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Historical Vs. Fair Value. concept
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Transcript of Historical Vs. Fair Value. concept
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Historical Vs. Fair Value 1
Historical Vs. Fair Value
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Historical Vs. Fair Value 2
Contents
Abstract ........................................................................................................................................... 3The Debate ...................................................................................................................................... 4Accounting Standards and Practices across the Globe ................................................................... 5Similar Reporting Rules .................................................................................................................. 8
Definition of fair value................................................................................................................ 8Valuation techniques ................................................................................................................... 8
Income approach: .................................................................................................................... 8Cost approach: ........................................................................................................................ 8
Fair value hierarchy .................................................................................................................... 8Disclosures .................................................................................................................................. 9
Different Reporting Rules ............................................................................................................... 9
Conclusion .................................................................................................................................... 10Works Cited .................................................................................................................................. 11
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Abstract
The contemporary accounting practices steered mainly by accounting globalization are inclined
more towards fair value based on the just value conceptions. However, the concept of historical
cost has existed since the inception of accounting systems and is well established in many parts
and companies around the globe (Ramanna, 2013). This shift is full of implications around the
world since the basis of accounting, irrespective of being historical or fair value, critically affects
all managerial decisions, investment choices and subsequently affects the larger economic
activity of the globe. It is to be noted that the choice between fair value and historical cost
accounting has been the most widely debated issue/ topic in the world of accounting. The debate
is so old and consolidated that it dates back to the 1930s and is still not over (Paton & Dixon,
1958, pp. 739-747). The debate still largely remains unsettled probably because of lack of
concrete evidence in favor of one concept (Laux & Leuz, The Crisis of Fair Value Accounting:
Making Sense of the Recent Debate, 2009). This paper will critically evaluate traditional conflict
between the concepts of fair value and historical costs. This paper will also comprehensively
delve into how IFRS and GAAP have handled this issue and to what extent the quantitative
characteristics of accounting information has affected this conflict.
The Concepts
In order to work on the above mentioned aims of this paper, the concepts of fair value and
historical cost needs to be discussed briefly for the reader to grasp the argument holistically.
Following are some of the key features of each concept:
Fair Value
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Accounting Standard defined: Assets should be exchanged or liabilities should be
exchanged on fair value between all parties.
The market value is measured and represented from what it is currently in a robust and
perfectly efficient market. If no market with such conditions exists, the market value is
calculated/ estimated conceptually.
Fair value can also be based on a model devised to imitate perfect market situations. If
such market exists and accessible, the fair value is based on observed market value.
Source: (Emerson, Karim, & Rutledge, 2010)
Historical cost
Historical cost is the price which the liability or asset was initially purchased or obtained.
When it is expected that the historical cost have changed from the final current value,
amortization or depreciation of the value is applied. This results in either an amortized
cost or depreciated cost which is more accurate than historical cost and similar to the
actual current cost, however not as accurate as the fair market value.
Source: (Rogerson, 2011)
The Debate
The historical cost principle works on the accounting principle of reliability sine historical cost is
one cost on which each and everyone can very easily be agreed upon. However, there are very
simple and apparent shortcomings of the concept. For example, a piece of land is purchased 20
years might worth insurmountable more today than it is being valued in balance sheet. This is
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just one example out of the hundreds in which historical cost concept fails to estimate real
market value. For this reason, the concept of fair value was introduced by the accountants
worldwide that values cost on the basis of its market value as discussed above. The fair value
concept is more practical and relevant in all cases but also has some major shortcomings. For
example, one item, if auctioned, can have different market value proposals and thus can have
multiple market values depending on whose valuing it. However, these shortcomings were
workable and thus professional appraisers came up with more systematic approaches of
determining the market values based on opinions and judgments with confirmable data with
valuations based on assets useful life and output information. However, even then, all of these
approaches enable the valuation of a fair value of an asset to become more relevant but not more
reliable (Laux & Leuz, 2009). The proponents of historical cost concept thus emphasize on the
reliability of valuation of fair value. To date, the reliability vs. relevancy debate centers the
debate of historical cost vs. fair value concepts. The IFRS and GAAP are working closely to
undermine the conceptual and reporting differences and reach a common platform. GAAP is
going through a major transformation since they have been historically more biased towards
historical cost concepts. How GAAP & IFRS are addressing the debate is what is discussed
following in detail (Cho, Kim, & Lim, 2006).
Accounting Standards and Practices across the Globe
Financial statements across the world are prepared according to a particular standard or
accounting framework. In the US, the accounting framework under practice is termed as US
GAAP, while in the UK; UK Accounting board has established the UK GAAP. As the economy
becomes more and more globalized, an international framework for accounting has become
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increasingly important and the International Financial Reporting Standards have been put into
place, however, valuation principles between all these standards still show differences despite the
similar practices and the motivation to converge these practices to the IFRS (Sawani, 2011).
The fair value versus historical cost debate is not only old; it is also complicated with respect to
the number of standards followed, and financial analysis conducted across geographical
boundaries. The UK GAAPs fair valuation principles are part of the FRS 26 standard while
IFRS defines the valuation principles in IAS 39 & IFRS 13, and US GAAP defines them in FAS
157. Each standard has a different definition of fair value and its calculation, the details of which
will follow further through in this paper.
Calculating Costs and Evaluating Difference between the Standards
When the IFRS standards for fair value calculation were in inked, particularly with
globalization as the key to these standards, the primary question raised was the implication and
application of these principles in emerging and developing economies. The lack of market
information within these economies could be a particular hindrance in the calculation of fair
value; hence, to avoid such an instance, IASB (International Accounting Standards Board)
developed a set of rules that would allow all economies to be able to conduct fair value exercise
without difficulty, allowing for organizations and valuation analysts to be able to converge their
valuation exercises for all the economies, irrespective of the accounting standards implemented.
Furthermore, IASB also came to the conclusion that the above raised concerns are not specific to
emerging or developing economies only, and issues like lack of availability of realistic market
data are a worldwide constraint, not regional one. Subsequently, IASB has come up with
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comprehensive educational literature on the subject of fair value measurement for audiences in
both developing and developed economies.
Moving on, the Financial Accounting Standards Board (FASB) and the U.S. Securities and
Exchange Commission (SEC) have taken a major transition recently to reconcile their fair value
standards more in line with that of IASB. This is majorly because no matter what, the concept of
fair value is gaining ground more recently as after the financial crisis, lessons from intense
market volatility and uncertain macroeconomic environments have aggravated a need for more
realistic valuation technique. A compound cooperative effort is under process between FASB
and IASB to develop a common framework with respect to fair value accounting (Metzger,
2009). Both FASB and IASB have issue drafts that aim to end disconnect of GAAP with fair
value accounting and to bring it closer to IFRS in terms of fair value accounting.
FASB has issued a new Accounting Standards Codification System in 2006 in which the concept
and implementation fair value has been discussed in Topic 820 which was formerly Financial
Accounting Standard No. 157: Fair Value Measurement.
The IASB has also issued a similar reply draft in May 2009 on the topic of fair value
measurement which was answered by FASB with another draft in July 2010. Following are some
of the key elements of common grounds reached between IFRS and FASB in terms of a unified
valuation method with respect to fair value. Both of the boards aim to establish a single source
of literature with respect to disclosure and valuation of assets based on fair value concepts.
Previously there were so many grey areas that led to confusions and complexities (IFRS
Foundation, 2011).
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Similar Reporting Rules
Both IFRS and GAAP have come up with tea me definitions of different components of fair
value concept. Following are the key points regarding fair value computations, interpretations
and reporting standards that both IFRS and GAAP have commonly agreed upon in their latest
drafts.
Definition of fair value
Fair value is the direct price which can be acquired by selling the asset or transferring a liability
normally in the market on any given date.
Valuation techniques
Income approach: The income approach technique effectively coverts all future amounts to
single present discounted amount.
Cost approach: This approach is based on the amount required to replace the service capacity of
an asset at any given point in time.
Fair value hierarchy
There are certain levels through which fair value is determined and the following is the detail of
hierarchy; Level 1 inputs are related to market quoted prices in open and active markets which
are accessible and measurable on a certain date. Level 2 inputs are based on level 1 but not
directly related to the asset or liability but rather similar to the assets or liabilities in
consideration. An example of this is the quoted prices of similar assets. Level 3 inputs are inputs
for the valuation sources not based on discernible or interpretable market data. These are called
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unobservable inputs. Unobservable inputs shall be used in situations where observable inputs are
not available. For example, when analyzing market activity or industry situations of an asset or
liability: these inputs are level 3 inputs (Metzger, 2009).
Disclosures
The assets and liabilities that are valued based on fair value principles on recurring basis for
example, trading securities, should also disclose information the enables all users of financial
statements to access the efficacy of the factors that have been used to determine the market
value. All levels of inputs (Level 1, Level 2 & level 3) should be disclosed articulately.
Different Reporting Rules
Both the boards are working closely to harmonize their fair value computations and valuations;
however there are still some significant differences between IASB and GAAP fair value
measurement standards which are discussed following in detail.
Both IFRS and GAAP reference fair value transactions in different documents. GAAP does it in
Topic 850: Related Party Disclosures while IFRS does it in International Accounting Standard
No. 24: Related Party Disclosures. Different assets, liabilities and equity instruments can be
measured according to the fair value concepts. However, the permits for fair value measurement
are different in IFRS and GAAP; consequently, an asset, liability or instrument that is measured
according to fair value in IFRS might not necessarily be measured on fair value in GAAP and
vice versa. Also, there are different requirements of IFRS and GAASP with respect to the
measurement of fair value of investments in entities of investment companies. Several
disclosures regarding fair value measurements are contrastingly different in GAAP and IFRS.
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For example, there is no distinction between recurring and non recurring fair value computations
in IFRS. Moreover, IFRS does not emphasize on the presentation and intricacy of the
derivatives, thus the level 3 inputs that refer to derivatives in GAAP might contrastingly differ in
IFRS (PricewaterhouseCoopers LLP, 2012).
Conclusion
Even though there are still some major reporting differences between IFRS and GAAP over the
accounting treatment of historical and fair value concepts, both FASB & IASB are adamant that
future corrections and additions in reporting standards would minimize the inconsistency of both
standards with respect to fair value valuation. Both boards are working tirelessly to ensure that
the value and interpretation of fair value of an asset, liability or equity instrument is equal and
same in both the accounting standards. Moreover, the subsequent fair value disclosures will also
be the same in future except some minor differences in vocabulary, style and importance of
hierarchies.
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Works Cited
Cho, M., Kim, O., & Lim, S. C. (2006). Reliability As a Means to Achieve Relevance in
Valuation: Does Historical Cost Qualify As What It Purports to Represent?Chicagi: Fordham
University.
Emerson, D. J., Karim, K. E., & Rutledge, R. W. (2010). Fair Value Accounting: A Historical
Review Of The Most Controversial Accounting Issue In Decades. Journal of Business &
Economics Research, 77-85.
IFRS Foundation. (2011, May 12). IASB and FASB issue common fair value measurement and
disclosure requirements. Retrieved October 25, 2013, from ifrs.org:
http://www.ifrs.org/news/press-releases/Pages/ifrs-13-fvm-may-2011.aspx
Laux, C., & Leuz, C. (2009). The crisis of fair value accounting: Making sense of the recent
debate.Frankfurt: Center for Financial Studies (CFS), Goethe University Frankfurt.
Laux, C., & Leuz, C. (2009). The Crisis of Fair Value Accounting: Making Sense of the Recent
Debate.Accounting, Organizations and Society, 826834.
Metzger, L. (2009). GAAP And IFRS: Reconciling Fair Value Measurements. Retrieved October
25, 2013, from FSA Times: http://www.theiia.org/fsa/2011-features/gaap-and-ifrs-reconciling-
fair-value-measurements/
Paton, W. A., & Dixon, R. L. (1958).Essentials of accounting.London: McMillan.
PricewaterhouseCoopers LLP. (2012, October). IFRS and US GAAP: similarities and
differences. Retrieved October 25, 2013, from IFRS readiness series: 2012:
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http://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/ifrs-and-us-gaap-
similarities-and-differences-2012.pdf
Ramanna, K. (2013, March). Why Fair Value Is the Rule. Retrieved October 20, 2013, from
Harvard Business Review: http://hbr.org/2013/03/why-fair-value-is-the-rule/ar/1
Rogerson, W. P. (2011). On the Relationship Between Historic Cost, Forward Looking Cost and
Long Run Marginal Cost.Review of Network Economics.
Sawani, A. (2011). The Changing Accounting Environment: International Accounting Standards
and US implementation .Journal of Finance and Accountancy.