What Is Fair-Value Accounting?
One of the hardest tasks in accounting is assigning a proper value to assets and liabilities on the balance sheet. Fair value accounting is one of several methods accounting professionals can use to value assets and obligations. Depending on circumstances, this method can produce dramatically different results from other accounting treatments.
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Valuation Basics
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Conventional assets are usually easy to value. If, for instance, a firm buys a delivery truck for $30,000 and expects to sell it for $10,000 after five years, the value of the vehicle at any point before the sale can be accounted for based on a simple formula. Since the truck's value will decline by $20,000 in five years, the annual decline in value can be assumed as $4,000. After two years, for example, the truck can be valued at approximately $22,000.
Firms can use more complex valuation schemes as well. Instead of decreasing -- or "depreciating" as it is known in accounting -- the truck's value by the same amount each year, an above-average hit can be recorded in the first year when new vehicles tend to lose most of their resale value.
Fair Market Valuation
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When using the fair market valuation for an asset, accountants consider the price at which the same asset can be replaced today. Assume the truck in the example is now three years old, out of warranty and experiencing a transmission problem. While the truck's value is $18,000, according to the formula in Section 1, a few quick calls to used vehicle dealers reveals that the same type of truck with this sort of common transmission problem can be bought for about $13,000.
Fair market value accounting would require the truck's book value on the balance sheet be decreased to this "replacement value."
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Liabilities
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When accounting for liabilities, fair value accounting standards require that the accounting basis should be the price at which the liability can be settled or incurred between two willing parties. Assume, for instance, that you have agreed to advertise on a billboard for the next six months and agreed to pay $10,000 for this right. However, billboard rates have dropped significantly and your contract allows you to cancel this agreement at no cost. You could simply get out of the present contract and rent the same billboard for $8,000.
Again, fair value accounting requires that you record an obligation of $8,000 instead of the contractually stipulated $10,000, because this is the value at which your present obligation can be settled.
Issues
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The primary issue with fair value accounting is the difficulty of finding fair prices for hard-to-value assets. While a delivery truck may be relatively easy to price by calling used vehicle dealers, the same may be nearly impossible for a 2-year-old giant crane. Highly specialized rare machinery, certain financial products and various other kinds of assets and liabilities often do not have a secondhand market, and fair value accounting may therefore be difficult to apply for certain firms.
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References
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