Fair Value Accounting: Beneficial or Problematic?

 

What is Fair Value?

According to the FASB Accounting Standards codification 820, fair value is defined 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.” Quite simply, fair value is what someone is willing to pay for an asset or transfer a liability in a transaction.

Benefits of Fair Value

Some benefits of Fair Value accounting is that it provides investors and creditors with better information. It allows financial statement users such as investors to more accurately measure a company’s worth because they know exactly the value of a company’s assets and liabilities.  Fair value provides the most relevant measure of a company’s assets and liabilities and is a better measurement than the current methods such as historical cost. Could theoretically enhance comparability between companies because there will no longer be management judgment and estimation on the value of certain items such as depreciation on equipment.

Top ten issues with Fair Value: 

Issue 10: Depreciation expense would be eliminated because it would theoretically the fair value of the asset would decrease as the asset is used up. Investors and creditors may have a difficult time distinguishing between depreciation and this could potentially translate into a loss of information.

Issue 9: There would be Enormous book/tax differences because it can complicate book/tax differences dramatically. There could be an incentive to use fair value for books and another method for tax.

Issue 8: What would be the definition for Fair Value? Would it be what someone is willing to pay for something or a discounted cash flow model? Who would be in charge of making the fair value valuation? Would it be the firms themselves or independent appraisers.

Issue 7: Which market would be used to determine the fair value of the item? Would it be a local market, global market, or an average of the two?

Issue 6: Net income would be largely impacted by market conditions because market fluctuations in the price of items could influence net income more than operations.

Issue 5: Fair value would create greater volatility in earnings so it could be difficult to discern between fair value changes and operations. Giant swings in net income could make investing very difficult to predict.

Issue 4: Fair value measurement can cause erroneous “gains” from asset acquisitions and exchanges.

Issue 3: It can lead to fraudulent valuations. Fair value is highly subjective measurement so firms could engage in appraisal “shopping” and go with the appraisal which results in the highest measurement. This could lead to an independent issue as well.

Issue 2: It is difficult to value certain assets such as rare items which are used in niche industries or trademarks and other intangible assets. For example: how much is the Nike logo worth?

Issue 1: Lastly, it could cause financial statement preparation costs and audit costs to increase significantly because auditors would have to test the fair value valuation methods and appraisers must be hired by the firm and the auditors to determine the fair value of the items.

In conclusion, the fair value valuation method provides very little additional beneficial information but creates a number of issues which prove to be very problematic.

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