Fair Value Accounting

Every company keeps records of what it owns. This record is called a balance sheet. The question then arises as to what number should be entered there for a given asset. One option is the price that was paid at the time of purchase. The other option is the price one would receive today if the item were sold. This second figure is precisely what is called fair value. Fair value accounting, then, does not carry the past into the books, but the present.

Why this makes balance sheets more volatile

The old purchase price is a convenient figure. It is fixed and never changes. But that is exactly its problem. A bank that bought shares for 100 million euros would still carry that figure in its books even if the shares were now worth only 40 million. Anyone reading the balance sheet would get a completely false picture of the situation.

Fair value accounting is meant to prevent this. Investors, regulators, and lenders see what the company actually has today. That is the great advantage: more honesty about the current market situation.

The price for this is turmoil. When markets rise and fall, that movement immediately flows into the balance sheet and often into reported profit as well. A company can report losses without having sold anything at all. Critics therefore accuse the method of amplifying crises: in a crash, everyone has to write down assets at the same time, which further fuels panic. This effect is called procyclicality.

The three levels to a price tag

The simplest case is when a genuine market price exists. A stock traded on an exchange has a price every day. You look it up, enter the figure, and you’re done. Experts refer to this as level one, or Level 1.

Often there is no direct price. In that case, one looks for comparable items for which prices exist. A rarely traded security can be measured against similar securities, an office building against recently sold neighboring buildings. This is level two: calculating using observable external data.

Level three is the tricky case. Here there is neither a price nor a good comparison. In that case, the company estimates the value itself, usually using a calculation model that converts future income into today’s terms. Assumptions flow into the model: expected growth, interest rates, default risks. Anyone who changes these assumptions changes the result. This is precisely why auditors scrutinize level three so closely.

Where this figure turns up in the news

Fair value is most often mentioned in connection with banks and insurers. They hold large portfolios of bonds and stocks whose values are constantly fluctuating. This became a hot topic during the 2023 banking crisis: several US banks were sitting on bonds that had lost significant market value due to rising interest rates. As long as they held onto the securities, the loss remained invisible. When they had to sell, it became real.

The term is also common in the technology industry. Venture capital firms and funds hold stakes in start-ups that are not publicly traded. Their value is a level-three estimate. When an AI start-up is said to be worth ten billion, there is rarely an actual sale behind that figure — instead, it’s the price of the last funding round plus a model.

A common misconception: fair value does not mean fair or objectively correct. The word “fair” here simply means in line with the market. And a market price can be exaggeratedly high or panic-strickenly low. The method reflects the mood of the market, not some higher truth about the value of a thing.