A valuation allowance is a balance sheet line item that offsets all or a portion of the

value of a company's deferred tax assets because the company doesn't expect it will
be able to realize this value.
Sometimes, a company expects it will not be able to realize the benefits of its deferred tax
assets. For example, if a company loses $10 million, it would record a deferred tax asset
representing the decrease in taxes on its next $10 million in earnings. However, if the
company doesn't expect profits for the next several years, and doesn't expect to earn $10
million in the seven-year time horizon before these deferred tax assets expire, it can't
record them at full value - because the company won't be able to take advantage of this
tax benefit.
If a company expects there is more than 50% chance it will not be able to realize some of
its deferred tax assets (because its future income won't be large enough to take full
advantage of these tax breaks), it must report a valuation allowance to account for this.
Earnings Manipulation
A valuation allowance depends a great deal on management assumptions - who's to say
how high a company's future profits will be, and therefore whether the company will be
able to take advantage of its deferred tax assets? If management changes its assumptions
about future earnings, the valuation allowance changes, and the difference is reported as
earnings, today. So, management at companies with valuation allowances can directly
change reported earnings today by changing assumptions about earnings tomorrow.
Changing a valuation allowance is one way that management can manage or manipulate
its earnings.
ASSET IMPAIRMENT
What is Impairment?
Assets are said to be impaired when their net carrying value, (acquisition cost
accumulated depreciation), is greater than the future undiscounted cash flow that these
assets can provide and be disposed for.
Under U.S. GAAP impaired assets must be recognized once there is evidence of a lack of
recoverability of the net carrying amount. Once impairment has been recognized it
cannot be restored. Analysts must know that some foreign countries and the IASB allow
companies to recognize increases in previously impaired assets.
Asset impairment occurs when there are:

Changes in regulation and business climate

Declines in usage rate
Technology changes
Forecasts of a significant decline in the long-term profitability of the asset
Once a company has determined that an asset is impaired, it can write down the asset or
classify it as an asset for sale. Assets will be written down if the company keeps on using
this asset. Write-downs are sometimes included as part of a restructuring cost. It is
important to be able to distinguish asset write-downs, which are non-cash expenses, from
cash expenses like severance packages.

Write-downs affect past reported income. The loss should be reported on the income
statement before tax as a component of continuing operations. Generally impairment
recognized for financial reporting is not deductible for tax purposes until the affected
assets are disposed of. That said, in most cases recognition of an impairment leads to a
deferred tax asset.
Impaired assets held for sale are assets that are no longer in use and are expected to be
disposed of or abandoned. The disposition decision differs from a write-down because
once a company classifies impaired assets as assets for sale or abandonment, it is actually
severing these assets from assets of continuing operations as they are no longer expected
to contribute to ongoing operations. This is the accounting impact: assets held for sales
must be written down to fair value less the cost of selling them. These assets can no
longer be depreciated.
Assets Impairment - Effects on Financial Statements and Ratios

Past income statements are not restated. The current income statement will
include an impairment loss in income before tax from continuing operations. Net
income will also be lower.
On the balance sheet, long-term assets are reduced by the impairment. A deferredtax asset is created (if there was a deferred tax liability it is reduced).
Stockholders' equity is reduced as a result of the impairment loss included in the
income statement.
Current and future fixed-asset turnover will increase (lower fixed assets).
Since stockholders' equity will be lower, debt-to-equity will be lower.
Debt-to-assets will be higher.
Cash flow based ratios will remain unaffected (no cash implications).
Future net income will be higher as there will be lower asset value, and thus a
smaller depreciation expense.
Future ROA and ROE will increase.
Past ratios that evaluated fixed assets and depreciation policy are distorted by
impairment write-downs.

EFFECTS OF CAPITALIZING VS. EXPENSING

Expenses can be expensed as they are incurred, or they can be capitalized. A company is

able to capitalize the cost of acquiring a resource only if the resource provides the
company with a tangible benefit for more than one operating cycle. In this regard, these
expenses represent an asset for the company and are recorded on the balance sheet.
Effects of Capitalization on Key Figures
The decision to capitalize or expense some items depends on management. As such, this
choice will have an impact on a company's balance sheet, income statement and cash
flow statement. It will also have an impact on a company's financial ratios.
Here is what the decision will have an impact on:
Net income - Capitalizing costs and depreciating them over time will show a
smoother pattern of reported incomes. Expensing firms have higher variability in
reported income. In terms of profitability, in the early years, a company that
capitalizes costs will have a higher profitability than it would have had if it
expensed them. In later years, the company that expenses costs will have a higher
profitability than it would have had if it capitalized them.

Stockholders' equity Over a long time frame, the choice of expensing a cost or
capitalizing it will have little effect on a shareholders' total equity. That said,
expensing firms will have a lower stockholders' equity at first (less profit, thus
smaller retained earnings).

Cash flow from operations A company that capitalizes its costs will display
higher net profits in the first years and will have to pay higher taxes than it
would've had to pay if it expensed all of its costs. That said, over a long period of
time, the tax implications would be the same. But the choice for capitalizing over
expensing have a much larger effect on the reported cash flow from operations
and cash flow from investing. If a company expenses its cost it will be included in
cash flow from operations. If it capitalizes, then it will be included in cash flow
from investing (lower investment cash flow and higher cash flow from
operations).

Assets reported on the balance sheet - A company that capitalizes its costs will
display higher total assets.

Financial ratios A company that capitalizes its costs will display higher
profitability ratios at the onset and lower ratios in the later stages. Liquidity ratios
will experience little impact, except for the CFO ratio, which will be higher under
the capitalization method. Operation-efficiency ratios such as total asset and
fixed-asset turnover will be lower under the capitalization method, due to higher
reported fixed assets. Furthermore, at the onset, equity turnover will be higher
under the capitalization method (lower total equity due to lower net profit).
Companies that capitalize their costs will initially report higher net income, lower
equity and higher total assets. Remember that, on average, an equal dollar effect
on a numerator and denominator will produce a higher net result. That said, on
average, ROE & ROA will initially be higher for capitalizing firms. Solvency

ratios are better for firms that capitalize their costs because they have higher
assets, EBIT and stockholders' equity.
Consider figure 8.2 below for an overview of the effect of capitalizing and expensing on
key financial ratios.
What Does Capitalize Mean?
An accounting method used to delay the recognition of expenses by recording the
expense as long-term assets.
In general, capitalizing expenses is beneficial as companies acquiring new assets with a
long-term lifespan can spread out the cost over a specified period of time. Companies
take expenses that they incur today and deduct them over the long term without an
immediate negative affect against revenues.
Investopedia explains Capitalize
If a company capitalizes regular operating expenses, it is doing so inappropriately, most
likely to artificially boost its operating cash flow and look like a more profitable
company. Because a company can't hide its expenses forever, such a practice will fail in
the long run.
It is important not to confuse capitalize with capitalization.
What Does Amortization Mean?
1. The paying off of debt in regular installments over a period of time.
2. The deduction of capital expenses over a specific period of time (usually over the
asset's life). More specifically, this method measures the consumption of the value
of intangible assets, such as a patent or a copyright.
Investopedia explains Amortization
Suppose XYZ Biotech spent $30 million dollars on a piece of medical equipment and that
the patent on the equipment lasts 15 years, this would mean that $2 million would
be recorded each year as an amortization expense.
While amortization and depreciation are often used interchangeably, technically this is an
incorrect practice because amortization refers to intangible assets and depreciation
refers to tangible assets.
Amortization can be calculated easily using most modern financial calculators,
spreadsheet software packages such as Microsoft Excel, or amortization charts and tables.
What Does Capitalized Cost Mean?
An expense that is added to the cost basis of a fixed asset on a company's balance sheet.
Capitalized Costs are incurred when building or financing fixed assets. Capitalized Costs
are not expensed in the period they were incurred, but recognized over a period of time
via depreciation or amortization.

Investopedia explains Capitalized Cost

Capitalizing costs is an attempt to follow the Matching Principle of accounting. The
Matching Principle seeks to match expenses with revenues. In other words, match the
cost of an item to the period in which it is used, as opposed to when the cost was
incurred. As some assets have long lives and will be generating revenue during that
useful life, their costs may be amortized over a long period.
An example of this would be costs associated with constructing a new factory. The costs
associated with building the asset (including labor and financing costs) can be added to
the carrying value of the fixed asset on the balance sheet. These capitalized costs will be
recognized in future periods, when revenues generated from the factory output are
recognized.
What Does Goodwill Mean?
An account that can be found in the assets portion of a company's balance sheet.
Goodwill can often arise when one company is purchased by another company. In an
acquisition, the amount paid for the company over book value usually accounts for the
target firm's intangible assets.
Investopedia explains Goodwill
Goodwill is seen as an intangible asset on the balance sheet because it is not a physical
asset such as buildings and equipment. Goodwill typically reflects the value of intangible
assets such as a strong brand name, good customer relations, good employee relations
and any patents or proprietary technology.
What Does Book Value Mean?
1. The value at which an asset is carried on a balance sheet. To calculate, take the cost of
an asset minus the accumulated depreciation.
2. The net asset value of a company, calculated by total assets minus intangible assets
(patents, goodwill) and liabilities.
3. The initial outlay for an investment. This number may be net or gross of expenses such
as trading costs, sales taxes, service charges and so on.
Also known as "net book value (NBV)".
In the U.K., book value is known as "net asset value".
Investopedia explains Book Value
Book value is the accounting value of a firm. It has two main uses:
1. It is the total value of the company's assets that shareholders would theoretically
receive if a company were liquidated.

2. By being compared to the company's market value, the book value can indicate
whether a stock is under- or overpriced.
3. In personal finance, the book value of an investment is the price paid for a security or
debt investment. When a stock is sold, the selling price less the book value is the capital
gain (or loss) from the investment.
What Does Carrying Value Mean?
An accounting measure of value, where the value of an asset or a company is based on
the figures in the company's balance sheet. For assets, the value is based on the original
cost of the asset less any depreciation, amortization or impairment costs made against the
asset. For a company, carrying value is a company's total assets minus intangible assets
and liabilities such as debt.
Also known as "book value".
Investopedia explains Carrying Value
This is different from market value, as it can be higher or lower depending on the
circumstances, the asset in question and the accounting practices that affect them. In
many cases, the carrying value of an asset and its market value will differ greatly. This is
because, in accordance with accounting rules, the assets are held based on original costs.
If a company holds land that was purchased 100 years ago, it holds it at the cost paid.
Over time, however, this real estate has likely gained considerably in value.
What Does Market Value Mean?
1. The current quoted price at which investors buy or sell a share of common stock or a
bond at a given time. Also known as "market price".
2. The market capitalization plus the market value of debt. Sometimes referred to as "total
market value".
Investopedia explains Market Value
1. In the context of securities, market value is often different from book value because the
market takes into account future growth potential. Most investors who use fundamental
analysis to pick stocks look at a company's market value and then determine whether or
not the market value is adequate or if it's undervalued in comparison to it's book value,
net assets or some other
What Does Fair Market Value Mean?
The price that a given property or asset would fetch in the marketplace, subject to the
following conditions:
1. Prospective buyers and sellers are reasonably knowledgeable about the asset; they are
behaving in their own best interests and are free of undue pressure to trade.

2. A reasonable time period is given for the transaction to be completed.

Given these conditions, an asset's fair market value should represent an accurate
valuation or assessment of its worth.
Investopedia explains Fair Market Value
Fair market values are widely used across many areas of commerce. For example,
municipal property taxes are often assessed based on the fair market value of the owner's
property. Depending upon how many years the owner has owned the home, the difference
between the purchase price and the residence's fair market value can be substantial.
Fair market values are often used in the insurance industry as well. For example, when an
insurance claim is made as a result of a car accident, the insurance company covering the
damage to the owner's vehicle will usually cover damages up to the fair market value of
the automobile.
Capitalized Costs
Capitalized costs are those expenses that are incurred in building or financing a fixed
asset. Examples of capitalized costs include labor expenses incurred in building a fixed
asset or interest expenses incurred as a result of financing the construction of a fixed
asset. For accounting purposes, those expenses are capitalized, or added to the cost of the
asset. They are not deducted from revenue in the period in which they were incurred.
Instead, capitalized costs are deducted from revenues over time through depreciation,
depletion, or amortization.
The way an expense is categorized for accounting purposes affects a company's reported
net income. Current net income is obtained by deducting current expenses from current
revenues and taking other factors into account. Since capitalized costs are added to the
cost of a fixed asset, they contribute to the basis value of the asset upon which
depreciation, depletion, and amortization are calculated. Rather than being treated as a
current expense and deducted from current revenues, capitalized costs affect net income
over several reporting periods through depreciation, depletion, and amortization expenses
associated with the fixed asset.
Fixed assets that qualify for such accounting treatment include facilities and other assets
that a company constructs for its own use. Also covered are assets that a company
constructs as a separate project and intends to sell or lease, such as a real estate
development, a large office building, or a ship. Capitalized costs include certain financing
and construction expenses associated with building such assets.
By capitalizing such expenses, or adding them to the cost basis of the asset, a truer
accounting picture emerges of the acquisition cost that more accurately reflects the
company's investment in the asset. Since the asset will be generating revenue over future
periods of time, it is more accurate to deduct the capitalized costs associated with the

asset from revenues over those future accounting periods. Adding capitalized costs to the
cost basis of a fixed asset follows the standard accounting practice of matching expenses
with revenues in the periods in which revenues are earned.
What is the amortization of premium on bonds payable?
Lets use the following example to illustrate the amortization of premium on bonds
payable: A corporation issues bonds having a face value of $1,000,000 and receives a
premium of $60,000. The bond premium occurred because the bonds stated interest rate
was slightly greater than the interest rate required by the investors in the bond market.
The corporation records the bonds as follows: debit Cash for $1,060,000; credit Bonds
Payable for $1,000,000; credit Premium on Bonds Payable for $60,000. The Premium on
Bonds Payable is a liability account that must be reduced to $0 by the time the bonds
mature. Reducing the Premium on Bonds Payable each period by a logical amount is
called amortizing the premium on bonds payable or amortizing the bond premium.
Since the premium of $60,000 is related to the interest rates when the bonds were issued,
the amortization of the premium involves the account Interest Expense. If we assume that
the bonds will mature 20 years after they were issued, then each year the corporation will
make this entry: debit Premium on Bonds Payable $3,000 and credit Interest Expense
$3,000. As you can see, the $60,000 difference between the $1,060,000 it received and
the $1,000,000 it must repay is reported as a reduction of interest expense over the life of
the bonds.
Reducing the balance in the account Premium on Bonds Payable by the same amount
each period is known as the straight line method of amortization. A more precise method,
the effective interest rate method of amortization, is preferred when the amount of the
premium is a very large amount.
The IRS requires investors who purchase certain bonds at a premium (i.e., above par,
which means above face value) to amortize that premium over the life of the bond. The
reason is fairly straightforward. If you bought a bond at 101 and were redeemed at 100,
that sounds like a capital loss -- but of course it really isn't, since it's a bond (not a stock).
So the IRS prevents you from buying lots and lots of bonds above par, taking the interest
and a phony loss that could offset other income.
Here's a bit more discussion, excerpted from a page at the IRS. If you pay a premium to
buy a bond, the premium is part of your cost basis in the bond. If the bond yields taxable
interest, you can choose to amortize the premium. This generally means that each year,
over the life of the bond, you use a part of the premium that you paid to reduce the
amount of interest that counts as income. If you make this choice, you must reduce your
basis in the bond by the amortization for the year. If the bond yields tax-exempt interest,
you must amortize the premium. This amortized amount is not deductible in determining
taxable income. However, each year you must reduce your basis in the bond by the
amortization for the year.
To compute one year's worth of amortization for a bond issued after 27 September 1985
(don't you just love the IRS?), you must amortize the premium using a constant yield
method. This takes into account the basis of the bond's yield to maturity, determined by

using the bond's basis and compounding at the close of each accrual period. Note that
your broker's computer system just might do this for you automatically.
IRS publication 550 states that a bond holder can choose to begin amortizing the bond at
any time. However, if the bond holder wishes to stop amortizing the bond, the IRS must
be notified. This choice does not affect the acquisition price to use, which is the price
adjusted as if amortization began in the first year of ownership.
Book value
In accounting, book value or carrying value is the value of an asset according to its
balance sheet account balance. For assets, the value is based on the original cost of the
asset less any depreciation, amortization or impairment costs made against the asset.
Traditionally, a company's book value is its total assets minus intangible assets and
liabilities.[1][2] However, in practice, depending on the source of the calculation, book
value may variably include goodwill, intangible assets, or both.[3] When intangible assets
and goodwill are explicitly excluded, the metric is often specified to be "tangible book
value".[citation needed]
In the United Kingdom, the term net asset value may refer to the book value of a
company.
Asset book value
An Asset's initial book value is its actual cash value or its acquisition cost. Cash assets are
recorded or "booked" at actual cash value. Assets such as buildings, land and equipment
are valued based on their acquisition cost, which includes the actual cash cost of the asset
plus certain costs tied to the purchase of the asset, such as broker fees. Not all purchased
items are recorded as assets; incidental supplies are recorded as expenses. Some assets
might be recorded as current expenses for tax purposes. An example of this is assets
purchased and expensed under Section 179 of the US tax code.[citation needed]
Depreciable, amortizable and depletable assets
Monthly or annual depreciation, amortization and depletion are used to reduce the book
value of assets over time as they are "consumed" or used up in the process of obtaining
revenue.[5] These non-cash expenses are recorded in the accounting books after a trial
balance is calculated to ensure that cash transactions have been recorded accurately.
Depreciation is used to record the declining value of buildings and equipment over time.
Land is not depreciated. Amortization is used to record the declining value of intangible
assets such as patents. Depletion is used to record the consumption of natural resources.[6]
Depreciation, amortization and depletion are recorded as expenses against a contra
account. Contra accounts are used in bookkeeping to record asset and liability valuation
changes. "Accumulated depreciation" is a contra-asset account used to record asset
depreciation.[7]

Sample general journal entry for depreciation

Depreciation expenses: building... debit = $150, under expenses in retained

earnings
Accumulated depreciation: building... credit = $150, under assets

The balance sheet valuation for an asset is the asset's cost basis minus accumulated
depreciation.[9] Similar bookkeeping transactions are used to record amortization and
depletion.
"Discount on notes payable" is a contra-liability account which decreases the balance
sheet valuation of the liability.[10]
When a company sells (issues) bonds, this debt is a long-term liability on the company's
balance sheet, recorded in the account Bonds Payable based on the contract amount. After
the bonds are sold, the book value of Bonds Payable is increased or decreased to reflect
the actual amount received in payment for the bonds. If the bonds sell for less than face
value, the contra account Discount on Bonds Payable is debited for the difference
between the amount of cash received and the face value of the bonds.[11]
Net asset value
In the United Kingdom, the term net asset value may refer to book value.[12]
A mutual fund is an entity which primarily owns "financial assets" or capital assets such
as bonds, stocks and commercial paper. The net asset value of a mutual fund is the market
value of assets owned by the fund minus the fund's liabilities.[13] This is similar to
shareholders' equity, except the asset valuation is market-based rather than based on
acquisition cost. In financial news reporting, the reported net asset value of a mutual fund
is the net asset value of a single share in the fund. In the mutual fund's accounting
records, the financial assets are recorded at acquisition cost. When assets are sold, the
fund records a capital gain or capital loss.[citation needed]
Financial assets include stock shares and bonds owned by an individual or company.[14]
These may be reported on the individual or company balance sheet at cost or at market
value.
Corporate book value
A company or corporation's book value, as an asset held by a separate economic entity, is
the company or corporation's shareholders' equity, the acquisition cost of the shares, or
the market value of the shares owned by the separate economic entity.
A corporation's book value is used in fundamental financial analysis to help determine
whether the market value of corporate shares is above or below the book value of
corporate shares. Neither market value nor book value is an unbiased estimate of a

corporation's value. The corporation's bookkeeping or accounting records do not

generally reflect the market value of assets and liabilities, and the market or trade value
of the corporation's stock is subject to variations.
Tangible Common Equity
A more obscure variation of book value, tangible common equity, has recently come into
use by the U.S. Federal Government in the valuation of troubled banks.[15][16] Tangible
common equity is calculated as total book value minus intangible assets, goodwill, and
preferred equity, and can thus be considered the most conservative valuation of a
company and the best approximation of its value should it be forced to liquidate.[17]
Since tangible common equity subtracts preferred equity from the tangible book value, it
does a better job estimating what the value of the company is to holders of specifically
common stock compared to standard calculations of book value.
Stock pricing book value
To clearly distinguish the market price of shares from the core ownership equity or
shareholders' equity, the term 'book value' is often used since it focuses on the values that
have been added and subtracted in the accounting books of a business (assets - liabilities).
The term is also used to distinguish between the market price of any asset and its
accounting value which depends more on historical cost and depreciation. It may be used
interchangeably with carrying value. While it can be used to refer to the business' total
equity, it is most often used:

as a 'per share value': The balance sheet Equity value is divided by the number of
shares outstanding at the date of the balance sheet (not the average o/s in the period).
as a 'diluted per share value': The Equity is bumped up by the exercise price of the
options, warrants or preferred shares. Then it is divided by the number of shares that
has been increased by those added.

Uses
1.

2.

Book value is used in the financial ratio price/book. It is a valuation metric that
sets the floor for stock prices under a worst-case scenario. When a business is
liquidated, the book value is what may be left over for the owners after all the
debts are paid. Paying only a price/book = 1 means the investor will get all his
investment back, assuming assets can be resold at their book value. Shares of
capital intensive industries trade at lower price/book ratios because they generate
lower earnings per dollar of assets. Business depending on human capital will
generate higher earnings per dollar of assets, so will trade at higher price/book
ratios.
Book value per share can be used to generate a measure of comprehensive
earnings, when the opening and closing values are reconciled.
BookValuePerShare, beginning of year - Dividends + ShareIssuePremium +
Comprehensive EPS = BookValuePerShare, end of year.[18]

Changes are caused by

1. The sale of shares/units by the business increases the total book value. Book/sh
will increase if the additional shares are issued at a price higher than the preexisting book/sh.
2. The purchase of its own shares by the business will decrease total book value.
Book/sh will decrease if more is paid for them than was received when originally
issued (pre-existing book/sh).
3. Dividends paid out will decrease book value and book/sh.
4. Comprehensive earnings/losses will increase/decrease book value and book/sh.
Comprehensive earnings, in this case, includes net income from the Income
Statement, foreign exchange translation changes to Balance Sheet items,
accounting changes applied retroactively, and the opportunity cost of options
exercised.
New share issues and dilution
The issue of more shares does not necessarily decrease the value of the current owner.
While it is correct that when the number of shares is doubled the EPS will be cut in half,
it is too simple to be the full story. It all depends on how much was paid for the new
shares and what return the new capital earns once invested. See the discussion at stock
dilution.
Net book value of long term assets
Book value is often used interchangeably with "net book value" or "carrying value,"
which is the original acquisition cost less accumulated depreciation, depletion or
amortization.
Fair value, also called fair price (in a commonplace conflation of the two distinct
concepts), is a concept used in accounting and economics, defined as a rational and
unbiased estimate of the potential market price of a good, service, or asset, taking into
account such objective factors as:

acquisition/production/distribution costs, replacement costs, or costs of close

substitutes
actual utility at a given level of development of social productive capability
supply vs. demand

and subjective factors such as

risk characteristics
cost of and return on capital
individually perceived utility

In accounting, fair value is used as a certainty of the market value of an asset (or liability)
for which a market price cannot be determined (usually because there is no established

market for the asset). Under US GAAP (FAS 157), fair value is the amount at which the
asset could be bought or sold in a current transaction between willing parties, or
transferred to an equivalent party, other than in a liquidation sale. This is used for assets
whose carrying value is based on mark-to-market valuations; for assets carried at
historical cost, the fair value of the asset is not used. One example of where fair value is
an issue is a college kitchen with a cost of $2 million which was built five years ago. If
the owners wanted to put a fair value measurement on the kitchen it would be a
subjective estimate because there is no active market for such items or items similar to
this one. In another example, if ABC Corporation purchased a two-acre tract of land in
1980 for $1 million, then a historical-cost financial statement would still record the land
at $1 million on ABCs balance sheet. If XYZ purchased a similar two-acre tract of land
in 2005 for $2 million, then XYZ would report an asset of $2 million on its balance sheet.
Even if the two pieces of land were virtually identical, ABC would report an asset with
one-half the value of XYZs land; historical cost is unable to identify that the two items
are similar. This problem is compounded when numerous assets and liabilities are
reported at historical cost, leading to a balance sheet that may be greatly undervalued. If,
however, ABC and XYZ reported financial information using fair-value accounting, then
both would report an asset of $2 million. The fair-value balance sheet provides
information for investors who are interested in the current value of assets and liabilities,
not the historical cost.
Fair value vs market price
There are two schools of thought about the relation between the market price and fair
value in any kind of market, but especially with regard to tradable assets:

The efficient market hypothesis asserts that, in a well organized, reasonably

transparent market, the market price is generally equal to or close to the fair value, as
investors react quickly to incorporate new information about relative scarcity, utility,
or potential returns in their bids; see also Rational pricing.
Behavioral finance asserts that the market price often diverges from fair value
because of various, common cognitive biases among buyers or sellers. However, even
proponents of behavioral finance generally acknowledge that behavioral anomalies
that may cause such a divergence often do so in ways that are unpredictable, chaotic,
or otherwise difficult to capture in a sustainably profitable trading strategy, especially
when accounting for transaction costs.

Fair value vs market value

As the term is generally used, Fair Value can be clearly distinguished from
Market Value. It requires the assessment of the price that is fair between two
specific parties taking into account the respective advantages or disadvantages
that each will gain from the transaction. Although Market Value may meet these
criteria, this is not necessarily always the case. Fair Value is frequently used when
undertaking due diligence in corporate transactions, where particular synergies
between the two parties may mean that the price that is fair between them is
higher than the price that might be obtainable in the wider market. In other words

Special Value may be generated. Market Value requires this element of Special
Value to be disregarded, but it forms part of the assessment of Fair Value.[1]
Fair value measurements (US markets)
The Financial Accounting Standards Board (FASB) issued Statement of Financial
Accounting Standards No. 157: Fair Value Measurements ("FAS 157") in September
2006 to provide guidance about how entities should determine fair value estimations
for financial reporting purposes. FAS 157 broadly applies to financial and
nonfinancial assets and liabilities measured at fair value under other authoritative
accounting pronouncements. However, application to nonfinancial assets and
liabilities is deferred until 2009. Absence of one single consistent framework for
applying fair value measurements and developing a reliable estimate of a fair value in
the absence of quoted prices has created inconsistencies and incomparability. The
goal of this framework is to eliminate the inconsistencies between balance sheet
(historical cost) numbers and income statement (fair value) numbers.
FAS 157 defines fair value as the price received to sell an asset or the price paid to
transfer a liability in a transaction taking place in an active market. This is sometimes
referred to as "exit value". In the futures market, fair value is the equilibrium price for
a futures contract. This is equal to the spot price after taking into account
compounded interest (and dividends lost because the investor owns the futures
contract rather than the physical stocks) over a certain period of time. On the other
side of the balance sheet the fair value of a liability is the amount at which that
liability could be incurred or settled in a current transaction.
FAS 157 emphasizes the use of market inputs in estimating the fair value for an asset
or liability. Quoted prices, credit data, yield curve, etc. are examples of market inputs
described by FAS 157. Quoted prices are the most accurate measurement of fair
value; however, many times an active market does not exist so other methods have to
be used to estimate the fair value on an asset or liability. FAS 157 emphasizes that
assumptions used to estimate fair value should be from the perspective of an
unrelated market participant. This necessitates identification of the market in which
the asset or liability trades. If more than one market is available, FAS 157 requires the
use of the "most advantageous market". Both the price and costs to do the transaction
must be considered in determining which market is the most advantageous market.
Why is hedge accounting necessary?
Many financial institutions and corporate businesses (entities) use derivative financial
instruments to hedge their exposure to different risks (for example interest rate risk,
foreign exchange risk, commodity risk, etc.).
Accounting for derivative financial instruments under International Accounting Standards
is covered by IAS39 (Financial Instrument: Recognition and Measurement).

IAS39 requires that all derivatives are marked-to-market with changes in the mark-tomarket being taken to the profit and loss account. For many entities this would result in a
significant amount of profit and loss volatility arising from the use of derivatives.
An entity can mitigate the profit and loss effect arising from derivatives used for hedging,
through an optional part of IAS39 relating to hedge accounting.
What hedge accounting options are available to an entity?
All economic hedges aim to manage foreign currency exposure, meaning they are
undertaken for the economic aim of reducing potential loss from fluctuations in foreign
exchange rates. However, not all hedges are designated for special accounting treatment.
Accounting standards enable hedge accounting for three different designated forex
hedges:

A cash flow hedge may be designated for a highly probable forecasted

transaction, a firm commitment (not recorded on the balance sheet), foreign currency
cash flows of a recognized asset or liability, or a forecasted intercompany transaction.
A fair value hedge may be designated for a firm commitment (not recorded) or
foreign currency cash flows of a recognized asset or liability.
A net investment hedge may be designated for the net investment in a foreign
operation.

The aim of hedge accounting is to provide an offset to the mark-to-market movement of

the derivative in the profit and loss account. For a fair value hedge this is achieved either
by marking-to-market an asset or a liability which offsets the P&L movement of the
derivative. For a cashflow hedge some of the derivative volatility into a separate
component of the entity's equity called the cash flow hedge reserve.
Where a hedge relationship is effective (meets the 80%125% rule), most of the mark-tomarket derivative volatility will be offset in the profit and loss account.
To achieve hedge accounting requires a large amount of compliance work involving
documenting the hedge relationship and both prospectively and retrospectively proving
that the hedge relationship is effective.
Simple Procedure of Hedge Accounting
To know simple procedure of hedge accounting, we should divide hedge into two parts.
One is fair value hedge and other is cash flow hedge. When we have risk of decreasing
the share prices, we take the contract of fair value hedge. We give option to other at
current prices. If anybody accepts and if in future, prices of share decreases, we will get
gain from option and will record like general income record.

In cash flow hedge accounting, we do hedge for reducing the risk of increasing the prices.
If prices will increases, we will have to paid same but we will receive the cash profit from
future contract. We also record the payment and gaining amount from such transactions.
Mark-to-market or fair value accounting refers to accounting for the fair value of an
asset or liability based on the current market price of the asset or liability, or for similar
assets and liabilities, or based on another objectively assessed "fair" value. Fair value
accounting has been a part of Generally Accepted Accounting Principles (GAAP) in the
United States since the early 1990s, and has been used increasingly since then.
Mark-to-market accounting can change values on the balance sheet frequently, as market
conditions change. In contrast, historical cost accounting, based on the past transactions,
is simpler, more stable, and easier to perform, but does not reflect current fair value at all.
It summarizes past transactions instead. Mark-to-market accounting can become
inaccurate if market prices change unpredictably. Buyers and sellers may claim a number
of specific instances when this is the case, including inability to accurately collectively
value the future income and expenses, often due to unreliable information, overoptimistic, and over-pessimistic expectations.
FAS 157 defines "fair value" 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.
Simple example
Example: If an investor owns 10 shares of a stock purchased for $4 per share, and that
stock now trades at $6, the "mark-to-market" value of the shares is equal to (10 shares *
$6), or $60, whereas the book value might (depending on the accounting principles used)
only equal $40.
Similarly, if the stock falls to $3, the mark-to-market value is $30 and the investor has
lost $10 of the original investment. If the stock was purchased on margin, this might
trigger a margin call and the investor would have to come up with an amount sufficient to
meet the margin requirements for his account.