Made famous by the housing crisis, fair-value measurements have gotten a bad rap for allegedly plunging the nation into economic turmoil. Of course, that's not the whole story; fair-value measurements, estimates made on the basis of determining what value would be assigned to an asset during an orderly transaction based on current market conditions, have both benefits and disadvantages.
Mirrors Economic Reality
Proponents of fair-value accounting argue that using fair-value measurements is necessary for financial records to represent the economic reality of the business. Because conventional accounting only allows for asset values to be written down, book values tend to underestimate the value of assets. Fair-value accounting in the U.S. allows the value of investments to be written up and down as market values change. Under International Financial Reporting Standards (IFRS) the rules are even more liberal; companies are not limited to investments when applying fair-value accounting.
Because losses are reported when asset values change, not when they are involved in a transaction, proponents of fair-value accounting contend that investors are not as easily able to be misled by companies that try to hide losses. For example, let's say a company holds an investment in the stock of another company that it is holding as available for sale. Under book-value accounting, losses and gains on the unsold securities are not recorded as income until the securities are sold; under fair-value accounting, the losses and gains are recognized immediately.
A strong argument against fair-value accounting is its volatility. Because changes in value are recorded at each balance sheet date, even daily market changes can affect company valuation. A counterargument is that market changes affect all companies equally, so the effects cancel out; however, comparing the value of a company's fair-value assets over time becomes problematic when a component of the price change is related solely to sporadic market activity.
For assets that are not actively traded on a public exchange, fair-value measurements are subjectively determined. While the Financial Accounting Standards Board (FASB) provides a hierarchy of inputs for fair-value measurements, only level 1 inputs are unadjusted quoted market prices in active markets for identical items. If these are not available, the company either has to look to similar items in active markets, inactive markets for identical items, or unobservable company-provided estimates. These level 2 and level 3 estimates can be a source of contention between auditors and management.