Fair Value Vs Historical Cost Measurement

In the current climate with economies hitting an all time low and markets being unpredictable like never before, stakeholders are increasingly conscious about their investments and the value they currently hold. Accounting measures in this type of situation become a very critical component in maintaining shareholder confidence; and financial instruments if used appropriately, can significantly impact the outcome. Needless to say, the debate between the use of historical and fair value accounting has been going on for a long while and change has been slow but sure. The FASB has made it a mandatory requirement in the US for companies to use fair value accounting to value certain assets and liabilities. However, this imposition does not come free of critique. This essay will try to define fair value and discuss its merits and flaws to help the reader achieve some clarity in the process.

The FASB defines "fair value" as "the price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated willing parties" (FASB, 2004a).4 As the FASB notes, "the objective of a fair value measurement is to estimate an exchange price for the asset or liability being measured in the absence of an actual transaction for that asset or liability." Implicit in this objective is the notion that fair value is well defined so that an asset or liability's exchange price fully captures its value. http://www.bis.org/publ/work209.pdf

Pluses

Investors, in pursuit of returns, have a need to constantly evaluate the entity holding their investments and are always concerned with the value of assets and liabilities a company holds. Many efficiency, liquidity and investor ratios are based around these two items in the balance