What is the definition of fair value according to ASC 820? Do you believe the discounted cash flow method is capable of computing an estimate that would be considered a reasonably reliable fair value for the patent held by Morris Mining? Why or why not?

Question

What will be an ideal response?

Answer 1

According to FASB ASC 820-10-35-2, fair value is “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.” Essentially, it is the exit price that would be used in the market. As used in this definition,
an orderly transaction is “a transaction that assumes exposure to the market for a period prior to
the measurement date to allow for marketing activities that are usual and customary for transactions
involving such assets or liabilities.” In short, an orderly transaction is a transaction in which both parties
make the decision to enter into the transaction for their own benefit. Another important piece to the
definition of fair value is “market participants.” Market participants are buyers or sellers within the
market that are independent of one another.
The discounted cash flows method is a common way to determine the fair market value of
various assets and liabilities and fits well with the Morris Mining situation. This method makes the
assumption that the price that an independent “market participant” would pay for an asset would
be the present value of the future cash flows expected to be generated from the asset. Similarly, the
price paid to transfer a liability would be the present value of the discounted cash flows that a liability
obligates one to pay.
While using the discounted cash flows method to compute fair market value may be appropriate
in this scenario, it is not appropriate in every situation. Certain assets and liabilities may be hard to
value solely based on the discounted cash flows method. In fact, in some cases the discounted cash flows method would be considered an inferior method. For example, assume a corporation owns a building
complex in a business center. The corporation is selling the building, but at the time only 60 percent of
its capacity is leased out. Basing the fair market value of this building on the current expected future
cash flows (i.e. the contracts that are currently in place) would clearly be inappropriate because the
building’s earning capacity is greater. In fact, even basing the fair market value of the building on the
cash flows assuming it is leased out in its entirety may still be inappropriate because it fails to take into
consideration the location of the building, the structural quality, the surrounding area, the quality of
the lease contracts, etc.