Historical Cost versus Fair Value Accounting
Different accounting principles and concepts have been an issue of extensive discussion over the recent years as investors started pressing for harmonization in financial reporting standards and increased comparability of annual reports. The two concepts of historical cost and fair value accounting seemed to be very inconsistent with one another and to create a gap between the UK-US and continental accounting models that would be difficult to overcome. The purpose of the paper hereto is to compare briefly both concepts and to outline when and why the application of each of them would be appropriate. It will also try to discuss the extend to which the discrepancy between fair value and historic cost accounting affects the present and future activity of the international standard-setting bodies.
First, it would be beneficial to provide a brief comment on fair value and historic cost accounting, as well as to outline their core differences. As explained by Collins, J. (2007), historical cost accounting is based on the concept that assets and liabilities are measured and booked as per their original acquisition price. Therefore, assets that tend to bear significant changes in value over time (eg, due to technological changes and innovation or land and buildings) would result being improperly measured in the financial statements a number of years after their acquisition by the business. A generally accepted view on the effect of historical cost accounting on company’s financial reports is that it tends to understate value of assets and overstate liabilities (Shortridge, R., The CPA Journal, July 2006). However, this is fully in line with the prudence concept and the conservatism that would tend to show the worst-case scenario of a firm’s financial standing. Furthermore, the reliability and accuracy of a given acquisition value would rarely be questionable. Right on the contrary, fair value accounting, would allow managers to present investors with a different view of firms’ financial standing by valuing assets and liabilities at a kind of current market prices. The concept of fair value accounting, as per the general IASB definition used by Alexander, D. (2007), would assume as a fair value of an asset “the amount for which that asset could be exchanged, or a liability settled, between knowledgeable willing parties in an arm’s length transaction”. However, here arises the problem of finding a good estimate of the market price. There may be cases when this would be a straight forward operation, but it may also sometimes be a problem. It is still arguable how a reliable market price can be obtained for a given asset, as in some cases arguments involve estimation of markets in terms of being perfect and complete. The opposition of fair value concept to historic cost concept is still open for discussion, as arguments in favour of and against both practices may be easily cited. Overall, it can be summarized that fair value would add relevance to a statement, while historic cost would add reliability. Still, it will be useful to elaborate further on the cases when each of the concepts would add quality to company’s financial reports.
Having both concepts defined, we are more confident in identifying when a given method would be applied more successfully than the other. Since assets would be booked at their acquisition price under the historical cost concept, there is a risk that at some point in time this value may be far from the actual market value of assets. Following the example of Collis (2007), we could discuss the case of technology or equipment which is subject to fast technological enhancement. In two years time, an asset of such type may not be much depreciated in the company’s balance sheet. It may also be in perfect condition, but still its market value may be far below its book value because of better technology available on the market. On the other hand when dealing with assets that actually appreciate in time, for example land and buildings, historic cost accounting fails to capture the increase in the market value of those assets and results in understatement of the balance sheet. In such cases, the fair value accounting would be better able to reflect an asset value which is much closer to its actual market value. Furthermore, an approach implied by the fair value accounting, as mentioned by Alexander, D. (2007), is the annual test of assets for impairment opposed to amortization. This also provides some flexibility in cases when assets may actually increase in value. However, some papers would argue that even being applicable, fair value concept has its minuses. And one of the serious shortcomings of fair value accounting is that in some cases it may be difficult to arrive at a fair market price of an asset. Shortridge, R. (The CPA Journal, July 2006) even presents the substitution of the historic cost with fair value as trading off reliability for relevance. In any case, historic cost accounting would be good where market values are not expected to fluctuate significantly in the future or when a given market value is too unreliable. On the other hand, if it is easy to arrive at reliable market value of an asset and there is a material difference between that market value and the book value of the asset, it would be beneficial to apply the fair value concept. Overall, in the ideal case one should seek to increase both reliability and relevance of financial reports.