September 28, 2008

The Perils of Fair Value Accounting

Filed under: Business,Economics — Bottom's Up @ 12:40 pm
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Any new student of accounting gets bewildered by the historical cost concept. The premise of this being that long term assets should be reported on the books at the value that they were bought at (apart from depreciation etc). The most commonly used example is that of land – land is usually reported on the books in the US system at the cost at which it was bought at. Land being such, usually appreciates and thus in the course of time, the value on the books ends up being being below the market value and firms are forced to report less assets than they have.

However, in recent years, firms have been allowed to report financial assets at market values instead of historical costs. For sometime this was considered a good idea, but in recent months has become the cause of much debate thanks to the credit crisis. The Economist last week had a great article on problems related to the same. An interesting point that the Economist brought out and which this writer was not aware of was

Today the treatment of a financial asset is determined by the intention of the company. If it is to be traded actively, its market value must be used. If it is only “available for sale” it is marked to market on the balance sheet, but losses are not recognised in the income statement. If it is to be “held to maturity”, or is a traditional loan, it can be carried at cost, subject to impairment. This is a dog’s breakfast. Different banks can hold the same asset at different values.

Noe this is indeed terrible. A big part of the problem recently has been one of the adverse selection problem. The only way around adverse selection problems is to reduce the level of assymetric information when it comes to dodgy products. Of course, this is easier said than done.

UPDATE: Justin Fox of Time has an interesting update on what’s happening on this front currently.


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