Why is fair value not used as the basis for all accounting measurement and reporting?
The reason “fair value” accounting is not used as the basis for all accounting measurement and reporting, despite its broad acceptance as a viable tool for assessing value, is because, unlike conventional accounting measures that reflect straightforward representations of assets and liabilities, it incorporates a considerable degree of subjectivity that cannot necessarily be quantified. Fair value has been defined by the Financial Accounting Standards Board (FASB) as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value accounting is used to estimate value based upon assumptions, for example, the revenue that would be generated if specified assets were sold at a specified date and under specified conditions. Assuming all operating assumptions are accurate – and the margin for error could be very limited – the estimated value could be entirely credible. Quantifying such a conclusion, however, is highly problematic given the range of variables that could intervene. As the FASB further notes, “a fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability.” That is a reasonable concept for assessing value, and has broad acceptance in business accounting, but it is a more tenuous instrument for many accounting purposes where assumptions can lead to increased scrutiny on the part of tax agencies. [See Statement of Financial Accounting Standards No. 157: Fair Value Measurements, linked below]
These caveats aside, fair value accounting is a credible tool for businesses to employ, and has a large number of supporters among corporate financial analysts and accountants. Advocates argue that fair value accounting allows for more frequent modifications to take into account changing circumstances, that more accurate assessments are derived precisely because of the ‘real-world’ conditions under which they are calculated, and that the requirement to list losses and gains in the year in which the transaction occurs rather than when they are realized provides for more timely and useful disclosure. [See, for instance, Stephen G. Ryan, “Fair Value Accounting: Understanding the Issues Raised by the Credit Crunch,” Council of Institutional Investors, July 2008] Fair value accounting is not used for ALL accounting measurement and reporting, but it is used for much measurement and reporting. It will likely never be used in all situations, however, precisely because, as noted above, it hinges on assumptions, and is sanctified by the accounting industry’s own organization for establishing standards, the FASB, the integrity of which is subject to dispute. [See on this point Karthik Ramanna, “Why ‘Fair Value’ is the Rule,” Harvard Business Review, March 2013]