Fair Value Accounting Is It Fair?

Fair value accounting,

is it fair or is it a risk?

BA 566

Nicolas Freche

Summary

I. Introduction

II. Fair value measurement (FAS 157)

III. Critique of fair value accounting

IV. Advantages of fair value accounting

V. Conclusion

I. Introduction

In accounting and economics, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset. It takes into account such objective factors as:

* acquisition/production/distribution costs, replacement costs, or costs of close substitutes

* actual utility at a given level of development of social productive capability

* supply versus demand

And subjective factors such as

* risk characteristics

* cost of and return on capital

* individually perceived utility

In accounting, fair value is used as a certainty of the market value of an asset or liability for which a market price cannot be determined (usually because there is no established market for the asset). Under US GAAP “generally accepted accounting principles" (FAS 157), fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties, or transferred to an equivalent party, other than in a liquidation sale. This is used for assets whose carrying value is based on mark-to-market valuations; for assets carried at historical cost, the fair value of the asset is not used. One example of where fair value is an issue is a college kitchen with a cost of $2 million which was built five years ago. If the owners wanted to put a fair value measurement on the kitchen it would be a subjective estimate because there is no active market for such items or items similar to this one. In another example, if ABC Corporation purchased a two-acre tract of land in 1980 for $1 million, then a historical-cost financial statement would still record the land at $1 million on ABC’s balance sheet. If XYZ purchased a similar two-acre tract...