Fair value accounting is a controversial topic, and rightfully so I
believe. My article
by Karthik Ramanna of Harvard Business Review,
raises some interesting points. Fair value accounting only entered the
mainstream again over the past few decades. Fair value accounting
was blamed for the 1929 collapse, banned by the SEC until the 70’s,
and then blamed again for crashes since, most notably the 2008
collapse. Cost accounting is certainly more conservative, whereas fair
value accounting allows for manipulation of data (Ramanna, 2013).
Fair value can appear to make sense in certain instances. If an equity
investment with a $100,000 cost basis experiences enough capital
appreciation to value the asset at $400,000, we are missing out on
reporting $300,000 in assets that, on paper at least, we have. The
problem arises when this investment experiences a 40% loss like we
saw in 2008 in the equity markets, and it looks like a company lost
nearly half of its assets in a matter of weeks. This can wreak havoc
on financial reporting and judging only the balance sheet, can make
things look a lot bleaker than they actually are. Using cost accounting
would avoid this scenario entirely, though at the cost of being a very
conservative approach (Ramanna, 2013).
As a personal example, I know most people probably look at their
brokerage accounts and just see a number. They think they “have”
that number, so when the market corrects and they lose 15% of their
net worth in a couple weeks, they panic. Did we ever actually have
that money, though? Ultimately, we do not gain or lose anything until
we sell. When people panic and liquidate their life savings, they
actually do lose money, because they make those unrealized losses
real. Looking at our cost basis might be a better indicator of the state
of panic than looking at how an overinflated stock we bought years
ago fell 15%, still leaving us in the black. The same scenario can be
applied to large cap companies listed on the S&P500. When asset
valuations drop under fair value, it can look like the sky is falling and
make investors panic, which ripples throughout the market at large.
Under cost accounting, we practice the fact that we have not gained
or lost anything unless we sold our asset, regardless of valuation, and
the most reliable method is cost.
Reference:
Ramanna, K. (2013). Why 'fair value' is the rule: How a controversial
accounting approach gained support. Why 'Fair Value' Is the Rule: How
a Controversial Accounting Approach Gained Support - Article -
Faculty & Research - Harvard Business School. Retrieved March 23,
2022, from https://www.hbs.edu/faculty/Pages/item.aspx?
num=44233
