three main strategies you can utilize to find the present value. Each approach will give you a different answer and you will need to determine which approach best fits with the assets and liabilities you hold.
Market Approach
The market approach involves looking at the value of other similar businesses within the same time frame. This strategy can help determine the value of a company while it is still private.
This strategy involves carefully looking at how the market currently performs in a particular sector and the financial instruments of the business.
In real estate, agents often refer to this strategy as "comps," as it involves using comparable properties to determine the fair value of a house or commercial property.
Income Approach
The income approach is most frequently used when determining the value of a property or business that will be used to generate income. When using this method, buyers must take into account the condition of the property, which may impact their ability to rent it out. It will also otherwise diminish their returns by forcing a greater upfront investment in repairing any damages.
Cost Approach
The cost approach is also typically used when determining the fair market value of real estate, such as commercial real estate. This strategy looks at the cost of the land, how much it would cost to build the structure entirely from scratch right now, and then subtracts some cost based on depreciation.
For businesses, this is an asset-based strategy that looks directly at the net assets of the business. However, the main drawbacks are that it does not account for any intangible value, such as the power of the brand, and it relies on historical cost over fair market value for certain calculations.
Let Skynova Help You Manage Your Small Business's Financial Reporting
Understanding how to find fair value estimates can help you as you build your small business and take control of your accounting. Although it can seem confusing to run a business in the United States, including understanding the different account regulations, Skynova is here to help. With accounting software and business templates to help you with each step of the process, our software products are designed to help small business owners thrive.
Those interested in working with fair value accounting will find that our software makes it easy to enter key information, such as the book value of assets and measurement date, so that you can move forward confidently. Mark-to-market and exit prices can all help you properly derive the value of your business and get incorporated into your accounting setup.
Don't let small business accounting overwhelm you any longer. Get started with Skynova today.
Notice to the Reader
The content within this article is meant to be used as general guidelines for accounting and business valuation and may not apply to your specific situation. Always consult with a certified public accountant (CPA) to ensure you're meeting accounting standards.