Most business owners would agree that choosing the right accounting methodology is critical for accurately reporting finances.
By understanding the key differences between fair value and historical cost accounting, you can make an informed decision to select the best approach for your business.
In this post, we'll compare fair value versus historical cost accounting across key areas like asset valuation, liabilities, financial ratios, income volatility, and more. You'll get a clear picture of the advantages and disadvantages of each methodology to help determine the ideal accounting framework for your organization's financial reporting needs.
Introduction to Fair Value vs Historical Cost Accounting
Defining Fair Value and Historical Cost Accounting
Fair value accounting refers to valuing assets and liabilities at their current market values on the balance sheet. Historical cost accounting values assets and liabilities at their original purchased costs and does not reflect changes in current market values.
Key concepts:
- Fair value uses current market values that reflect changes over time
- Historical cost uses original purchased costs that remain static over time
Key Differences Between Fair Value and Historical Cost
The main differences include:
- Asset valuation: Fair value reflects current market value. Historical cost reflects original purchased cost.
- Value changes: Fair value accounts for value changes over time. Historical cost does not reflect value changes.
- Financial statement impact: Changes in asset/liability fair values impact net income. Historical cost changes do not impact income.
Advantages and Disadvantages of Fair Value Accounting
Advantages:
- Reflects current economic realities
- Can provide more accurate financial status
Disadvantages:
- Prone to volatility from market swings
- Complex to implement
Advantages and Disadvantages of Historical Cost Accounting
Advantages:
- Simple to understand and apply
- Less prone to volatility in statements
Disadvantages:
- Does not reflect current asset values
- Can over/under-value balance sheet
The Significance of Accounting Method Choice
The choice of accounting method can significantly impact perceptions of financial health. Fair value better reflects current status but introduces income statement volatility. Historical cost provides stability but may over/under-value balance sheets. As such, the accounting method choice has implications for financial statement users when assessing organizational finances.
What is the difference between historical cost and fair value in accounting?
Historical cost accounting records assets at their original purchase price, while fair value accounting records assets at their current market value.
Key Differences
Some key differences between historical cost and fair value accounting include:
- Valuation basis - Historical cost uses the original purchase price paid for an asset, while fair value uses the asset's current market value.
- Volatility - Fair value accounting can create more volatility in financial statements as asset values fluctuate. Historical cost is more stable over time.
- Depreciation - Assets under historical cost are depreciated based on their initial cost. Fair value assets are not depreciated.
- Financial ratios - Using fair value accounting can impact financial ratios like return on assets (ROA) and leverage ratios.
Pros and Cons
Both methods have their advantages and disadvantages.
Pros of historical cost accounting:
- More straightforward and easier to implement
- Less prone to manipulation or volatility from market swings
- Depreciation spreads asset costs over useful life
Cons of historical cost accounting:
- Does not reflect current asset value on balance sheet
- Can overstate profits if assets rise in value
Pros of fair value accounting:
- Reflects current market value of assets
- Can reduce use of estimates and adjustments
- No depreciation needed
Cons of fair value accounting:
- More complex and involves professional judgement
- Increased volatility in financial statements
- Difficult to audit and verify
Overall, historical cost accounting is simpler, more stable and prudent, while fair value accounting is more complex but attempts to represent current financial position. Companies weigh the pros and cons of each to determine the best fit.
What is the difference between book value and historical cost?
The key difference between book value and historical cost is:
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Book value is the value of an asset according to its balance sheet account balance. This balance is based on the original cost of the asset less any accumulated depreciation and impairment charges made against the asset.
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Historical cost refers specifically to the original cost paid to acquire the asset, without adjustments.
Some key points:
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Book value changes over time as depreciation expenses are recorded. Historical cost does not change.
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Book value attempts to reflect an asset's fair or current value. Historical cost shows the acquisition cost only.
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Comparing book value to market values is useful in financial analysis to gauge if assets are over or undervalued.
The original purchase price paid for an asset is its historical cost. This cost stays the same on the balance sheet unless the asset is revalued. As the asset is used, its book value is reduced to reflect wear and tear. By comparing book value to market values, companies can assess if assets are over or undervalued over time.
What is the difference between the cost method and the fair value method?
The key difference between the historical cost method and the fair value method in accounting is how assets and liabilities are valued on the balance sheet.
Historical Cost Method
The historical cost method records assets and liabilities at their original purchased price. This cost is not updated for changes in market value, except for impairments or depreciation.
For example, if a company purchases equipment for $10,000, that equipment will remain valued at $10,000 on the books until it is fully depreciated. Even if the equipment market value rises to $15,000 or drops to $5,000, the reported value stays at the historical purchase price under this method.
Some of the advantages of the historical cost method include:
- Simplicity - Easy to implement and understand
- Objectivity - Free from subjective valuations and estimates
- Verifiability - Values can be easily proven with documentation
However, the historical cost method does not reflect current asset values. This can distort financial ratios and performance metrics when asset values change significantly over time.
Fair Value Method
The fair value method records certain assets and liabilities at their current market value on the balance sheet date. This aims to provide a more accurate and up-to-date view of a company's financial position.
For example, equity investments and some financial instruments are reported at fair value rather than historical cost under US GAAP and IFRS rules. This means their balance sheet value is adjusted whenever the market value changes.
Some of the main advantages of the fair value method are:
- Relevance - Balance sheet reflects current values
- Transparency - Investors see the realizable value of assets
- Comparability - Easier to compare companies using similar valuation methods
However, estimating fair values can be complex and subjective. This can open the door to earnings management and volatility from value fluctuations.
In summary, while historical cost is simpler, fair value accounting aims to increase relevance and transparency. But it also introduces complexity and subjectivity into asset valuation. Companies and regulators continue to debate the appropriate balance between these two methods.
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How is historical cost accounting different from current value accounting?
Historical cost accounting records assets and liabilities at their original purchase price, while current value accounting records assets and liabilities at their current fair market value.
Some key differences include:
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Basis of valuation: Historical cost uses the original purchase price, while current value uses the current fair market value.
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Impact on financial statements: Historical cost shows the original cost on the balance sheet, while current value shows the current value. This can make a big difference over time.
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Depreciation calculations: Depreciation under historical cost is based on the original cost, while under current value it is based on the current asset value.
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Net income volatility: Current value accounting introduces volatility into the income statement as asset values change. Historical cost net income is more stable.
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Usefulness: Current value is viewed as more useful in some cases since it reflects current values. But historical cost has the benefit of greater reliability and verifiability.
In practice, most companies use historical cost accounting as required under GAAP rules. But current value accounting does play a supplemental role in some areas like impairment testing. The choice depends on the specific business, industry, and reporting objectives. Both methods have tradeoffs to consider regarding accuracy, reliability, and relevance.
Understanding the Fundamentals of Fair Value Accounting
Fair value accounting aims to provide more relevant information to investors by reflecting the current market values of assets and liabilities, rather than just historical costs. This section will explain some key concepts and methodologies behind fair value accounting.
Exploring the Mark-to-Market Principle and Market Value
The "mark-to-market" principle underpins fair value accounting. It means that assets and liabilities are remeasured to their current fair market values at each reporting date. Fair market values represent the prices that would be received to sell an asset or paid to transfer a liability in an orderly transaction between independent market participants. Determining these values requires looking at current market data and conditions.
For example, the fair value of a building would reflect its current resale value on the open real estate market. This gives investors a clearer picture of what the asset is truly worth today.
Determining Fair Value: Hierarchy of Inputs
Accounting standards like IFRS 13 and ASC Topic 820 lay out a hierarchy of inputs to measure fair values:
- Level 1: Quoted prices in active markets for identical assets or liabilities. This provides the most reliable evidence of fair value.
- Level 2: Quoted prices for similar assets/liabilities in active markets, or inputs that are observable for the asset/liability.
- Level 3: Unobservable inputs for the asset/liability, used when relevant observable inputs are not available. This requires more management judgement.
For instance, a Level 1 input would be the current stock market price for a publicly-traded security. A Level 3 input would be estimated cash flows for an impaired fixed asset.
Exercising Judgement in Fair Value Estimations
Fair value estimates can be subjective when:
- Valuing unique, specialized assets that lack market comparisons.
- Determining fair values during volatile, stressed, or inactive market conditions.
- Using unobservable Level 3 inputs that require internal modelling and assumptions.
This increases the need for careful judgement and transparency around measurement methodologies used.
Transparency in Fair Value Accounting: Disclosure Requirements
Key disclosures under fair value standards include:
- Fair value hierarchy level that assets/liabilities are classified under.
- Significant unobservable inputs and valuation techniques used for Level 3 fair values.
- Reasons for any transfers between hierarchy levels.
This provides investors more insight into the extent of judgement involved.
Applying Fair Value and Historical Cost Accounting in Practice
Asset Valuation: Fair Value vs Historical Cost
Fair value accounting tends to be better suited for valuing certain assets compared to historical cost accounting. Specifically:
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Financial instruments like stocks, bonds, and derivatives are typically valued using fair value accounting. Their values fluctuate frequently based on market conditions, so fair value accounting allows their balance sheet valuation to stay current.
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Fixed assets like property, plant, and equipment may be valued using either historical cost or fair value accounting. If their market values are expected to change substantially over time, fair value accounting often provides a more relevant measure on the balance sheet. However, historical cost may still be preferred for more stable, long-term fixed assets.
In contrast, historical cost accounting is often preferred for valuing assets like inventory. Since inventory turns over quickly, its historical purchase cost may be a reasonable approximation of value. The complexity of frequently revaluing inventory via fair value could outweigh the benefits.
Overall, both methods have roles to play in asset valuation. Assets with prices subject to significant variability or impairment are better suited to fair value accounting, while more stable asset values may be reasonable to maintain at historical cost.
Valuing Liabilities: Current Cost vs Fair Value
Fair value is also commonly used to value certain liabilities on the balance sheet, especially:
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Debt obligations may be valued at fair value, calculating the present value of future principal and interest payments based on current market interest rates and the firm's credit risk. This can provide a more accurate representation of the true economic liability compared to simple historical cost.
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Pension liabilities may be valued via actuarial estimates of the present value of future pension obligations. This "fair value" provides a more accurate economic picture than historical cost alone.
However, for short-term liabilities like accounts payable or accrued expenses that will be paid at known, fixed amounts, historical cost values may still be most appropriate and practical.
Overall for liabilities, fair value allows certain long-term obligations to be valued appropriately on the balance sheet, while historical cost works for short-term payables.
The Effect on Financial Ratios and Net Income Volatility
The choice between fair value vs historical cost accounting can significantly impact financial ratios like return on assets (ROA) and return on equity (ROE).
Because fair value accounting incorporates current asset values and economic conditions faster, it can introduce greater volatility into net income and thus ratio denominators from period to period. This may make ratios and performance trends harder to decipher for fair value based financial statements.
However, ratios may provide more comparability between firms when based on fair values rather than disparate historical costs. And fair value's inclusion of unrealized gains/losses provides a more comprehensive perspective on period performance.
Overall the firm should weigh whether income statement and ratio volatility is an acceptable tradeoff for the benefits of relevant fair value balance sheets. Sensitivity analysis can quantify the impacts.
The Transition from Historical Cost to Fair Value: Considerations and Challenges
For firms transitioning wholly or partially from historical cost to fair value accounting, some key considerations and practical challenges can arise:
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Systems and Processes: New processes must be created to periodically revalue assets and liabilities per fair value methodology. This may require modifications to financial systems and reporting tools.
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Expertise: Personnel will need proper expertise in fair value techniques like discounted cash flow valuation, options pricing models, or comparative market multipliers. Often finance or analytics teams support on specialized valuations.
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Costs: Upfront investments will be required to build infrastructure, systems, and staff to support ongoing fair value analysis. The costs of transition must be weighed against the long-term benefits.
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Subjectivity Concerns: Since some fair values depend on judgment, internal controls and audit processes should be enhanced accordingly. Governance is needed to ensure consistency and objectivity.
While moving to fair value accounting can better reflect economic realities, the feasibility, costs, and disruptions required should be carefully assessed beforehand. A phased, hybrid approach may allow a smoother transition for certain assets/liabilities.
Real-World Applications and Case Studies
Fair Value Accounting During the Financial Crisis: A Controversial Role
The 2008 financial crisis sparked intense debate around fair value accounting's role. Proponents argue it provided transparency by reflecting assets' real values. However, critics claim it exacerbated write-downs and created a downward spiral.
Banks were forced to revalue assets to depressed market prices under fair value rules. This led many to record large losses, reducing capital at a precarious time. Some believe this deepened the crisis by eroding confidence.
However, fair value advocates counter that it revealed problems already brewing. They argue banks were holding risky, overvalued assets that posed systemic risk. Fair value shone a light on this, whereas historical cost obscures real values.
Ultimately, there are good arguments on both sides. Fair value has benefits but may amplify volatility in crises. More research is needed to determine appropriate standards across industries and asset types.
Historical Cost Example: Real Estate Asset Valuation
Consider a commercial office building purchased for $20 million. Under historical cost accounting, the asset is recorded at $20 million until disposal. Only depreciation impacts value over time.
However, its actual market value fluctuates. Within 5 years it could be worth $15 million or $30 million. Historical cost does not capture these changes.
Under fair value accounting, the building is revalued to market price every reporting period. This impacts net income and equity. If the market value rose to $30 million, the gain would flow through financials.
The key difference is fair value reflects current worth, while historical cost is unchanged. This creates volatility but could argue represents true asset value.
Comparing Impairment Approaches: Goodwill Under Fair Value vs Historical Cost
Goodwill impairment testing varies greatly between fair value and historical cost models. Under historical cost, goodwill is amortized slowly over time. Only major events might trigger immediate writedowns.
However, fair value demands ongoing impairment testing against market prices. If acquisition synergy assumptions change, goodwill could be impaired sooner. This happened often during the financial crisis.
The fair value approach recognizes economic shifts faster, but at the cost of volatility. Historical cost leads to smoother financial reporting. Standard-setters must weigh these tradeoffs carefully.
Conclusion: Fair Value vs Historical Cost Accounting Recap
Recapping the Benefits of Fair Value Accounting
Fair value accounting has a few key advantages for financial statement users:
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Reflects current market values rather than outdated historical costs. This gives investors a more accurate picture of a company's financial position.
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Increases transparency about assets and liabilities. Marking to market provides more visibility into fluctuations in value over time.
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Aligns with principles of relevance and reliability under GAAP guidelines. Using current values is often viewed as more relevant for decision-making.
Revisiting the Advantages of Historical Cost Accounting
Historical cost accounting also has some benefits, especially for preparers:
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Easier to implement since it relies on objective, verifiable data about the original cost. Less subjective estimates needed.
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Results in fewer fluctuations in earnings over time compared to fair value changes. Provides more stable financial reporting.
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Matches the principle of conservatism under GAAP. Tendency is to understate rather than overstate net assets.
Critical Decision Points in Accounting Method Selection
A few key examples where the choice of accounting method matters:
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Reporting of long-term assets like property, plant and equipment. Depreciation under historical cost can diverge materially from fair market values.
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Treatment of financial instruments, derivatives, and hedges. Fair value better reflects current risks though introduces income statement volatility.
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Choice of inventory accounting method (FIFO, LIFO or AVCO). Each has different effects on cost of goods sold and net income.
In general, asset-heavy companies are more impacted by the accounting method decision given the materiality of non-cash changes in asset values over time.
