An overview of Fair Value (FV) Accounting:

For the past two decades, fair value accountingthe practice of measuring assets and
liabilities at estimates of their current valuehas been on the ascent. This marks a major
departure from the centuries-old tradition of keeping books at historical cost. It also has
implications across the world of business, because the accounting basiswhether fair value
or historical costaffects investment choices and management decisions, with consequences
for aggregate economic activity.
An alternative approach to measurement that seeks to capture changes in asset and liability
values over time. The International Accounting Standards Board (IASB) defines fair value as
"... an amount at which an asset could be exchanged between knowledgeable and willing
parties in an arms length transaction".
Under the fair value measurement approach, assets and liabilities are re-measured
periodically to reflect changes in their value, with the resulting change impacting either net
income or other comprehensive income for the period. The result is a balance sheet that better
reflects the current value of assets and liabilities. The cost is greater volatility in periodic
reported performance caused by changes in fair value.
The notion of fair value accounting is intuitive when applied to quoted investments such as
equities, bonds, commodities, etc. that are carried in an entitys balance sheet at their market
value. This form of fair value accounting is often termed mark-to-market accounting.
However, while market prices are one aspect of fair value measurement, the term is
increasingly being used to describe measurement by other means. For example, accountants
often arrive at an estimate of fair value for non-quoted investments based on a model (e.g., a
share option valued by applying a specialist option valuation model) or specialist opinion.
Such applications of fair value measurement are referred to as mark-to-model accounting.
The IASB has followed US standard-setters in dealing with the problem of fair values that do
not result from market prices. Specifically, IFRS 13 Fair Value Measurement applies the
following valuation hierarchy:
Level 1: fair values are derived from quoted market prices for identical assets or liabilities
from an active market for which an entity has immediate access
Level 2: where there are market prices available for similar (as opposed to identical) assets or
liabilities

Level 3: if values for levels 1 or 2 are not available, fair value is estimated using valuation
techniques
Fair value accounting is most frequently applied to financial assets and liabilities because
market prices or reliable estimates thereof are most likely to exist for such elements.
Proponents argue that fair value accounting for assets or liabilities better reflects current
market conditions and hence provides timely information. Opponents, on the other hand,
argue that fair values can be irrelevant and potentially misleading for a variety of reasons. For
example, some claim that fair value is not relevant for items that are held for a long period
(i.e., to maturity) as investors are not interested in interim value changes. Others argue that
fair values can be distorted by market inefficiencies, investor irrationality or liquidity
problems and that estimated values derived from models may lack reliability.
Finally, fair value accounting has been criticised for contributing to procyclicality in the
financial system by exacerbating market swings and causing a downward spiral in financial
markets. In particular, some commentators argue that emphasis on level 1 and 2 valuations
makes it difficult to deviate from market prices, even if prices are below fundamentals or they
give rise to contagion effects.

Advantages or Disadvantages of Fair Value Accounting

Fair value accounting is a financial reporting approach, also known as the mark-to-market
accounting practice, under generally accepted accounting principles (GAAP). Using fair
value accounting, companies measure and report the value of certain assets and liabilities on
the basis of their actual or estimated fair market prices. Changes in asset or liability values
over time generate unrealized gains or losses for the assets held and liabilities outstanding,
increasing or reducing net income, as well as equity in the balance sheet.
Accurate Valuation
A primary advantage of fair value accounting is that it provides accurate asset and liability
valuation on an ongoing basis to users of a companys reported financial information. When
the price of an asset or liability has increased or is expected to increase, the company marks
up the value of the asset or liability to its current market price to reflect what it would receive
if it sold the asset or would have to pay to relieve itself from the liability. Conversely, the

company marks down the value of an asset or liability to reflect any decrease in the market
price.
True Income
Fair value accounting limits a companys ability to potentially manipulate its reported net
income. Sometimes management may purposely arrange certain asset sales, for example, to
use gains or losses from the sales to increase or decrease net income as reported at its desired
time. Using fair value accounting, gains or losses from any price change for an asset or
liability are reported in the period in which they occur. While an increase in asset value or a
decrease in liability value adds to net income, a decrease in asset value or an increase in
liability value reduces net income.
Limitations of Fair Value (FV) Accounting
Value Reversal: Fair value accounting can also present challenges to companies and users of their
reported financial information. Conditions of the markets in which certain assets and liabilities are
traded may fluctuate often and even become volatile at times. Applying fair value accounting,
companies revaluate the current value of certain assets and liabilities even in volatile market
conditions, potentially creating large swings in the value of those assets and liabilities. However, as
markets stabilize, such value changes likely reverse back to their previous normal levels, making any
reported losses or gains temporary, which means fair value accounting may have provided misleading
information at the time.
Market Effects: The use of fair value accounting may further affect a down market adversely. For
example, after an asset has been revalued downward because of drops in the current market trading
prices, the lower value of the asset could trigger greater selling of the asset at a potentially even more
depressed price. Without valuation markdown as required by fair value accounting, companies may
not feel the need to sell an asset in a down market to prevent potentially further downward valuation
of the asset. Absent additional selling pressures, the market may stabilize over time, which would help
preserve the value of the asset.