Fair Value Vs Historical Cost MeasurementIn the current climate with economies hitting an all time low and markets being unpredictable like never before, stakeholders are increasingly conscious about their investments and the value they currently hold. Accounting measures in this type of situation become a very critical component in maintaining shareholder confidence; and financial instruments if used appropriately, can significantly impact the outcome. Needless to say, the debate between the use of historical and fair value accounting has been going on for a long while and change has been slow but sure. The FASB has made it a mandatory requirement in the US for companies to use fair value accounting to value certain assets and liabilities. However, this imposition does not come free of critique. This essay will try to define fair value and discuss its merits and flaws to help the reader achieve some clarity in the process.
The Future of Fair Value Analysis The current debate has not been as strong as we have expected. The debate is still open and unresolved. In fact, it seems to appear to be almost over. The topic has not yet been properly addressed yet. For now, there is a lack of consensus in the industry about a solution to how fair value analysis is done. That said, there are some promising ideas for solving the gap between the U.S. government and the private sector. The first is the Fair Value Management, or FFMA, developed in 2002. There is even an ongoing discussion about the use of FFMA. The final and most important work on the issue is the U.S. Fair Value and Financial Accounting Standards, released in December 2010. This document provides a summary of the current state of the art and some of the potential opportunities and pitfalls for the industry to improve its approach to fair value. The summary is based on analysis of information from 1,824 financial statements with over 1,350 statements that can be evaluated in any case, including those of individual companies. This is published using a publicly available spreadsheet system. It does not contain information on the legal or financial obligations of each company. A major advantage of using FFMA. In this document, FFM is a fully standardized accounting framework that does not require any personal knowledge of the financial industry (as opposed to the traditional U.S. FASB standard, which requires extensive experience with accounting). Therefore, it could have a wider applicability beyond the individual financial industry. While FFM does not require any training or extensive background experience regarding financial management, most current executives of the leading financial companies understand its importance. It is also a great tool for anyone new to the industry to review industry and financial performance or to determine the impact of their current financial situation without being familiar with the industry at large. This is an excellent start and provides an excellent way to get at understanding the economics, technicalities, and needs of the specific financial firms. Although there is no mention of FFM, one of its main strengths as a means of reducing uncertainty and improving operational efficiency is its high rate of efficiency. While other tools, such as audited financial statements as well as FASB, can simplify an individual person’s job, a high level of efficiency can also mean greater financial stability. This applies most effectively to individual companies. This means having to make the hard decision between accounting practice and financial management can be a difficult task. The other major advantage of FFM is its ease of use. The FFMF is available on open online databases that are accessible to all. It has been around for over 30 years (now in its 12th year but updated every 30 years). The most widely used tool for the U.S. FASB is version 9, and it has been around for more than 15 years (today’s version is version 10, version 5.0). It provides a complete understanding of the economic and financial processes of a company as well as what that process looks like. Moreover, at the highest level, it allows management to better understand how companies would change (such as how to manage capital without changing a company’s accounting practices) without being overwhelmed by current operating difficulties. This allows a team of executives who typically work in finance to focus on particular areas of business rather than on an application for a particular function. That said, the data it provides provides are invaluable, with some major implications for all business. F.A. Hayek, The Austrian Economics of Value and Profit (New York: McGraw-Hill, 1995), 3. The idea in these books is to provide a view of the economy for the purposes of assessing the value of one sector over another. They do not show how these processes affect the value that an individual stock will ultimately hold. Rather,
The FASB defines “fair value” as “the price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated willing parties” (FASB, 2004a).4 As the FASB notes, “the objective of a fair value measurement is to estimate an exchange price for the asset or liability being measured in the absence of an actual transaction for that asset or liability.” Implicit in this objective is the notion that fair value is well defined so that an asset or liabilitys exchange price fully captures its value.
PlusesInvestors, in pursuit of returns, have a need to constantly evaluate the entity holding their investments and are always concerned with the value of assets and liabilities a company holds. Many efficiency, liquidity and investor ratios are based around these two items in the balance