Fair value system is for all seasons

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: Pooja Gupta

Historical cost accounting is fading as corporate India marches into a new era. In the fair value accounting regime, what is a company’s real worth? This is the central question that accounting attempts to answer, and it is no easy exercise. Every answer invites debate, and that debate has now intensified, thanks to fair value accounting.

Under fair value, a company values its assets and liabilities based on what they would fetch today, rather than what they originally cost. The concept is not new—accounting has long operated under a mixed model, which records many items at historical cost while requiring that companies mark to market certain asset classes (such as securities and derivatives).

But a host of factors have suddenly propelled the calculation of fair value from a secondary concern to a dominant theme of corporate accounting, and many companies are just beginning to understand the ramifications. If fair value takes full hold, as some have suggested it should, company results may look far different than they do today.

In stark contrast to most other accounting concepts, fair value has already achieved the improbable feat of making front-page news, thanks to its alleged role in the subprime mortgage crisis. Mired in mess, many financial services giants have staggering losses.

The question is: Has fair-value accounting played a role in the economic meltdown? The proponents of fair value say that the accounting standards merely help companies show how much their assets are truly worth at this very moment—and that the downfall of the financial institutions that took major write-downs after applying fair value was actually a delay in showing investors how much these banks were truly worth and were representative of a move toward a down market.

The ultimate intent of fair value is to give investors better visibility into how companies value their assets, and a few deny that it achieves that aim. While recent events on Wall Street provide only an imperfect proxy for fair value’s impact, those who claim that it will increase volatility have plenty of evidence on their side. The recent market conditions are most immediately felt by those fair valuing financial instruments. Fair value in accounting itself has come under attack from some quarters accused of making problems worse.