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.
Advantage: 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 the company's 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.
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Advantage: True Income
Fair value accounting limits a company's 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.
Disadvantage: Value Reversal
Fair value accounting can also present challenges to companies and users of 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 reevaluate 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 previous normal levels, making any reported losses or gains temporary, which means fair value accounting may have provided misleading information at the time.
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Disadvantage: 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.
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