To many businesses the process of accounting is simple: keep track of costs and weigh them against revenue to determine profit. But some of the world’s largest companies prefer to figure out their financial well being by using a more complicated, predictive method. Known as fair value accounting, this technique measures a company’s assets by valuing them on estimates and projections rather than hard data. Its proponents argue that it makes accounting information more relevant for day-to-day operations. Critics of fair value, on the other hand, accuse the system of obscuring important facts that are necessary in determining a company’s financial health.

Fair value accounting was banned for much of the 20^th century after it was blamed for contributing to the 1929 stock market crash. By the 1980s, though, financial theory had changed to a point where many experts assumed that financial markets were efficient and their prices reflected real-world values. As economists argued in favor of this notion, the government repealed their ban on fair value accounting. The practice went on unfettered until 2008 when the nation experienced another stock market crash. Once again critics condemned fair value, especially for the role it played in overvaluing derivatives and mortgage-backed securities.

But unlike their Depression-era predecessors, regulators didn’t ban fair value accounting. In fact, the world’s two major accounting principles and standards organizations continue to champion the method. Fair value has also grown in popularity with financial services companies that suggest the technique for businesses both big and small. Regardless of fair value’s ubiquity, however, evidence shows that historical accounting is far more accurate and valuable to both companies and shareholders in the long run. After all, it makes more sense to value an asset based on the data available to the accountant rather than to place an assumption on its future worth. But as long as fair value remains in vogue, it will only get more and more difficult to gauge the true value of a company and its holdings.

Questions:

1. What’s the key consideration in selecting an accounting system?

2. Should the FASB include members from the financial services industry?

Source: Karthik Ramanna, “Why Fair Value Is the Rule,” Harvard Business Review, March 2013. Photo courtesy of Dave Wilson Cumbria.