What is Fair Value Accounting Practice?

Fair value accounting is the measurement of assets and liabilities of a business based on the estimation of current market values. It means the assets can be sold or a liability settled in an orderly transaction to a third party under current market conditions. Therefore this method of accounting is also known as ‘mark-to-market accounting practice ’under generally accepted accounting principles (GAAP).

Ind AS defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The argument for fair value accounting is that it makes accounting information more relevant. Those with a background in the financial services industry like investment banking or investment management consider fair value accounting to make accounting information more relevant and propose to use fair value methods for accounting.
Fair value accounting marks a major departure from the centuries-old tradition of keeping books at historical cost. Many scholars and accounting practitioners consider the historical accounting system to be more reliable compared to fair value accounting. They argue that the fair value accounting system was responsible for the 2008 global financial crisis. Bankers and funds -managers have linked the run-up to the 2008 crisis to fair value principles wherein certain securities rose to abnormal ascendance during that period and the professionals marked those securities to market, booked the profit, and used the same for executive bonuses, etc. by recognizing them as net income. When asset value started falling, these executives blamed fair value marks for the rapid decline in the value of the assets.
However, globally over 100 countries accepted GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) and continue to use Fair Value Accounting Principles for measurement of assets and liabilities. These countries have recognized prevailing prices are reliable measures of value measures particularly in accounts concerning derivatives and hedges, employee stock options, financial assets, and goodwill impairment testing.

In India, Ind AS establishes a fair value hierarchy that categorises into three levels of the inputs to valuation techniques for measuring fair value.

(i) Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.

(ii) Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

(iii) Level 3 inputs are unobservable inputs for the asset or liability.

The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs).

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