Legal Definitions - fair-value accounting method

The fair-value accounting method is an approach to financial reporting where assets and liabilities are recorded at their current market price, or an estimated market price, rather than their historical cost. This method aims to provide a more relevant and up-to-date picture of a company's financial position by reflecting the economic value of its holdings as of the reporting date. It contrasts with the historical cost method, which records items at their original purchase price.

Here are some examples to illustrate the fair-value accounting method:

• Example 1: Investment Portfolio of a Mutual Fund

  A mutual fund holds a diverse portfolio of publicly traded stocks and bonds. Every day, the market value of these securities fluctuates based on supply and demand, company performance, and economic news. Using the fair-value accounting method, the mutual fund would adjust the reported value of its entire portfolio on its financial statements daily to reflect the current closing prices of all its holdings. This ensures that investors see the most accurate, real-time value of their investments, rather than what the fund originally paid for each stock or bond years ago.

• Example 2: Commercial Real Estate Held by a Development Company

  A property development company owns several undeveloped land parcels and commercial buildings. Instead of keeping these properties on its books at their original purchase price from decades ago, the company might use fair-value accounting. This would involve obtaining regular appraisals from independent experts to determine the current market value of each property, considering factors like location, zoning changes, local economic conditions, and recent comparable sales. The company's balance sheet would then reflect these updated, current market values, providing a more realistic assessment of its assets to potential investors or lenders.

• Example 3: Derivative Financial Instruments Held by a Bank

  A large bank uses various complex financial instruments, such as interest rate swaps and foreign currency options, to manage risk or for trading purposes. The value of these "derivatives" can change rapidly based on movements in interest rates, exchange rates, or commodity prices. Under the fair-value accounting method, the bank would regularly re-evaluate these instruments, often daily, using sophisticated financial models to determine their current market value. Any increase or decrease in their value would be immediately reflected in the bank's financial statements, providing transparency about the bank's exposure and the current worth of these volatile assets and liabilities.