GAAP's definition of fair value

GAAP defines fair value as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transactions between market participants at the measurement date" (ASC 820-10-35-2).

How is fair value estimated?

GAAP defines a three level fair value hierarchy (see below). Level 1 is the best way to measure fair value, level 2 is permitted when level 1 information is not available, and when all else fails, level 3 is permitted.

Bond example

• Suppose our company has bonds outstanding at December 31, 2020 and their current value in the balance sheet is $671,297 (i.e., their book value).

• Suppose we determine the bonds fair value is $714,943.

• We then have to update the value in the balance sheet at December 31, 2020 with the following entry.

It is important to note that changes in fair value that are related to changes in the credit risk of the debt are recorded to other comprehensive income which is a shareholders' equity account.

If fair value changes for other reasons (e.g., fluctuations in market interest rates), the debit in the entry above would be to an income statement (loss) account.