For the past two decades, fair value accounting—the practice of measuring assets and liabilities at estimates of their current value—has been on the ascent. This marks a major departure from the centuries-old tradition of keeping books at historical cost. It also has implications across the world of business, because the accounting basis—whether fair value or historical cost—affects investment choices and management decisions, with consequences for aggregate economic activity.
The argument for fair value accounting is that it makes accounting information more relevant. However, historical cost accounting is considered more conservative and reliable. Fair value accounting was blamed for some dubious practices in the period leading up to the Wall Street crash of 1929, and was virtually banned by the U.S. Securities and Exchange Commission from the 1930s through the 1970s. The 2008 financial crisis brought it under fire again. Some scholars and practitioners have connected its proliferation in accounting-based performance metrics to the actions of bankers and other managers during the run-up to the crisis. Specifically, as asset prices rose through 2008, the fair value gains on certain securitized assets held by financial institutions were recognized as net income, and thus sometimes used to calculate executive bonuses. And after asset prices began falling, many financial executives blamed fair value markdowns for accelerating the decline.
One explanation for the rise of fair value accounting is that finance theory—in particular, the idea that financial markets are efficient and their prevailing prices are reliable measures of value—permeated academic accounting research in the 1980s and 1990s, thus changing opinions on the relative merits of historical cost and fair value.
A study that the Harvard Business School doctoral student Abigail Allen and I published in the May 2012 issue of the Journal of Accounting and Economics, “Towards an Understanding of the Role of Standard Setters in Standard Setting,” points to another explanation. The study covers all the members of the Financial Accounting Standards Board, which sets standards for GAAP, from its inception, in 1973, through 2006. We investigated their backgrounds and the nature of the standards they proposed. To control for both hindsight and potential researcher bias, we relied on the contemporaneous assessments of the largest audit firms as expressed in 908 separate comment letters filed at the FASB archives in Norwalk, Connecticut. Specifically, we examined how the auditors evaluated the proposed standards on the dimensions of accounting “relevance” and “reliability.” The FASB recognizes a trade-off between those two goals and has justified the increased use of fair value accounting by arguing that it increases accounting’s relevance. Several academics, myself included, have argued that it decreases financial reporting’s reliability.
We found that the backgrounds of the individual standard setters on the FASB predict which standards they have proposed. Notably, those with a background in the financial services industry—defined for our purposes as investment banking or investment management—are more likely to propose the use of fair value methods. Before 1993 the FASB included no financial services veterans; now such members make up more than a quarter of the board (see the exhibit “The Shift to Fair Value”). The link between fair value proposals and a background in financial services is robust to numerous substantive controls, including other background factors such as members’ tenure on the board, their political affiliation, the backgrounds of contemporaneous members of the SEC, broader market and macroeconomic conditions, and biases, if any, among the large audit firms.
This empirical link can be augmented with anecdotal evidence. For example, the Investment Company Institute, a U.S. industry association of asset management firms, strongly supported the use of fair value accounting when lobbying the SEC in 2008 on FASB Statement 157, which helps define fair value. And in 2000 and 2001 the then three largest investment banks—Goldman Sachs, Morgan Stanley, and Merrill Lynch—were all enthusiastic supporters of fair value rules for mergers and acquisitions during FASB deliberations on the subject.
The possible motives for individuals from financial services to support fair value accounting are complex and numerous; here I outline a few likely ones. First, investment banks and asset managers are accustomed to using fair value in their day-to-day business to prepare in-house balance sheets for risk-management purposes. This familiarity with the method may have shaped their preferences in public financial reporting standards. Second, GAAP profits defined on a fair value basis rather than a historical cost basis accelerate the recognition of gains, particularly in periods of rising asset prices. To the extent that managerial bonuses are based on GAAP profit numbers, financial services executives reap richer rewards in a fair value regime. Third, the use of fair value to determine impairment of goodwill from M&A activity (in lieu of the historical cost approach of amortizing goodwill) imposes, on average, less drag on earnings, thus potentially boosting M&A activity—a major revenue source for investment banks.
Does this mean that the selection process for FASB members has been captured by special interests from finance? It’s hard to say for certain. Members are chosen by the trustees of the private Financial Accounting Foundation in a poorly understood process that is often influenced by the Securities and Exchange Commission. The growth in the proportion of FASB members who have backgrounds in financial services may represent the growth in that industry—and the growth in its political clout. Also, the SEC and the FASB have generally viewed the asset-management sector of the financial services industry not as a special interest but as a consumer of accounting information whose interests need to be protected. In any case, more research is needed to explain why financial services representation has increased.
What is clear is that it has increased, with a concomitant impact on accounting standards. Perhaps tellingly, privately held companies in the United States—which are less oriented toward capital markets than their publicly traded counterparts are—have recently set up their own accounting standards board, the Private Company Council, in part to get away from fair value accounting. A version of this article appeared in the
Fair value accounting | Finance & Capital Markets | Khan Academy
Why is fair value important?
Fair value is an important metric for setting prices of assets because it allows for a more accurate assessment of the worth, even when there are no recent sales to reference. There are many different methods of determining an assets fair value to allow for estimations in a variety of situations.
Relying exclusively on the historical value of assets doesnt allow for other external factors, such as changes in the market. As time passes, the value of assets can appreciate or depreciate. With fair value, you can estimate the changes to value since the last estimation or set a fair price if no prior price exists. The more accurate the financial assessment of the asset is, the more informed any decisions related to the asset will be.
What is fair value?
Fair value is an estimated price for an asset, good or service designed to accurately represent its approximate worth. The goal of a fair value assessment is to determine a price for a product that both the buyer and seller can agree upon. Several factors may be used in setting a fair value price, including the last known sale price for the asset, changes to market values since the last sale and estimates of future value provided by the asset.
Advantages of using fair value
Using fair value in your accounting is an excellent way to maintain accurate financial records, which is why it is the most popular standard for accounting. Benefits of using fair value accounting include:
Fair value is more dynamic and capable of adjusting to the realities of the market for assets. This allows for a more accurate valuation of a companys overall worth.
A company may have a variety of different assets on its books, ranging from tangible items like inventory to intangible concepts like stock shares. These types of assets also often have different ways of accruing value. A fair value accounting approach allows you to judge each asset in the manner most appropriate to get accurate results.
Better income assessment
Assigning a true value to all of a companys assets and expected income provides the ability to better develop financial plans. This helps to protect the company from the negative effects of an unforeseen shortcoming as a result of inaccurate financial estimates.
If a company has assets that have undergone depreciation, fair value accounting can help save money. Reporting the losses due to the depreciation that the fair value registers can earn a write-off in the companys taxes for the amount lost. This can be particularly useful during times of financial struggle to help keep the company operating while executing a recovery plan.
Fair value accounting is popular both in maintaining a companys own books and assessing the financial strength of other companies for potential investment. The versatility and accuracy of the method make it ideal for assessing in a dynamically changing market where precise estimation is required.
Methods to derive fair value
There is no one specific formula for calculating the fair value that you can use for any situation. Since there are different types of assets in need of valuation, there are many preferred methods for each of those classes of asset. Two separate accounting or investing professionals can devise two different fair value assessments for the same asset depending on the method they use. Common styles of fair value calculation include:
Comparable information calculation
One of the simplest but most effective methods of assessing fair value is using fair comparisons. For example, if a company is selling a piece of equipment, it would compare prices in the market by checking stores or searching online. By taking average prices found from different sources for the equipment based on age and condition, the company can find a fair value.
Cash flow calculation
In a cash flow assessment of an investment opportunity, the expected cash flow of an investment is calculated for each year in the investment. The cash flow is measured against any potential expenses of the investment, such as interest paid on any lines of credit to secure the purchase. By taking the resulting value and subtracting the initial cost of the investment, a fair value for the investment is determined.
Change assessment calculation
For an asset that has experienced a variable that changes its worth, such as a company launching a successful new product or an antique item made popular by an appearance in popular culture, a new approach is required. By assessing the expected result of the change in status and how it will affect value, fair value is calculated using the established value and the expected change in value as a result of the new variables.
An experienced accounting or investing professional will know the best method to use when assigning a fair value to an asset. Finding an accurate rating is important in all phases of assessment, whether attempting to buy, sell or maintain accurate records of the value of any current holdings.
Fair value vs. carrying value
Carrying value, also known as book value, is another method of estimating the value of an asset. To calculate the carrying value you need to know the last assigned value in a sale, how long ago that sale was and the established rate of depreciation or appreciation. By taking the original sale rate and applying the rate of appreciation or depreciation multiplied by time, you find the carrying value.
For example: A business purchases a projector for $1,500 with an expected annual depreciation of $100 per year. After three years, the business wants to sell the projector. The book value—or carrying value—of the projector would be $1,200, as it has experienced $300 in depreciation in the three years since the company first purchased it.
Although this is a simpler calculation to determine, it is not always as accurate as using fair value to assess the value of the asset. Fair value estimation can more accurately assess the assets worth in the current market. This flexibility can include such factors as the condition of the asset, competitiveness in the market and expected performance of the market going forward. Although fair value estimates may at times resemble carrying value, they can also vary greatly as a result of these differences.
Fair value vs. market value and market price
Fair value assessment as similarities to other types of assessments, most notably market value and market price. There are two main approaches to understanding market prices and the ways they can be used to predict fair value:
The efficient market hypothesis
Under this assessment of the open market, the price of the product when it was last sold serves as an accurate representation of that assets fair value. This is based on the idea that the open market is capable of responding to changes and adjusting accordingly in near real-time.
Behavioral finance theory
This view on sales states that there can be a significant variance between the actual fair value of an asset and the price it sells at. These differences can be attributed to factors, such as the opinions of either the buyer or seller, which lead to one or both parties over or undervaluing the asset. These variances do not tend to skew in one direction or the other and can make using sales value as the only indicator challenging.
How do you calculate fair value?
What is the difference between fair value and market value?