Fair value accounting is the process of periodically adjusting an item’s value in accounting books. Assets and investments are the most common items that apply under this accounting principle. This principle changes the traditional accounting reporting method, which used historical costs to value items on a company’s books. Significant disadvantages exist in fair value accounting.
In volatile markets, an item’s value can change quite frequently. This leads to major swings in a company’s value and earnings. Accountants typically write off losses on items against a company’s earnings. Publicly held companies find this difficult as investors may find it difficult to value the company with such swings in place. Additionally, the potential for inaccurate valuations can lead to audit problems.
Accountants may find fair value accounting less reliable than historical costs. For example, accountants typically look to the market when finding a new value for assets or investments. When an item has different values in different regions, however, accountants must make a judgment call on valuing items on the books. If a company with similar assets or investments values items differently than another, issues may arise because of the accountant’s valuation method.
Inability to Value Assets
Businesses with specialized assets or investment packages may find it difficult to value these items on the open market. When no market information is available, accountants must make a professional judgment on the item’s value. Accountants must also make sure that all valuation methods used are viable and take into account all technical aspects of the item. Essentially, companies must have strong reasons for placing values on assets and investments.
Reduces Book Value
A company’s book value is the total of all assets owned. Historically, a company’s book value changed when a company purchased new assets and/or disposed of old assets. Fair value accounting now changes a company’s book value for seemingly arbitrary issues. For example, if an asset or investment experiences a significant drop in value for a short time period, a company may need to make accounting adjustments. If the value goes back up, the adjustment did nothing but drop the company’s book value for a small time period.