A hundred years ago, the fair value of your business assets didn't affect your income statement. The money you realized by selling the assets was the only income that mattered. Twenty-first century financial statements are supposed to reflect the fair value of an asset. The income statement is used to report any gain or loss in value since you made the investment.
The Income Statement
Your business's income statement shows the bottom line for a given period, such as a month or a year. The accounting practice is complicated but the theory is simple: show how much money came in and how much money you spent. Add them together. The result is your net income.
Normally, the income statement doesn't detail assets such as investments or equipment. You record those on the balance sheet. Under "fair value" accounting, if the asset gains or loses value during the income-statement period, you treat that as positive or negative income. "Fair value" is defined as whatever price a buyer and seller agree on if they know the market and both want to make the deal.
When you sell an investment, you include the amount of money you received on the income statement as part of your income. Suppose you haven't sold an investment, but it lost $10,000 in value in the past year. If you include that loss with your income it will make your company look less profitable than it really is. Likewise, an increase in value would pad your income.
The solution is to include it in a separate category, "other comprehensive income." This section of the statement covers gains and losses that don't affect your income but do affect the equity, the worth of your business assets. You can combine income and comprehensive income into one statement, or separate them into two. If you have gains and losses from multiple assets, report them individually, then give the total.
Mark to Market
Fair-value accounting of assets is sometimes called "mark to market." That's because the simplest way to keep values fair is to mark them at whatever price the market sets when you draw up the statement. If that's changed since the last income statement, you report the change as comprehensive income.
Investments that aren't constantly traded the way stocks and bonds are may not have an obvious market value. In those situations, accountants can use a "mark to model" method. The accountant uses a model, a theoretical measure of how the value should change, or they ask a financial specialist for an opinion. The accountant then marks the value to the model.
- Companies usually transfer the other comprehensive income balances to "accumulated other comprehensive income" in the stockholders' equity section of the balance sheet at the end of an accounting period.
- Fair value adjustments also apply to derivative instruments. Companies use derivatives to hedge exposures to interest rate volatility, foreign exchange fluctuations and changes in fixed asset market values. The treatment of gains and losses on these derivatives depends on the intended use of the hedging. Consult a qualified tax accountant for more details on how to record fair value adjustments for derivative hedges.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com