Final answer:
Fair value is the price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. It is determined based on exit price and is a key concept in GAAP.
Step-by-step explanation:
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It is determined based on the exit price, which is the price at which an asset or liability could be exchanged or settled in a current transaction between knowledgeable, willing parties.
Fair value is a key concept in U.S. generally accepted accounting principles (GAAP) and is used to measure the value of assets and liabilities in financial statements.
To determine fair value, various valuation techniques can be used, such as market approach, income approach, and cost approach. The market approach involves comparing the asset or liability to similar assets or liabilities that have been sold in the market. The income approach considers the present value of the future cash flows the asset or liability is expected to generate. The cost approach estimates the replacement cost of the asset or liability.
For example, let's say a company owns a building. To determine the fair value of the building, the company may compare it to recent sales of similar buildings in the area (market approach), estimate the future rental income it can generate (income approach), and consider the cost to construct a similar building (cost approach). The fair value of the building would be the estimated value based on these valuation techniques.