Fair Value V. Historical Cost

There has been much discussion about fair value accounting. Disclosing assets at their fair value as opposed to their historical cost is preferred by some but opposed by others. The use of fair value accounting has been around for decades primarily for financial assets.

There are many issues involved with fair value accounting. Some argue that fair value is beneficial to investors when they are trying to evaluate risk, return and valuation of a business. If a company marks to market, does it not give an investor a better understanding of that company’s current value? Some may say that this method can help the company in times of economic trouble and credit problems, and others feel that it is merely a band-aid on a wound that needs stitches. To some people, it is a problem to have to decipher financial statements to understand what is listed at fair value and what is listed at historical cost. Switching to one method would mean that there would be no more implementing both methods for different assets. Would that more truthfully represent a company? Would this valuation system be beneficial to banks lending money to these companies?

In the event that a company has credit problems in a troubled economy, the use of fair value accounting may benefit them. At the same time if the economy is volatile and the value of everything significantly decreases, this would be another problem. The use of fair value could drastically help a company get approved for loans, however, if the company is doing horribly and needs a loan to survive, inflating the value of their assets may help them acquire the financial aid they need but it may not help the business turn a profit. In that case, the company may have been better off not taking out a loan, but instead realizing that they can not survive. In a volatile market with unstable price fluctuations, fair value may not be such a good idea. Suppose this company were to value their assets at current market value and receives a loan because of it. What happens when the company defaults on their loan and at the same time the market crashes causing all of the company’s assets to drop in value? Would this not be a problem for the banks?

When a company’s value in comprised of assets that are valued at their current market value instead of what they paid for them, it is obvious that the difference is material. Fair value can help just as much as it can hurt. It really depends on the type of asset being valued and whether or not people know how to use it. The FASB should probably hold off on making new rules until they can come up with some sort of guidelines so people understand when and where to use it.

When valuing assets at historical cost, depreciation seems to be a simple concept. If companies start valuing all of their assets at fair value, this will most likely create problems with depreciation as well as appreciation of assets. Just as companies want to capitalize on the loss of value of an asset, would they want to pay tax on gains of some appreciating asset that they normally would not have had to do if reporting under the historical cost principle?

Historical cost and fair value have both been around for a long time. Whether or not to make a permanent switch to fair value is an important decision for the FASB to make. All the angles need to be covered when considering this switch. Does the good outweigh the bad? The historical cost principle has worked fine all this time, why mess with something that has proven its reliability?