Fair Value Accounting (FVA)

Definition

Fair Value Accounting (FVA) refers to a method in which assets and liabilities are measured and reported at their current market price or an estimate of that price. All changes in that value are recognized in the profit and loss account. FVA allows for the recording of unrealized gains and losses where the market price of assets and liabilities differs from their historical cost.

Development and Evolution

FVA developed during the 1980s and 1990s, alongside the growth of the derivatives market and the practice of marking financial instruments to their market price (marking to market) or using pricing models (marking to model).

Examples

Derivatives: A financial institution holds derivatives that it must mark to market. If the market value of these derivatives increases, this unrealized gain is recorded in the profit and loss account.
Real Estate: A company owns a portfolio of real estate assets. Under FVA, these properties are valued at their current market prices, reflecting any increase or decrease in value.
Securities: A bank holds a large number of securities that are traded actively. The bank will revalue these securities to their market price at each reporting date.

Frequently Asked Questions (FAQs)

Q: What is the key difference between Fair Value Accounting and Historical-Cost Accounting? A: The key difference is that FVA measures and reports assets and liabilities at their current market price, while Historical-Cost Accounting records them at their original purchase price. FVA recognizes unrealized gains and losses, whereas Historical-Cost Accounting does not.

Q: How does Fair Value Accounting impact financial statements? A: FVA can introduce significant volatility to financial statements because it includes unrealized gains and losses in the profit and loss account, reflecting changes in market conditions even if the assets are not sold.

Q: What were some criticisms of FVA during the banking crisis of 2008? A: Critics argue that FVA exacerbated the crisis by inflating the balance sheets of financial institutions during boom periods and causing rapid declines during bust periods, especially when complex derivatives became toxic assets.

Q: Is Fair Value Accounting mandatory? A: Yes, FVA is now required under various regulatory frameworks, including International Financial Reporting Standards (IFRS) and the Financial Reporting Standard Applicable in the UK and Republic of Ireland (Sections 11 and 12).

Marking to Market: Valuing an asset or liability based on its current market price.
Marking to Model: Valuing an asset or liability using a financial model when market prices are not available.
Historical-Cost Accounting: An accounting method where assets and liabilities are recorded at their original purchase price.
Hedge Accounting: An accounting method that modifies the recognition of gains and losses from hedging instruments to match the hedged item.
Toxic Assets: Financial assets that have significantly dropped in value and have become illiquid.
International Financial Reporting Standards (IFRS): Global standards for financial reporting designed to ensure consistency and transparency.

Online Resources

Suggested Books for Further Studies

“Fair Value Measurement: Practical Guidance and Implementation” by Mark Zyla
“The Fair Value of Insurance Liabilities” by Irwin T. Vanderhoof
“International Financial Reporting Standards (IFRS) 2021” by PKD Ponniah

Accounting Basics: Fair Value Accounting Fundamentals Quiz

### FVA measures assets and liabilities at their: - [ ] Historical cost - [x] Current market price - [ ] Replacement cost - [ ] Estimated salvage value > **Explanation:** Fair Value Accounting (FVA) measures assets and liabilities at their current market price, accounting for fluctuations in value regardless of the original cost. ### One of the primary benefits of using FVA is: - [x] Reflecting the true market value of assets and liabilities - [ ] Simplifying financial reporting - [ ] Reducing tax liabilities - [ ] Eliminating volatility in financial statements > **Explanation:** Fair Value Accounting aims to present financial statements that more accurately reflect the true market value of assets and liabilities. ### Critics argue that FVA contributed to the 2008 financial crisis due to: - [ ] Complexity in accounting rules - [ ] High historical costs - [x] Inflated balance sheets and downward pricing spirals - [ ] Lower market liquidity > **Explanation:** Critics believe that FVA inflated balance sheets and contributed to a downward pricing spiral, particularly with complex derivatives, exacerbating the financial crisis. ### What system did FVA replace in a significant way? - [x] Historical-Cost Accounting - [ ] Mark-to-Fantasy - [ ] Cost-of-Goods-Sold Method - [ ] Direct Valuation > **Explanation:** Fair Value Accounting significantly replaced historical-cost accounting, which valued assets and liabilities at their historical purchase prices. ### Which regulatory framework mandates the use of FVA? - [ ] GAAP in the US only - [x] International Financial Reporting Standards (IFRS) - [ ] Only for private companies in the UK - [ ] No major framework mandates FVA > **Explanation:** The use of FVA is mandated under various regulatory frameworks, including the International Financial Reporting Standards (IFRS). ### How does FVA impact profit and loss accounts? - [ ] It reduces them since unrealized gains are not considered - [ ] It has no impact - [x] It introduces volatility by recognizing unrealized gains and losses - [ ] Helps them remain constant > **Explanation:** Fair Value Accounting introduces volatility to profit and loss accounts by including unrealized gains and losses in the financial statements. ### The practice of using a pricing model when market prices are unavailable is known as: - [ ] Fair Valuation - [x] Marking to Model - [ ] Intrinsic Valuation - [ ] Estimated Fair Pricing > **Explanation:** When market prices are unavailable, a pricing model is used, known as marking to model. ### What are ‘toxic assets’ in the context of FVA? - [ ] Highly valuable assets - [ ] Assets with high liquidity - [x] Assets that have drastically fallen in value and become illiquid - [ ] Long-term investments > **Explanation:** Toxic assets are financial assets that have drastically dropped in value and become illiquid, potentially harming a company's financial health. ### Which section of the FRC's Financial Reporting Standard pertains to FVA? - [ ] Section 1 - [ ] Section 5 - [ ] Section 8 - [x] Sections 11 and 12 > **Explanation:** Sections 11 and 12 of the Financial Reporting Standard Applicable in the UK and Republic of Ireland relate to fair value accounting. ### What accounting method modifies gains and losses from hedging instruments? - [ ] Historical-Cost Accounting - [x] Hedge Accounting - [ ] Cost Accounting - [ ] Double-Entry Accounting > **Explanation:** Hedge Accounting modifies the recognition of gains and losses from hedging instruments to match those of the hedged item.

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