In order to conform to the most widely accepted accounting standards developed throughout the world, financial statements generally must be prepared on the accrual method of accounting. But in many cases, especially with smaller businesses, cash-basis financial reporting may be perfectly acceptable, because the use of the financial statements is more limited—to simply monitor financial activities or to report revenues received to a bank in connection with a loan.

Under the cash basis of accounting, revenues are recorded when they are collected and expenses are recorded when they are paid. But with accrual accounting, the timing of revenue and expense recognition is different. Revenue is recorded when it is earned, which may come either before or after it is actually collected. Likewise, expenses and/or liabilities are recorded when the benefits have been received, such as when services have been provided by a vendor or goods are received. Accrual accounting is the foundation of all of the world’s commonly used accounting standards, including both of the systems covered in this book.

But even accrual accounting has undergone much change—and that change is not limited to the increased use of fair value accounting. The very concept of when to recognize an asset or liability has evolved. One of the best examples of this is with asset retirement obligations, a topic explained in Chapter 13. Prior to the development of the current standards dealing with asset retirement obligations, the carrying amount of land or a building was the amount paid to acquire the asset, including any amounts borrowed. The thought of accruing an additional amount to the asset and an additional liability for a cost that might not be incurred for years was thought of as violating accrual accounting. Not anymore. Under the current rules, costs necessary to dismantle or retire such assets must be accrued today. So, the whole idea of when a cost has been incurred has changed as accrual accounting has evolved. Similar developments have occurred with respect to many other elements of the financial statements.

This brings us to the use of fair value accounting. For most of the history of accounting, financial reporting has been based on historical cost, under which purchased assets are reported at the amount paid for the asset, less accumulated depreciation where appropriate. Similar principles are utilized for other assets and liabilities, which have traditionally been reported at the face amount of what is owed.

Fair value accounting, by contrast, relies on the principle that an asset should be reported at an amount that reflects what the asset is worth, not what an entity paid for it. Likewise with liabilities—although for many liabilities, fair value is equal to the amount that is owed to a vendor or bank.

Upon initial observation, the effect of fair value appears to be potentially greater on assets than it is on liabilities. An investment in stock that was purchased many years ago for $1,000 that is now worth $100,000 looks much different when fair value accounting is utilized.

Arguments for and against fair value accounting have been ongoing for many years. The principal argument in favor of valuing all assets and liabilities at current fair values is that this provides information of greatest value to most investors and many other readers of audited financial statements. Fair value accounting can provide a more current picture of the financial condition of an enterprise than historical cost accounting.

The argument in favor of reporting assets at historical cost is that cost is rarely subjective. Unlike fair value accounting, which can require extensive use of judgment and often requires specialized expertise, historical cost accounting is usually objective. It is usually easy to prove.

Like it or not, the increased use of fair value accounting is likely here to stay. Both U.S. and international accounting standards now include extensive use of fair value accounting. A reversal of this concept would appear to be extremely unlikely.

In connection with the global economic downturn that became a crisis in 2008, many wondered whether fair value accounting was partly to blame and that its use should be suspended. The general consensus is that the use of fair value accounting should continue, albeit perhaps with some clarification and increased disclosures.

In its December 2008 Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-to-Market Accounting, the U.S. Securities and Exchange Commission (SEC) not only encouraged the continued use of fair value accounting, it suggested an expansion of fair value accounting. This study was mandated by Congress in connection with an October 2008 law aimed at bringing stability to the financial institutions sector hit hard by the economic downturn. The law mandated that the SEC study the fair value accounting provisions described in SFAS 157 and other standards, examining six issues:

In its endorsement of fair value accounting, the SEC noted that the current accounting standards were each subject to a lengthy and thorough due diligence process. A quick suspension of fair value accounting (which was suggested by some members of Congress) would circumvent this due process and could actually result in greater uncertainty over financial reporting by investors and others.

Rather, in its report the SEC suggests that clarifications and modifications be made to SFAS 157 and some other standards with fair value accounting requirements. The Commission also stated that more practical, useful guidance on best practices and other fair value accounting applications is necessary.

Although its analysis of the use of fair value accounting was limited to a group of specific financial institutions, the SEC’s conclusions clearly were intended for all entities subject to U.S. GAAP.