Pros and Cons of Fair Value and Historical Cost Accounting

According to the Christian Laux and Christian Leuz’s paper on the contribution of fair value to the financial crisis, fair value accounting “involves reporting assets and liabilities on the balance sheet at fair value and recognizing changes in fair value as gains or losses in the income statement (93). While, historical accounting “equals the fair value when the assets were originally purchased and are adjusted for amortization and impairments, but not for increases in assets values (97).” These two options are used to account for assets and liabilities, with each having pros and cons.

A pro of fair value accounting is that it is flexible, meaning that companies can provide timely and relevant information about the true valuation of their assets and liabilities. This is good in that potential investors can get up to date information so that they can make informed decisions. Also, fair value accounting allows companies to faster recognize losses in their assets and liabilities (Laux, 95). This puts pressure on companies to take corrective actions to deal with the losses. This is beneficial because banks, who lend money, can determine credit more accurately, and companies can quickly see when something internally needs to be fixed. However, a con of this is that even though this information may be relevant, it may not be reliable. Lots of fair value accounting is subject to estimates, thus management can manipulate the information. For instance, page 880 of Intermediate Accounting describes gains trading as, “companies sell their winners, reporting the gains as income, and hold on to their losers.” There are three ways to classify debt: held to maturity (HTM), available for sale (AFS), or trading. The difference between the three is that HTM is valued with amortized costs, thus gains or losses are not recognized. So what companies can do is switch between the classifications, reporting the winners in AFS or trading, and keep the losers in HTM. This...