Historical Vs.

Fair Value

Historical Vs. Fair Value Student Name Institution Name

Historical Vs. Fair Value

Contents
Abstract ........................................................................................................................................... 3 The Debate ...................................................................................................................................... 4 Accounting Standards and Practices across the Globe ................................................................... 5 Similar Reporting Rules .................................................................................................................. 8 Definition of fair value................................................................................................................ 8 Valuation techniques ................................................................................................................... 8 Income approach: .................................................................................................................... 8 Cost approach: ........................................................................................................................ 8 Fair value hierarchy .................................................................................................................... 8 Disclosures .................................................................................................................................. 9 Different Reporting Rules ............................................................................................................... 9 Conclusion .................................................................................................................................... 10 Works Cited .................................................................................................................................. 11

Historical Vs. Fair Value

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

Historical Vs. Fair Value

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

Historical Vs. Fair Value

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

Historical Vs. Fair Value

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

Historical Vs. Fair Value

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).

Historical Vs. Fair Value

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

Historical Vs. Fair Value

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-reconcilingfair-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-gaapsimilarities-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 .