Current Value Accounting
Current value accounting, also known as fair value accounting or mark-to-market accounting, is a method of accounting that measures and records the value of an asset or liability based on its current market price, rather than its original cost. The principle behind this approach is to provide a more accurate and up-to-date financial picture of a company.
Here’s how it works for different types of assets:
- Marketable securities: For assets like stocks or bonds, the current value is the market price of these securities. If the market price changes, the value of these assets on the company’s balance sheet is updated to reflect this change.
- Non-marketable securities or illiquid assets: For assets that aren’t actively traded on a market, such as certain types of real estate or privately-held companies, the current value is often estimated using various valuation methods, like discounted cash flow analysis, comparable sales, or replacement cost.
- Liabilities: The current value of a liability could be the amount that the company would have to pay if it were to settle the obligation at the current date.
While current value accounting can provide a more realistic assessment of a company’s financial position, it also has its challenges. The main one is that market prices can fluctuate significantly over time, which can lead to large swings in the reported value of assets and liabilities, and consequently in reported earnings. This can make a company’s financial results appear more volatile than they would under historical cost accounting.
Moreover, estimating the current value of illiquid assets can be complex and subjective, as it often involves making assumptions about future cash flows, discount rates, or other variables. These estimates can vary depending on the methodologies and assumptions used, and they can be influenced by management’s biases or incentives.
Example of Current Value Accounting
Suppose a company, XYZ Corp., purchased an investment property 10 years ago for $1 million. Over the years, the value of this property has increased, and it is now worth $1.5 million in the current real estate market.
Under historical cost accounting, this property would continue to be recorded on XYZ Corp.’s balance sheet at its original cost of $1 million, regardless of its current market value.
However, under current value accounting, the value of this property on XYZ Corp.’s balance sheet would be updated to reflect its current market value of $1.5 million. This would increase the total assets and the shareholders’ equity reported by XYZ Corp. by $500,000, compared to historical cost accounting.
Now, let’s assume that the real estate market experiences a downturn, and the value of the property decreases to $900,000. Under current value accounting, XYZ Corp. would need to write down the value of this property on its balance sheet by $600,000 ($1.5 million – $900,000), which would decrease its total assets and shareholders’ equity, and it would likely report a loss in its income statement for this write-down.
This example illustrates how current value accounting can make a company’s financial statements more responsive to changes in market conditions. However, it also shows how it can increase the volatility of reported assets, equity, and earnings due to fluctuations in market prices.
