Fair value accountingIntroduction Fair value is a concept used in accounting and economics, which provides an unbiased value of the market price of an asset. It is an estimation of the market value of an asset for which an asset’s market price cannot be determined. It is the amount that an asset can be bought or sold at current market conditions between willing parties. In accounting, fair value is used as an estimate of the liability and market price of an asset. The liability of an asset is the market value of that particular asset.
Under the accounting guidelines the fair value is used for assets whose value is based on the mark to market valuations and for those assets which have historical costs fair value is not used. Impact of fair value on financial statementsThe use of fair value for measuring assets has been controversial. The use of this measure on financial statements will reflect the impact of current market conditions on financial instruments. This will lead to greater transparency, as investors will have more information on which assets are valuable and which are not and will benefit from knowing the market liquidity.
There is the belief that fair value provides the most relevant information but concerns are about the reliability of their estimation. The impact caused by increasing the use of fair value is increasing the volatility of financial statement amounts. If financial statements are based on fair values then the amounts will change from period to period in the balance sheet as well as the income statement. The less volatile historical costs will then begin to change also in a fair-based value accounting system. The primary objective of providing financial reporting is the information relating to uncertainty of future cash flows.
If financial statements overstate the economic volatility investors will assess risk premium to the entity’s cost of capital that is higher than what is justified by the economic situation. Maintaining stability and soundness in the financial system is made difficult because of this volatility. The purpose of financial statements is to provide the financial position of an entity so that the users can make a variety of decisions based on the changes in the financial position to make decisions.
Fair value provides more transparency than historical cost based measurements. Regulation and market discipline is achieved when all financial instruments are measured at market value. This is because losses achieved by investors and taxpayers alike are avoided. The interests of the investors and depositors are protected when financial instruments are measured at fair value. This way losses that are incurred by investors during the previous downturns in the economy is avoided. The financial instruments will reflect the impact of the current market conditions on financial instruments.
Fair value is therefore the best way to reveal these conditions. Whether positive or negative, fair value is the result of market forces. This is good news to investors because they benefit when companies reveal their views on the impact of the market liquidity in their financial statements.