Assets are shown in the balance sheet at the historical cost i.e. cost at which they were acquired. But it is not the case always that the assets presenting the values in the balance sheet are actually worth for that. There may be the case that actual value based on current market price is worth more or less than the value in the balance sheet. Some assets in the balance sheet such as land and building are generally worth more in the market than the value shown in the balance sheet at which they had been acquired many years ago. Therefore, conventional balance sheets often undervalue the companies’ assets.
[linkunit]To overcome the issue fair value accounting has been widely supported for where it is required that assets in the balance sheet should be presented at their current market value also called fair value. Formally speaking fair value is the rationalized and impartial approximation of the impending market price. Fair value is determined through the following aspects.
• At what cost the same asset in the same condition can be acquired, produced, replaced, or substituted.
• What is the actual utility of the asset? It means present value of future cash flows generated from current asset.
Firm A purchased a piece of land in 1990 for $10 million. The historical-cost financial statement would still record the land at $10 million in the balance sheet. If firm B purchased a similar piece of land in 2008 for $20 million, then it would report an asset of $20 million on its balance sheet.
In fair value accounting the land with Firm A will also be recorded at $20 million because at the historical cost grounds the balance sheet would be undervalued by $10 million.