How to Distinguish the Differences Between the Terms "Fair Market Value" & "Fair Value"
Fair market value and fair value are two distinct standards of value. The federal tax courts for years have kicked around various methodologies and assumptions used to arrive at fair market value. Fair value is the preferred standard of value used in dissenting shareholder and minority shareholder oppression suits presided over at the state level. However, the proliferation of private equity funds using mark-to-market accounting has led to the need for increased transparency to increase investor confidence in capital markets. Regulatory bodies have increasingly moved toward fair value accounting standards.
Standards of Value
Because fair market value is the statutory standard for all federal tax cases, its Internal Revenue Service definition is generally the most accepted definition. You must consider arm's length transactions when turning to the market for data when you calculate fair market value. In calculating fair value, you focus on exit value -- the value of a business when it's being sold. You will likely arrive at widely divergent values for each standard of value. When estimating fair value, you must consider highest and best use; in the case of fair market value, you determine a hypothetical purchase price.
Control and Liquidity Considerations
Incorporate assumptions regarding the control and liquidity characteristics of the interest for which you are determining fair market value. Again, you will likely reach substantially different values between the two standards of value, because you typically will not consider control and liquidity factors when you calculate fair value. Investors typically pay premiums ranging from 10 percent to 30 percent to assume control of a company, depending on how much extra value can be extracted once control is asserted. Likewise, minority interest investments in privately traded companies typically trade at discounts of 25 percent and higher due to a lack of liquidity.
Refer to Financial Accounting Standards Board and IRS guidance in how to arrive at fair value and fair market value, respectively. FASB Accounting Standards Codification 820 lists eight steps for calculating fair value, including the provision of a hierarchy of valuation inputs. IRS Ruling 59-60 is an outline of the process for valuing closely held securities. Note the purpose and context these organizations consider when analyzing fair value, which is a complex process. You will typically need to differentiate between financial and nonfinancial assets when estimating fair value.
Financial Reporting Requirements
Financial assets include cash, equity and fixed income securities, contracts and receivables. According to the Securities and Exchange Commission, less than half of the assets of financial institutions can be valued using current market price. However, you may value a variety of nonfinancial assets for many purposes stated by FASB, including reporting for business combinations and goodwill impairment testing. Use fair market value to value intangible assets in the case of an ASC 805 valuation in connection with a business combination. Use fair value to value intangible assets not in use.