Fair value accounting involves adjusting an asset's value to its current market price, unlike historical cost accounting.
Understanding Fair Value Accounting
Fair value accounting aims to provide a more accurate representation of a company's financial position by reflecting the current market conditions. This method recognizes that asset values can fluctuate and records these changes in the financial statements.
Contrasting with Historical Cost Accounting
Historically, assets are recorded at their original purchase price. This historical cost method doesn't reflect changes in the asset's market value over time.
| Feature | Historical Cost Accounting | Fair Value Accounting |
|---|---|---|
| Asset Valuation | Original purchase price | Current market price |
| Market Fluctuations | Not reflected in value | Reflected in value |
| Accuracy of Financials | May not represent current value | Generally more reflective of current value |
Example: Land Valuation
Let's consider a real-world scenario to illustrate the difference between the two approaches:
- Scenario: A company purchased land for \$500,000 five years ago.
- Current Market Value: A land appraiser determines that the land is now worth \$600,000.
Historical Cost Method
Using the historical cost method, the company's balance sheet would continue to show the land at its original value of \$500,000 until the land is sold.
Fair Value Method
Under fair value accounting, the company would adjust the land's value on the balance sheet to \$600,000. This reflects the current market value.
Impact of Fair Value Accounting
The switch to fair value accounting could lead to:
- Increased transparency - providing a more accurate representation of a company's financial health.
- Adjusted financial statements - leading to either a profit or loss reflected on the income statement, even without the sale of the asset.
- Potential volatility - in the financial statement values, as asset prices change regularly.
Conclusion
Fair value accounting provides a more realistic view of a company's assets and liabilities by using current market values, whereas historical cost accounting utilizes the original purchase price. The example of the land shows how fair value accounting adjusts values to reflect the current worth of an asset.
