The Advantages of Fair Value vs. the Equity Method

Fair market valuation and the equity method are two accounting treatments that companies use that assess how much their investments are worth. Fair market value is defined as an asset's sale price if a transaction occurred between a willing buyer and seller. The equity method considers the asset's original purchase price and the investor's stake in the asset.

Companies that classify assets with the fair market value methodology anticipate selling the assets quickly, in a non-distressed market sale. In this way, the "liquid" asset is classified as "current assets" on the balance sheet. Assets such as stocks change prices every minute, so ascribing a valuation based on purchase price alone -- as the equity method requires -- may not reflect the asset's true value. However, if the company acquires a "significant influence" but not control in an asset, then the company may be forced to change how it records its value.

Investors may prefer the fair market valuation methodology because it makes a company's balance sheet more transparent. In other words, it's easier for investors to determine what a company is really worth when its assets are valued at prevailing market prices. Companies must provide a rationale for how the assets were valued -- this is much easier when a stock price or other comparable data is readily available -- and this gives the investor the full disclosure he seeks.

Because companies that file tax returns usually hire professionals to audit their books, the fair market valuations are reviewed for legitimacy and accuracy. According to the International Swaps and Derivatives Association, valuations are reviewed internally and externally, and cannot be adjusted without agreement and approval. When an asset's value rises, so does the company's worth; when it falls, so goes the company. Having an accurate read on real-time market valuation helps businesses make decisions for the future.

When assets are recorded with their fair market values, investors are able to easily compare valuations between companies and assess market direction. This is particularly true since the Financial Accounting Standards Board instituted FAS 157, the "mark to market" rule. While many companies adhered to the fair market value principle prior to FAS 157, the 2006 rule provided a specific framework that all companies should follow when valuing assets. As a result, now investors can rely upon companies playing by the same mark-to-market rules.