Fair Value Increases the Relevance of Financial Statements

It is hard to pick up a set of financial statements these days without seeing some reference to fair value. Whether you are a business owner, CEO, or CFO, you probably have an understanding that in the past, financial statements have been prepared using the historical cost basis of accounting. Opponents of that basis argue that financial statements don’t paint an accurate picture of the financial condition of an entity because they fail to reflect the current values of assets and liabilities. Although widespread use of fair value in the preparation of financial statements is still not permitted, standard setters have recognized that measuring certain assets and liabilities at fair value is appropriate. As a result, standard setters have issued guidance permitting the use of fair value in limited instances.

Understanding available options can help companies increase the efficiency of accounting department activities. Furthermore, it allows them to prepare financial statements that better reflect the economic reality. For example, many companies mitigate interest rate risk through hedging arrangements. However, the accounting rules around hedging activities are highly complicated, often leading to accounting results that fail to reflect the underlying economics of the hedge arrangement. Under current accounting standards, companies have the option of recognizing some of these arrangements at fair value. This results in a better depiction of the economics of the business, without the need to comply with complex accounting rules.

Additionally, entities have the option of reporting certain investments in unconsolidated entities at fair value. Absent this election, companies are generally limited to recognizing their share of income or losses, or impairments in the value of the investment. However, they are never permitted to recognize increases in the value of the investment unless it is sold.

Finally, purchase accounting rules now require the measurement of contingent consideration (i.e. earnouts) at fair value. Properly measuring fair value is critical to ensuring the accuracy of financial statements and that future results are not unnecessarily impacted by fluctuations in the amounts ultimately paid.

These are just a few examples of situations where the use of fair value may be beneficial.  Although the permitted use of fair value certainly is not widespread, it is clear that we are moving toward an environment where the use of fair value will expand. This is driven by continued efforts to align U.S. GAAP with international financial reporting standards, allowing more broad use of fair value. As a result, we can expect the landscape to continue to shift. To find out more about how these rules could impact your company or to learn more about ongoing developments, please feel free to contact us.

Christopher F. Meshginpoosh can be reached at Email or 215.441.4600.