Fair value accounting (FVA) is a financial approach in accounting in which a company measures and reports an estimate of the amount of money it would receive if all its assets were sold and the company relieved of its financial liabilities. Under this type of accounting, a company would report a loss if it reports a decrease in assets or an increase in the number of liabilities. Issued as a US accounting standard in 2006, FVA required mortgage securities to be valued according to their current market value instead of their projected value. Although this approach has a variety of pros and cons, according to Professor Christian Laux of Vienna University and Professor Christian Leuz from the University of Chicago, this type of accounting could have been a major contributing factor in the subprime mortgage crisis.
One major advantage of fair value accounting is that it is a clear concept. When the value of an asset goes up, the company makes an adjustment of the increase, which reflects the current market value. On the other hand, when a decrease occurs, the value of the asset or liability is marked down to reflect the change in value. This provides the accounting department with an accurate valuation of assets and liabilities at any given time.
When looking at the pros and cons of the fair value measurement standard, the Financial Accounting Standards Board reported that, in general, it met its objective; however, a disadvantage of the system was that some investors struggled to understand the fair value information that companies reported in their financial statements. When information was easy to understand, the level of satisfaction on the reports varied. Some investors believe there should be more information reported, while others thought there was too much information to weed through.
Another issue with fair value accounting is that market values change all the time. When asset values begin to drop and companies begin to sell, it can create a massive downward spiral in that market. However, once the market begins to stabilize again and the values go back up to their original levels, the situation will make the reported loss temporary, which means that FVA could have provided investors with misleading information at that time.
While there are both advantages and disadvantages of the fair value accounting standard, it is the most relevant measurement for financial instruments. It is also the most agreed-upon standard. In the past, assets were based on a historical cost. This meant that if a company purchased a piece of equipment for a set price, that price would continue to be listed on a balance sheet year after year. Fair value accounting allows for an increase or a decrease in that value. Fair value accounting is one of the largest events in accounting in recent years.
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