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My Great Grandparents, Grandparents, and Parents all had the American dream. Work hard, get a good job, start a family, and buy a house. Buying a house is the picture you envision when you think about the American dream. Most Americans had the determination and vision for success. They had the belief that anything can be achieved in America and success meant a new home. The white picket fence is what the American dream is known for and in 2008 many Americans had their dream crushed due to the stock market crash.
Homes were foreclosed upon and for many this was the realization that home ownership would never be achievable. “The crash created the biggest disruption to the U.S. housing market since the Great Depression.”(Business Insider) The inability to buy your dream home or have your dream home foreclosed upon was due in part to the accounting methods of fair value or mark-to market accounting. Many people perceive accountants as someone you would only use if you were to own a business.
They would balance your books and ensure you were paying your proper amount of taxes. The realization that accountants and their principle methods would affect so many lives was unfathomable. The fair value practice, which was responsible in part for the 2008 crash, changes people’s lives. It changed the American dream from being a homeowner to being a renter. The after effects of fair value accounting methods had set the world in a debate whether this method is the best to service the needs of the world and our country.
Should this method be used or should countries be in favor of historical cost accounting methods. The debate still rages today over fair value verses historical value. “Fair value and historical cost are not mutually exclusive. The two concepts are complementary each having their own strengths and weaknesses.” (Cozma p. 860) Fair value and historical cost are two disputed types of accepted accounting principles business use to measure assets and liabilities. Although both methods have their merits I found that the fair value accounting methods have a higher rate of accuracy when defining value on a financial statement.
Fair Value Accounting Methods or mark-to-market method is when a company records their assets and liabilities on their financial statement using the current market value. Proponents for this method find the financial information using this method is more accurate and relevant in today’s market. They believe it improves the accuracy of the financial statement and also shows the global value not just local value. Having the current value gives the true cost. The problem lies on paper and how to determine its fair value. The true cost of a building can easily be defined if it were to be sold. But what if the building is not sold but needs to be shown as an asset for the company. This estimate of the asset is the problem with the fair value accounting method. Companies and banks can increase its value with inflation on paper only. Determining the inflationary value needs to be accurate and not overly inflated. Since the economic markets continually fluctuate the true cost of the asset is unstable. This market price fluctuation can lead to depressions such as in the real estate meltdown in 2008. In 2008 the real estate market was booming and prices had risen. When the economy took a turn downward the property prices dropped because all the appraisals of the real estate assets were overvalued. If during this period the country had used the historical cost accounting methods the real estate value would have remained constant and would not have fluctuated so much causing the 2008 crash. Unlike historical costs the values are based on estimate made by qualified people. “This inherently shows this persons interpretation, how they processed the information, and its application of the data used, and sometimes giving it a biased calculation.” (Cozma p. 860)
Ambiguous accounting practices have taken place before such as in the period prior to the Crash of 1929. Inflated speculations of fair value assets gave false financial statements. Because of these skewed financial statements the “fair value accounting was virtually banned by the U.S. Securities an Exchange Commission from the 1930’s through the 1970’s”. (Harvard Business Review) They found that companies were committing fraud because they did not determine markets prices objectively. This is the problem with fair value methods when is the true value of the asset on the financial statement is to be applied and how to determine its appropriate value. To combat this problem in 2002 Congress, led by President Bush, passed the Sarbanes Oxley Act. This law was designed to oversee financial reporting. The Act required a review of financial statements to ensure the accuracy and reliability of the financial statement reported by corporations is accurate. Its purpose is to protect the investors and also to stop future speculator pricing and stop future depressions. (The Balance)
Those who are against the fair value accounting method are in favor of using another method call the historical value accounting. “This method was developed in the 19th century as a result of the industrial revolution.” (Munteanu p.92) “Historic cost accounting would enter this asset into the financial statement when the product is bought or created. ” (Munteanu p. 92) Accountants display a company’s assets on the balance sheet based on the purchase amount. This method is easy to calculate and reliable. The debate over using this method is whether this cost is relevant at a later time. For example if a company purchase a building for $200,000 in 1994 it would obviously be of greater value in today’s market. Using the historical value accounting method the balance sheet would stay constant with the building price at $200,000. This does not take into consideration the increase in the real estate market for 25 years and does not accurately reflect the current value of their buildings assets. Historical value method does take into account rising costs but does not keep up with current inflation prices. This is the reason many advocate for the true value method, to keep prices current. Historic accounting methods do not show future profits or the current costs caused by inflation. Those who are against this principle argue that the true costs are not represented and therefore undervalued. If the building you owned was being used as an asset set against a future purchase you would not have enough collateral if you used historical method compared to using the fair value method showing for inflation. Your company would show a greater value on the financial statement with the building asset increase. You have over the past 25 years made a profit with this asset but where do you recognize this profit? This is where this method has its problems. If the asset is not sold or traded your historical financial statement still shows the lower value of your real estate. “Historical accounting fails to reflect the actual cost of future profits which expresses the actual value of the company.”(Cozma p. 864)
The issue with both methods is how to set the value of an asset, debt, and equity. “Achieving a fair evaluation is in fact the key to success in financial services also, because in order to see or buy a financial instrument is important to know its value.” (Munteanu p.91) Here lies the debate. When to record and what is the value. There has to be a system input in placed to check when the assets are allowed to be counted as a profit on your financial statement. Using the historical value as a reference and the current value or fair market value as a guide. Both methods have their merit but after research I believe the fair value shows a more current value as long as the financial statement is properly noted. The problem is the measuring of the fair value of items. What is the value, what is the difference in changes to that value, and who evaluates their value? Unfortunately the fair value is the markets opinions, which is in constant change and does not always provide reliable information by those who are reporting it. There needs to be guidelines so that businesses do not inflate their values and are truly represented at a current and fair price. The Sarbanes-Oxley Act is one step toward better standards in the industry. The act is hopeful the standards which assets are reported are not much of a deviation from the market prices when statements are prepared. The debate on this subject of whether to us fair value or historical value accounting methods are far from over. The issue debated still is when the moment is relevant to use the chosen process for the accounting evaluation, when you actually assign the value. Both methods of fair value and historical value constantly influence each other without a clear winner. Most accountants opt for the fair value methods keeping values at current prices. They feel this is keeping updated prices and future accounting reporting models current. It can keep in sync with the variations in the markets as values of assets can and rise and fall according to their variances. This method however has to keep its evaluation of asset models constant and not gain a profit on assets value by raising the prices too high without appraisal. The value of the assets needs to be preserved at the correct and documented price.
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