When it comes to assets in accounting, it’s crucial to make sure that your valuations are accurate. Find out everything you need to know about fair value accounting, from the advantages and disadvantages of this accounting method to the differences between fair value and historical cost accounting. First off, what is fair value accounting anyway?
Understanding fair value accounting
Fair value accounting refers to the practice of measuring your business’s liabilities and assets at their current market value. In other words, “fair value” is the amount that an asset could be sold for (or that a liability could be settled for) that’s fair to both buyer and seller. Fair value accounting was implemented by the Financial Accounting Standards Board (FASB) in order to harmonize the calculation of financial instruments. When it comes to fair value accounting, you need to understand the following concepts:
Current market conditions – The fair value of an asset is based on the market conditions on the date of measurement, rather than historical transactions.
Intention of holder – It’s also important to note that the holder’s intention should be irrelevant when calculating fair value. For example, if the holder intends to sell the asset immediately, it could lead to a rushed sale, thereby lowering the price of the asset.
Orderly transaction – Also, fair value is based on orderly transactions where there isn’t any pressure on the seller to sell, which is why fair value accounting does not apply to companies that are in the process of liquidation.
Third party – Furthermore, fair value is understood to derive from the sale to a third party, rather than a corporate insider or anyone who is related in some way to the seller (as this could skew the value of the asset).
How do you value assets with the fair value accounting method?
According to GAAP, there are three levels of data that you can use to determine the value of an asset or liability. These are as follows:
Level 1 – The quoted price of identical items in an active market (market where liabilities and assets are transacted frequently and at high volumes, giving ongoing pricing information).
Level 2 – Observable information for similar items in active or inactive markets, rather than quoted prices. For example, real estate in similar locations.
Level 3 – Unobservable inputs, only used when markets are non-existent or illiquid. Examples include your company’s own data, such as an internally generated financial forecast.
Remember that these levels are only used to select your inputs to different valuation techniques, not to estimate the fair value of the assets themselves. There are a broad range of different valuation techniques that you may wish to make use of to make the actual valuation, including the market approach, the cost approach, or the income approach. These valuation techniques vary wildly, so the best technique to use for your company’s assets depends on the type of asset you hold.
Pros and cons of fair value accounting
There are many advantages of fair value accounting, which is why it’s one of the most commonly used methods of financial accounting. Firstly, it provides a much more accurate valuation of your assets, as it’s informed by current market value. Furthermore, fair value accounting limits your ability to manipulate reported net income, as you won’t measure income from profit/loss reports, but actual value. In addition, fair value accounting is adaptable to different types of assets.
However, it’s also important to remember that there are a couple of issues with fair value accounting. Most importantly, it can lead to large swings in value that take place frequently throughout the year, particularly if your business deals with volatile assets. Other issues with fair value accounting include the fact that it can lead to investor dissatisfaction, while it’s also possible that the observed value of the asset in the market isn’t indicative of its fundamental value.
Fair value vs. historical cost accounting
The differences between fair value accounting and historical cost accounting are stark. Essentially, historical cost accounting values assets and liabilities at the initial price they were exchanged for. In other words, it provides you with the cost of the asset. However, fair value accounting values assets at the prevailing market price. This means that it provides you with the expected return that an asset would fetch if you wanted to sell it.
There are a few other distinctions that are worth noting. Whereas fair value can be used to compare assets from different entities, historical cost cannot (as different methods may have been adopted for depreciation). It’s also worth remembering that the fair value calculation is much more complex than historical cost and requires various assumptions. So, when it comes to fair value vs. historical cost accounting, both accounting methods have virtues, but to assess the current value of an asset, fair value accounting is a more appropriate option.
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