Fair Value Accounting

Fair value is the price that would be received to sell an asset or pay off a liability. Fair value assumes that this transaction occurs under normal business conditions.

As illustrated earlier, generally accepted accounting principles require trading and available-for-sale investments to be recorded at fair value.

In contrast, many assets and liabilities are recorded and reported at amounts that differ significantly from their fair values. For example, when property, plant, and equipment is purchased, it is initially recorded at its purchase price, or cost. This purchase price, called historical cost, is allocated to income over its useful life through depreciation. As a result, the book value of property, plant, and equipment reflects the portion of the historical cost of the asset that has not been depreciated, and normally differs significantly from fair value.

1. Trend to Fair Value Accounting

The current trend is for the Financial Accounting Standards Board (FASB) and other accounting regulators to adopt accounting principles using fair values for valuing and reporting assets and liabilities. Factors contributing to this trend include:

  1. Current generally accepted accounting principles are a hybrid of varying measure­ment methods that often conflict with one another. For example, property, plant, and equipment are normally reported at their depreciated book values. However, GAAP require that if a fixed asset value is impaired, that it be written down to its fair value. Such conflicting accounting principles could confuse users of financial statements.
  2. A greater percentage of the total assets of many companies consists of financial as­sets such as receivables and securities that have readily available fair values. Fair values for such assets can often be readily obtained from stock market quotations or computed using current interest rates and present values. Likewise, many liabilities can be valued using readily available market quotations or current interest rates and present values.
  3. The world economy has compelled accounting regulators to adopt a worldwide set of accounting principles and standards. International Financial Reporting Standards (IFRSs) are issued by the International Accounting Standards Board (IASB) and are used by the European Economic Union (EU). As a result, the FASB is under increas­ing pressure to conform U.S. accounting standards to international standards. One area where differences exist is in the use of fair values, which are more often used by International Financial Reporting Standards.

While there is an increasing trend to fair value accounting, fair value measures also have several potential disadvantages. These disadvantages include:

  1. Fair values may not be readily obtainable for some assets or liabilities. As a result, accounting reports may become more subjective and less reliable. For example, fair values (market quotations) are normally available for trading and available-for-sale securities. However, fair values may not be as available for assets such as property, plant, and equipment or intangible assets such as goodwill.
  2. Fair values make it more difficult to compare companies that use different methods of determining (measuring) fair values. This would be especially true for assets and liabilities for which fair values are not readily available.
  3. Using fair values could result in more fluctuations in accounting reports because fair values normally change from year to year. Such volatility may confuse users of the financial statements. It may also make it more difficult for users to determine current operating trends and to predict future trends.

2. Effect of Fair Value Accounting on the Financial Statements

The use of fair values for valuing assets and liabilities affects the financial statements. Specifically, the balance sheet and income statement could be affected.

Balance Sheet When an asset or a liability is reported at its fair value, any difference between the asset’s original cost or prior period’s fair value must be recorded. As we il­lustrated for trading and available-for-sale securities, one method for doing this is to use a valuation allowance. The account, Valuation Allowance for Trading Investments, was used earlier in this chapter to adjust trading securities to their fair values.

Available-for-sale securities are recorded at fair value. Changes in their fair values are not recognized on the income statement, but are included as part of stockholders’ equity.

Income Statement Instead of recording the unrealized gain or loss on changes in fair values as part of stockholders’ equity, the unrealized gains or losses may be reported on the income statement. This method was illustrated earlier in this chapter for trading securities.

As shown above, differences exist as to how to best report changes in fair values— that is, whether to report gains or losses on fair values on the income statement or the balance sheet.

In an attempt to bridge these differences, the FASB introduced the concepts of comprehensive income and accumulated other comprehensive income. These concepts are described in the appendix to this chapter.

Source: Warren Carl S., Reeve James M., Duchac Jonathan (2013), Corporate Financial Accounting, South-Western College Pub; 12th edition.

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