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Fair value accounting requires a company to periodically assess the value of items on its balance sheet. To do this, accountants can use fair value models to change the value of items on the financial statement. A few of the more common types of models include discounted cash flows, the relative model, and option pricing models, though others may exist. Accountants must ensure a company follows all applicable national accounting standards when using fair value models. In some cases, accountants may have to make an estimate as no model will provide an exact figure for fair value.
Discounted cash flows are common fair value models that work best for assets or other projects that generate a financial return. Accountants look at the number of useful years left for the asset or other item. The future cash flows from this item need to be discounted to current dollar value using a cash flow factor. This allows the company to assess the current value of projects, investments, or assets compared to the balance sheet value. Differences between the values will probably result in an adjustment for the value of these items.
Relative fair model values use observed market values to produce a current value for assets or other items. Accountants must find an open market that contains either the exact same asset, investment, or item. If a market does not exist where the same item changes hands frequently, then a market with similar items may be usable. Either way, the market provides observable data that accountants can plug into fair value models. The observed data then results in a fair value so accountants can make adjustments as necessary for the balance sheet items.
Option pricing models are the final group accountants can use for fair value purposes. These types of fair value models are most common for financial securities or investments. National accounting standards often require companies to adjust the value of these items due to the frequency of changes in value. Many of these models include technical or complex calculations that use corporate finance formulas. Accountants look at current financial markets and determine which of the finance formulas will make the best model.
Disclosures are typically necessary to inform stakeholders about the fair value models used for valuation. Auditors also look at the models used to ensure they are appropriate and provide accurate data. If they do not, this can result in a serious violation that requires the company to revalue its assets, investments, or other items.