Fair Value

Accounting has traditionally recorded the value of assets at historical cost. This simply means that the asset has to be shown on the balance sheet, at least initially, at whatever price the company paid for it. As the asset wears out or gets used up over time, the value shown on the balance sheet should decline.

Take a truck, for instance. If a company pays $160,000 for a delivery truck, including all the fees and taxes associated with getting it into service, then the truck is shown in the long term assets section of the balance sheet as having a value of $160,000. If the company expects that the truck will be used for 10 years and will likely be sold for $10,000, then every year for 10 years the company will record that the truck depreciated in value by $15,000 = ($160,000 - $10,000) / 10. Other ways of doing this calculation exist, but this is one of the most popular approaches because it is so simple.

This "historical cost" model runs into problems, however, if the company buys an asset that goes up in value instead of down -- for instance, if it buys shares in another company and those shares go up in value.

In the last 20 years, accounting regulators have made considerable efforts to encourage accurate reporting of the current market value of assets, instead of their historical cost. Accountants call this "fair value" accounting, the implicit notion being that the value a company shows for its assets should be based on a fair (that is, unbiased) method of assessment.

Assessing the fair value of a truck is costly. You have to pay someone who is independent of your company to inspect it and check it against the current market for used trucks.

So, in practice, companies don't report fair value for the traditional kind of asset that goes down in value over time as it wears out. The historical cost approach is simple and cheap and it produces values that are "good enough."

Companies do use fair value for things that have a clear, easily determined market value, like stocks and bonds. Anything that trades on the financial markets is fair game for fair value.

This relatively new emphasis on fair values is supposed to produce balance sheets that are more useful to people who make decisions based on this sort of information, including investors, union negotiators, and lenders.

What could possibly go wrong?

Well, a lot, as it turns out. In practice, things don't always turn out as the regulators hope. This is why I write "Practice" articles, so read on...

Photos of fully depreciated vehicle taken at Kensington Market, Toronto, in 2016.