Sunday, 10 March 2013

Fair Value Vs Historical Cost

By Jackie, Researcher
Topic: Education
Area of discussion: Financial Accounting and Reporting
Chapter: Accounting Concepts

The objectives of this posting are: to critically compare and contrast the usefulness of fair value and historical cost (in different conditions); as well as to identify, explain, and analyse the benefits and limitations of both fair value and historical cost.

Fair Value
Fair value is also known as “market value” or “current value”; it is a rational and unbiased estimate of the potential market price of a good, service, or asset.

Arguments in support of fair value concept
  1. It is recommended to use fair value concept during inflation period or when the currency is unstable or fluctuate.
  2. It is also suitable to be used when there is an active and observable market; such market usually exists in popular and densely-populated area where there will be a lot of buyers and sellers trading daily.
  3. Depending on the nature of the assets, this valuation method is suitable for assets that undergo appreciation (i.e. value goes up) instead of depreciation (i.e. value goes down). For example: land and buildings, livestock and raw materials. Assets that follow this concept are required to undergo revaluation process after a specific time (if needed) and also test for impairment (if any) before the assets values are to be displayed in the financial statements (inside the annual reports).
  4. It upholds the accounting qualitative characteristic: relevance.
  5. Information about the assets values is updated. Hence, it is useful for decision making purposes (especially for potential buyers) 

Arguments against fair value concept
  1. Valuing assets using current market price is very subjective. It involves a lot of predictions, assumptions and careful analysis in order to get an estimated figure. However, not everyone can agree with that figure as the figure is usually open to dispute or debate as it involves a lot of judgements, thoughts and opinions which can be either personal or professional. Furthermore, the amount has not been “realised” yet (i.e. not incurred yet). Thus, it cannot be fully trusted.    
  2. Unlike historical cost, those estimated figures are usually given in a “range of values” instead of one clear-cut value for each asset.
  3. In reality, active and observable market is highly dependent on location. Therefore, if the assets (usually properties) are situated in an isolated location, it is very hard for the property agents to estimate the price of the properties because there is insufficient data to be used as comparison and analysis purposes.
  4. Some experts believe that as compared to historical cost, fair value concept is easier to be manipulated by unethical corporate directors and managers.
  5. It will be quite troublesome sometimes, because the preparers of financial statements are required to make some changes to the subsequent recording and readjust the depreciation amount. Thus, a lot of paperwork and additional disclosures are involved.

Historical Cost
According to the historical cost concept, assets are shown at the original cost price (i.e. the figures shown during the initial recording of those particular assets at the date of acquisition). 

Arguments in support of historical cost concept
  1. It is suitable to be used when the currency is stable.
  2. Depending on the nature of the assets, historical cost is suitable to be applied to any assets that undergo depreciation instead of appreciation. For example: plant and machinery, motor vehicles and office equipment. Assets that follow this type of valuation method are required to be depreciated accordingly usually per annum by using appropriate depreciation methods such as straight-line, reducing balance or sum-of-digits methods. Assets values that are displayed in financial statements are also known as Net Book Values (NBVs). NBVs are computed by using initial cost less accumulated depreciation.
  3. Valuing assets at their original cost is very objective. Everyone can accept and agree on it because it is based on a factual occurrence. Not only that, it also has a very concrete support in term of nature of evidence such as printed receipts, legal documents and purchase agreements.  
  4. It upholds the accounting qualitative characteristic: reliability.
  5. It gives one clear-cut and precise value for each asset.
  6. It is convenient and easy to use. It does not required active and observable market nor additional disclosure simply because there is no real change. 

Arguments against historical cost concept
  1. Information about the assets values is outdated. Accountants called it as “sunk cost”. Thus, it will not be helpful in decision making processes anymore.
  2. During the period of rising prices, using historical cost accounting might poses adverse effects on financial statements as well as some financial ratios. For example, in the Statement of Comprehensive Income (i.e. the Income Statement), the understated depreciation will cause the profit to be overstated. Meanwhile, in the Statement of Financial Position (i.e. the Balance Sheet), the cost of assets, accumulated depreciation of the assets and net book values of the assets will be all understated. On the other hand, financial ratios like ROCE (Return On Capital Employed) and ROA (Return On Assets) will be overstated. This is because the numerator tends to be overstated and the denominator tends to be understated. Ultimately, it makes the figures to be “unpresentable” and “unreflective” to the current situation. Not only that, it also poses risk and danger to the users of financial statements (especially for the shareholders and potential investors) as the information is misleading.

Additional readings, related links and references:

“Causes and consequences of choosing historical cost versus fair value”; this journal’s discussion is mainly on real estate. (IAS 40 – Investment Property) 

Historical cost vs. market (fair) value. Emphasize more on theories.

Does fair value accounting for non-financial assets pass the market test?

Historical cost vs. fair value. Examples are given with calculations too.

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