Fair-value accounting records the monetary value of assets and liabilities at a fair market value.
The Securities Exchange Commission (SEC) adopted a reporting standard in 1993 that requires companies to report their assets at fair market value on financial statements for all periods beginning after December 15, 1995.
Fair-value accounting has drawn criticism from some quarters of the business world. Its inherent volatility when valuing specific securities, such as those related to mortgages and real estate, is problematic.
Determining Fair Value
Fair market value is the price at which an asset or liability could be sold or exchanged in a current transaction between willing parties. Any differences between the actual cost of an asset and its fair value are reflected on the company’s balance sheet as unrealized gains or losses.
Thus, companies must now use the market value of an asset instead of its cost or historical book value. Sometimes. the former is higher than the latter, but only under certain conditions.
Under the Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (FAS 157), companies must report their assets at fair market value on financial statements for all periods beginning after December 15, 2007.
FAS 157 is a statement issued by the Financial Accounting Standards Board, requiring companies to report their assets at fair market value on financial statements for all periods beginning after December 15, 2007.
Is fair-value accounting helpful?
The primary purpose of FAS 157 was to bring more transparency into the valuation of assets and liabilities on financial statements. In addition, it also allows companies to better compare themselves with competitors who report using similar methods.
It also requires companies to make judgments about future cash flows that are very difficult to predict. Assumptions and biases can lead analysts in one direction or another.
Transparency is key
That is where fair-value accounting comes into play.
For example, suppose you’re working at a company whose stock price has plunged recently because it made news after its CEO was arrested for insider trading. In that case, you might want to find out what impact that would have on your pension assets if you were suddenly let go. How much would your pension be worth under either scenario?
Fair-value accounting intends to better reflect a company’s financial position in its balance sheet. Therefore, it seeks to provide more transparent information about a company’s financial statements. Additionally, it also ensures they represent current market conditions.
While applying fair-value accounting has many benefits, it also has some drawbacks.
Investors and analysts who wish to analyze financial statements must know how various assets are valued under different accounting conventions to make informed judgments about a company’s performance, finances, and future prospects.