The Advantages and Challenges of Fair Value Accounting Over Historical Cost Accounting

When it comes to financial accounting, two widely used methods are fair value accounting and historical cost accounting. Each has its own set of advantages and challenges. This article aims to explore the practical advantages and disadvantages of fair value accounting over historical cost accounting, while taking into consideration the recent developments in accounting standards and practices.

Introduction to Fair Value Accounting

Fair value accounting, also known as fair value measurement, involves valuing assets and liabilities at their current market value. This method, which is recommended by International Financial Reporting Standards (IFRS), provides a more transparent and up-to-date view of a company's financial position and performance. However, as with any accounting methodology, it comes with its own set of risks and challenges.

Theoretical Accuracy vs. Practical Implementation

Theoretically, fair value accounting is considered more accurate because it reflects the current market value of assets and liabilities. This approach provides a more realistic and relevant view of a companyrsquo;s financial situation, as it adjusts the book values of assets and liabilities to their current market price.

Practical Disadvantages and Challenges

The practical implementation of fair value accounting, however, is not without its challenges. One of the main issues is the requirement for significant and often subjective judgments by management. These judgments are necessary when valuing certain types of assets and liabilities, such as financial securities and other illiquid or complex assets.

Management Judgments and Potential for Manipulation

Management must make judgements on factors such as the benchmark to use for valuation and the costs associated with selling certain assets. While these choices can lead to a more accurate representation of financial performance, they can also provide opportunities for manipulation. It is difficult for auditors and regulators to challenge the assumptions made by management, which can lead to potential misrepresentations of a companyrsquo;s financial position.

Example of Inventory Valuation

Letrsquo;s consider an example to illustrate this point. Suppose a company has inventory consisting of a barrel of oil purchased in September at a price of $40, and the current market value is $85. Under fair value accounting, the value of the inventory would be $85 minus the cost to sell, which is estimated to be $5. Therefore, the value of the inventory would be $80. On the other hand, if the company values the inventory at its cost, it would be undervalued at $40.

The reasoning is straightforward when the market conditions are transparent and liquid, such as using benchmarks like Brent or WTI. However, the management will still need to choose a benchmark, and it might not always be as easy as it seems. If the asset being valued is a financial security, such as a bond, and the market is liquid and transparent, the process is relatively simple. But what about a less liquid asset, or one with a highly volatile price, such as an unlisted financial asset or a mortgage-backed security?

For more complex assets, management would need to develop a financial model to estimate the value, and models can be manipulated with different assumptions. The more complex the model, the more open it is to manipulation or bias, which can lead to unfair financial reporting.

Conclusion

In conclusion, fair value accounting offers a more accurate representation of a companyrsquo;s financial position by reflecting current market values. However, it comes with its own set of practical challenges, including the need for significant and often subjective judgments by management. These judgments can provide opportunities for manipulation, making it difficult for auditors and regulators to ensure accurate and fair financial reporting.