There are a few different financial reporting approaches that businesses can choose today. One of them, the fair value accounting method, allows for the measurement and reporting of liabilities and assets on their estimated or actual fair market price. Because there are changes to asset liability over time, there can be unrealized gains or losses in assets that are held. This method of accounting can help to measure and chart those gains.
As with any accounting method, there are several advantages and disadvantages that must be considered before adopting it fully.
The Pros of Fair Value Accounting
1. It provides an accurate valuation.
This method of accounting helps to provide more accuracy when it comes to current valuations from assets and liabilities. If prices are expected to increase or decrease, then the valuation can do the same. If sales occur, then there aren’t discrepancies that must be charted if the valuation differ from the transaction. The current market prices allow individuals or businesses to know exactly where they stand.
2. It provides a measurement of true income.
There is less of an opportunity to manipulate accounting data using the fair value approach. Instead of using the sale of assets to affect gains or losses, the price changes are simply tracked based on the actual or estimated value. The changes to income happen with the changes to the asset value, reflected in the final net income numbers.
3. It is the most agreed upon standard of accounting.
Instead of the historical cost value that isn’t always accurate after a long period of time, fair value accounting accurately tracks all types of assets, from equipment to buildings to even land. This makes it the most agreed upon standard of accounting because set prices, even if still accurate in value, aren’t the same because of monetary inflation. $10 today is not worth the same $10 from 1992. That’s why fair value can be so beneficial.
4. It provides a method of survival in a difficult economy.
In the historical method, the same value goes of an asset goes on the budget line every year. When there’s a difficult economy and prices are reduced, this can become a cumbersome financial burden. Fair value accounting allows for asset reductions within that market so that a business can have a fighting chance.
The Cons of Fair Value Accounting
1. It can create large swings of value that happen several times during the year.
There are some businesses that do not benefit from this method of accounting at all. These businesses typically have assets that fluctuate in value in large amounts frequently throughout the year. Volatile assets can report changes in income that aren’t actually accurate to the long-term financial picture, creating misleading gains or losses in the short-term picture.
2. Misery typically loves company.
If one business is seeing a reduction in net income thanks to asset losses, then this trend typically creates a domino effect throughout a region or an industry. Downward valuations are contagious and often trigger selling that is unnecessary because of the volatility of the market. When this method of accounting isn’t used and downward valuations don’t have to happen, there is more investor stability that can, in turn, keep a region or industry’s overall economics stable as well.
3. It reduces investor satisfaction.
Some investors don’t always notice that a company is using the fair value approach to accounting. This creates investor dissatisfaction because the loss of value in the net income becomes an income loss for the investors as well. Since many investors are trading these commodities instead of using them for an investment, it can create a tough hit for their portfolio and cause many investors to stay away from the business altogether.
4. It loses the historical perspective.
Although current accounting is important to measure, there must also be a general sense of what has happened historically for accuracy in tracking results. Because assets may have a down year and reduce net profits, it can artificially lower the successes that a business may have had. For example, if a small business has assets of $100,000 that suddenly become valued at $60,000 due to market losses and there were $50,000 worth of net profits outside of the asset reduction, the company’s net profits would actually be just $10,000.
The fair value accounting pros and cons show that for the most part, businesses can have a transparent and accurate method of tracking profit and loss. As long as investors are kept in the loop and know what is going on, the benefits will typically outweigh the risks in this matter.