Summary
Fair value accounting, or mark-to-market accounting, is not new. The debate of how to account for value has been around for decades. However the implications of fair value accounting, versus historical accounting, are far reaching and often not grasped. A society needs to be careful in setting accounting standards that may or may not reflect its cultural values.
Analysis
The debate on fair value accounting versus historical cost accounting versus a mix of the two is not new. In a perfect world, fair value is ideal. The current move to fair value accounting, away from historical cost accounting, is driven by two forces. First is the harmonization of international accounting standards (e.g., IFRS). Second, is better disclosures about the volatility, and thus risk, imbedded in a company's balance sheet (e.g., pensions).
However we live in a imperfect world, filled with a lot of disharmony and misunderstanding. The reality is fair value accounting works best where the legal framework of society accepts the subjectivity of market, and thus divergent values (e.g., Europe). The culture of the United States provides a very open legal system, based on ease of access. We can see this with contingent fees for lawyers and the high number of lawsuits. However, coupled with human nature, this may create significant problems when our (US) accounting methodology becomes more subjective with fair value accounting. Simply, people hate to admit they made a bad investment decision. People love to blame bad information for losing money. I am not sure we have grasped the fact that our society, so long dependent on historical cost numbers, is culturally ready to accept more subjective fair value numbers.
The bottom line is, with or without SOX, corporate management and their auditors are in for a rough ride as we transition to fair value accounting. First, investor expectations need to adjusted. Second, our legal system needs to adapt.
