Fair value in accounting is the price you would receive to sell an asset, or pay to transfer a liability, in an orderly transaction between market participants at the measurement date. It is an exit price, not a purchase price, and it comes from FASB ASC Topic 820.1SEC. ASC 820-10 Fair Value Definition The number reflects what the market would pay right now, not what the company originally spent, and it is built using a three-level hierarchy that ranks inputs by how observable they are.
What ASC 820 Actually Requires
The definition has several moving parts, and each one carries weight.
The transaction must be orderly. That rules out fire sales, forced liquidations, and any pricing set under duress. The participants are hypothetical: independent, knowledgeable, and acting in their own financial interest. The measurement date fixes the value to a specific point in time rather than an average across a period or a projection forward.
Fair value assumes the transaction happens in the principal market for the asset or liability, meaning the market with the greatest volume and level of activity for that item.2SEC. Fair Value Disclosures If no principal market exists, the measurement defaults to the most advantageous market, which maximizes what would be received for an asset or minimizes what would be paid to settle a liability. The company does not have to search every possible market, but it cannot ignore a market it has access to.
Highest and Best Use for Nonfinancial Assets
For nonfinancial assets like real estate, machinery, or natural resources, ASC 820 adds another requirement: the value must reflect the asset’s highest and best use from a market participant’s perspective, even if the company uses it differently today. A factory sitting on waterfront land that developers would pay a premium for is valued for that development potential, not for its current industrial use.
The analysis considers whether value is maximized on a stand-alone basis or in combination with other assets, and it screens for uses that are physically possible, legally permissible, and financially feasible. A company can presume its current use is the highest and best use when no market evidence suggests otherwise, so this does not force a full appraisal every reporting period. The concept does not apply to financial assets, derivatives, or liabilities.
Fair Value Is Not the Same as Fair Market Value
The two terms sound interchangeable and produce different numbers often enough that the distinction matters. Fair value is the accounting standard under ASC 820, used for financial reporting. Fair market value is the tax standard, rooted in IRS Revenue Ruling 59-60, which defines it as the price at which property would change hands between a willing buyer and a willing seller, neither under compulsion, both having reasonable knowledge of the relevant facts.
Both assume a hypothetical arm’s-length transaction and reject forced-sale pricing. But fair value under ASC 820 is an exit price measured in the principal market, while fair market value under the IRS framework rests on a broader willing-buyer, willing-seller concept without anchoring to a specific market. The practical gap shows up most often in business valuations and estate tax appraisals, where the two frameworks can produce meaningfully different figures for the same asset. If you are reading a financial statement, you are looking at fair value. If you are filing a tax return or valuing an estate, you are dealing with fair market value.
The Three-Level Fair Value Hierarchy
ASC 820 sorts the inputs used in a fair value measurement into three tiers based on how reliable and observable they are. The hierarchy gives the highest priority to Level 1 inputs and the lowest to Level 3.2SEC. Fair Value Disclosures Companies must use the highest-level input available for each measurement, and the level assigned to the overall measurement reflects the lowest-level input that is significant to the entire calculation, not the highest.
Level 1: Quoted Prices in Active Markets
Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities. A share of stock trading on a major exchange is the classic example. The closing price is public, verifiable, and requires no judgment. These measurements carry the highest transparency and the lowest audit risk.
One important restriction: companies cannot apply a blockage factor at Level 1. A blockage factor is a discount reflecting that selling a large position all at once would move the market against the seller. ASC 820 prohibits it. If a company owns 5 million shares of a listed stock, the fair value is the quoted share price multiplied by the number of shares, even if dumping that volume would realistically depress the price. The standard treats the individual share as the unit of account.
Level 2: Observable Inputs Other Than Quoted Prices
Level 2 inputs are observable market data that fall short of Level 1’s strict criteria. Common examples include quoted prices for similar (but not identical) assets in active markets, quoted prices for identical assets in markets that trade infrequently, and market-corroborated data like interest rates, yield curves, and credit spreads. A corporate bond that trades only a few times per month might be valued using the yield curve for bonds with similar credit ratings and maturities, adjusted for specific differences.
Level 2 requires professional judgment to adjust for differences between the item being measured and the comparable data. The key distinction from Level 3 is that the inputs remain grounded in observable, verifiable market data rather than the company’s own assumptions.
Level 3: Unobservable Inputs
Level 3 applies when there is little or no market activity for the asset or liability. The company relies on its own assumptions about what market participants would consider when pricing the item, often using internal models, projected cash flows, or proprietary data. Private equity holdings, complex derivatives, and unique real estate typically land here.
Because these inputs are subjective, Level 3 measurements attract the heaviest audit scrutiny and the most detailed disclosure requirements. Companies must reconcile beginning and ending Level 3 balances each period, describe the valuation process, identify the specific unobservable inputs used, and explain how changes in those inputs would affect the measurement.
Transfers Between Levels
Assets and liabilities can move between levels as market conditions change. A bond that was actively traded (Level 1) may become illiquid during a credit crisis and shift to Level 2 or Level 3. Companies must disclose the amounts of and reasons for significant transfers between levels and must apply a consistent policy for when transfers are recognized. That policy has to be symmetrical; you cannot recognize transfers into Level 3 at the beginning of the period and transfers out at the end.
How the Number Gets Calculated
ASC 820 identifies three broad approaches to estimating fair value. A company selects the approach, or combination of approaches, most appropriate given the available data and the nature of the asset or liability.2SEC. Fair Value Disclosures
Market Approach
The market approach uses prices and other data from actual transactions involving identical or comparable assets. Valuing a commercial building means looking at recent sales of similar buildings in the same area and adjusting for differences in size, condition, and location. This method works best when a robust history of comparable transactions exists, which is why it dominates valuations of publicly traded securities and real estate.
Income Approach
The income approach converts future expected cash flows into a single present-day value. Discounted cash flow analysis is the most common technique: project the asset’s future earnings, then discount them back at a rate reflecting current market risk and the time value of money. This approach is standard for intangible assets like patents or customer relationships, where the primary value lies in revenue the asset will generate over time.
Cost Approach
The cost approach measures what it would take to replace the service capacity of an asset today, adjusted for physical wear and economic obsolescence. For a custom-built production line with no active resale market, the cost approach asks what a market participant would pay to acquire a substitute with comparable utility. It shows up most often for specialized equipment and single-purpose facilities where comparable market transactions are rare.
Net Asset Value as a Practical Expedient
For certain investments, ASC 820 provides a shortcut. Entities can use net asset value per share, or its equivalent (such as member units in a partnership), as a practical expedient to measure fair value when the investment does not have a readily determinable fair value.3FASB. ASU 2015-07 Fair Value Measurement Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share This comes up often with hedge fund investments, private equity fund interests, and real estate funds. Investments measured under this expedient are not categorized within the three-level hierarchy but are disclosed separately.
When Fair Value Applies
Fair value is not applied to every line item on a balance sheet. It kicks in under specific circumstances defined by various accounting standards.
Recurring and Nonrecurring Measurements
Recurring fair value measurements happen every reporting period for assets and liabilities carried at fair value on an ongoing basis, like available-for-sale securities and derivatives held for trading. Nonrecurring measurements arise only when a specific event triggers a revaluation, such as an impairment write-down on a long-lived asset or the initial recognition of an asset acquired in a business combination.4SEC. Fair Value Measurements The distinction matters because recurring measurements come with more detailed and ongoing reporting.
Business Combinations and Goodwill
When one company acquires another, it must record all acquired assets and assumed liabilities at fair value on the acquisition date. Goodwill, the amount paid above the fair value of identifiable net assets, is then subject to ongoing impairment testing. Under Topic 350, companies must test goodwill for impairment at least annually by comparing the fair value of a reporting unit to its carrying amount. If the carrying amount exceeds fair value, the difference is recognized as an impairment loss.5FASB. Goodwill Impairment Testing Companies can perform a qualitative assessment first to determine whether it is more likely than not that fair value is below carrying amount, avoiding the full quantitative test when the answer is clearly no.
Crypto Assets
Starting with fiscal years beginning after December 15, 2024, FASB ASU 2023-08 requires companies to measure qualifying crypto assets at fair value each reporting period, with changes recognized in net income.6FASB. Accounting for and Disclosure of Crypto Assets Before this update, crypto was treated as an indefinite-lived intangible asset, so companies could write down losses but could not recognize gains until they sold. The new rule applies to crypto assets that are fungible, secured through cryptography, reside on a blockchain, do not give the holder enforceable claims on other assets, and are not issued by the reporting entity itself. Bitcoin and Ethereum meet these criteria; stablecoins and NFTs generally do not.
The Fair Value Option
Under ASC 825, companies can voluntarily elect to measure certain financial assets and liabilities at fair value on an instrument-by-instrument basis.7SEC. Summary of Significant Accounting Policies Once made, the election is irrevocable unless a new election date occurs, and unrealized gains and losses flow through earnings each reporting period. Companies typically use this option to reduce accounting mismatches, where economically related assets and liabilities would otherwise be measured under different frameworks and create artificial volatility in the financial statements.
How Fair Value Interacts With Taxes
Fair value adjustments for financial reporting do not automatically create taxable events. Most companies report book income under GAAP and taxable income under the Internal Revenue Code, and the two systems often diverge on when gains and losses are recognized. The main exception is dealers in securities, who are required under Section 475 of the Internal Revenue Code to use mark-to-market accounting for tax purposes.8Office of the Law Revision Counsel. 26 USC 475 Mark to Market Accounting Method for Dealers in Securities
Under Section 475, a dealer must recognize gain or loss as if each non-inventory security were sold at fair market value on the last business day of the taxable year. Any resulting gain or loss is treated as ordinary income or loss, not capital gain. The rule applies to any taxpayer who regularly buys or sells securities to customers in the ordinary course of business.9govinfo.gov. 26 USC 475 Mark to Market Accounting Method for Dealers in Securities Securities held purely for investment are excluded, but the taxpayer must clearly identify them in their records before the close of the day the security was acquired. Dealers in commodities can make a similar election, which once made applies to all future taxable years unless the IRS approves a revocation.
For non-dealer companies, the unrealized gains and losses that appear on a GAAP income statement from fair value adjustments typically create temporary differences that reverse when the asset is sold. Those differences show up as deferred tax assets or liabilities on the balance sheet but do not affect cash taxes until the gain or loss is realized through an actual transaction.