July, 2014.

Current cost accounting versus historical cost

accounting
(a critical review)
Bello A. Sulaimon
sulbellven01@yahoo.com; +(234) 8160442283

Department of Accounting, Bayero University, Kano

Abstract
Measurement of course, is the hub of accounting and good concepts sometimes fall against the demands of
measurement. Accounting based on asset and liability recognition and measurement in the balance sheet
produces a particular income measure, as a residual, that may be inconsistent with one driven by an income
concept that produces a balance sheet as a residual. Current Cost accounting which is also referred to as “Fair
value”, with an asset and liability focus, differs fundamentally from historical cost accounting driven by an
income concept; the two are mutually exclusive, so for given assets and liabilities, a design choice has to be
made. This study made a critical review of both method of measurement by analyzing how both fair value
accounting and historical cost accounting satisfy the valuation and stewardship objectives of reporting to
shareholders. It was however discovered that despite the fact that both methods may superficially appear to be in
conflict, it may well be that both fair value accounting and historical cost accounting have important roles to
play in structuring financial disclosure and ensuring that needed information is available to different groups of
users.

Key words: Accounting, Valuation, Residual, Measurement, Concept, Current cost,

Historical cost,

INTRODUCTION is imperfect and incomplete, the solution

proposed by IASB is to use a model for
The preparation and presentation of contents
measure the value of the flows generated by
in accounting profession is well guided with
the assets. An increasing number of
principles and concepts. Current cost
international standards are allowing or
accounting which is also referred to as fair
requiring the use of fair value accounting for
value accounting implies that financial assets
financial reporting purposes. The International
and liabilities are measured at their market
Accounting Standards Board (IASB) and
value (IAS, 39) namely the value under the
Financial Accounting Standards Board
theoretical assumption of a perfect, efficient
(FASB) have agreed to a global uniform
and complete market that should therefore
framework that establishes a standard
imply that the financial statement meets the
definition of fair value that is applicable in
needs of investors and creditors. If the market
Current cost accounting versus historical cost accounting
Page 1
(a critical review)
ascertaining the worth of assets and liabilities
without involving market value. In recent
years, there has been substantial controversy
over the use of fair value accounting as
opposed to the historical cost accounting
method
Statement of the Problem
Accounting reports information through
balance sheets and income statements that
articulate such that (comprehensive) income
equals the change in equity in the balance
sheet other than that due to transactions with
shareholders. The system produces two
bottom-line numbers, income in the
(comprehensive) income statement and book
value of equity or “net worth” in the balance
sheet. Since income and book value articulate,
the determination of assets and liabilities also
determines income, and vice versa.
Accordingly, accounting based on asset and
liability recognition and measurement in the
balance sheet produces a particular income
measure, as a residual, that may be
inconsistent with one driven by an income
concept that produces a balance sheet as a
residual. Fair value, with an asset and liability
focus, differs fundamentally from historical
cost accounting driven by an income concept;
the two are mutually exclusive, so for given
assets and liabilities, a design choice has to be
made. The objection that historical cost
accounting, with a focus on an income
concept driven by revenue recognition and
matching, produces assets and liabilities such
as deferred charges and unearned revenue that
are not “real” assets and liabilities as defined
Current cost accounting versus historical cost accounting
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(a critical review)
by an asset and liability focus, recognizes the
inherent tension; accruing an expense for
restoring a mining site against revenue from
the mine, for example, results in a liability
even though there is no legal requirement to
make the restoration.
Objectives of the Study
Measurement is, of course, the rub of
accounting and good concepts sometimes fall
against the demands of measurement. The
FASB requirement that fair value have some
objective basis – backed up by a market price
– invokes a desirable measurement standard,
and is endorsed. But under what
circumstances does fair value as exit value
enhance or frustrate equity valuation and
stewardship assessment?. The objective of
this study therefore is to assess and review the
two method of measurement used in the
valuation of assets and liabilities.
Significance of the Study
Advocates of fair value accounting often
misconstrue historical cost (transactions)
accounting, dismissing it as reporting “old
costs” rather than current values. The analysis
demonstrates how historical transactions
accounting – with its emphasis on the income
statement – works to inform about current
value (for shareholders), and at the same time
shows how fair value accounting – with its
balance sheet emphasis – also does so. The
analysis instructs the equity analyst for it
shows that fair value financial statements are
handled quite differently from historical cost
statements in equity valuation. Recent
arguments about the merits of expanding fair
value accounting treatment to new categories
of assets, such as banks’ portfolios of loans,
have necessitated the need to review these two
methods of measurement.
Scope of the Study
In discussions of fair value accounting,
“historical cost accounting” is typically
assumed to be the default. In differentiating it
from fair value accounting, historical cost
accounting is better referred to as “historical
transactions accounting” for it is based on
reporting value added from market
transactions rather than from fluctuations of
market prices (without transactions). This
study focuses on analysis of how both fair
value accounting and historical cost
accounting satisfy the valuation and
stewardship objectives of reporting to
shareholders.
CONCEPTUAL FRAMEWORK AND
LITERATURE REVIEW
Fair value accounting and historical cost
accounting are competing and mutually
exclusive ways of conveying information.
Their differences are by design, and that
design must be understood if one is to
appreciate what is gained or lost by adopting
one system over the other.
Overview of Fair Value Accounting
FASB defines fair value accounting through
the declaration of the statement - Financial
Accounting Standard No. 157: Fair Value
Measurements. FASB describes fair value as
Current cost accounting versus historical cost accounting
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(a critical review)
the price at which knowledgeable and
willing parties will exchange or settle assets
or liabilities. Fair value accounting is the
practice of declaring the value of the asset or
liabilities (Financial Standards Accounting
Board [FASB], 2011). Under fair value
accounting, a company resets the prices of
certain assets on its balance sheet every
quarter to reflect changes in the market
price; thus, called-to-market “mark
accounting”. For instance, the firm is
considering the exit price. This exit price is
considered as the fair value of the security
based on the assumption that the transaction
took place between willing and
knowledgeable participants (the buyer and
the seller of the security). However, the use
of exit price may fail to reflect the fairness
of the asset or liability value especially
when one participant is not knowledgeable
or willing to transact. For instance, forced
liquidations of assets may result in markedly
lower prices than ones based on fair value
on the expected cash flows of the asset.
The first definition is inappropriate in
determining the fair value of an asset or
liability. As a result, the FASB and IASB
have agreed on a modified method to
determine fair value. Instead of basing
market price on an exit price, the new rules
allow companies to look for the most
advantageous market for an asset or liability
when assigning it a fair market value.
Determining the true market value of an
asset is sometimes controversial, especially
for assets that do not have active and liquid
markets. By definition, the fair value does
not need the existence of an active market.
In case of market inexistence, IASB offers
guideline that looks at the type of assets or
liabilities. For instance, for property, plant
and equipment, depreciated replacement
cost is recommended if market based
evidence is unascertainable. For biological
assets (animals and plants), IASB suggest
the use of discounted present values of
future cash flows (Weetman, 2011).
The adoption of fair value accounting is
arguably the most important and controversial
issue facing regulators and accounting
standard setters today:
“A fundamental conceptual issue
[facing accounting standard setters] is
the extent to which the standards
should move away from traditional cost
based accounting to marking assets
and liabilities to market,
euphemistically referred to as „fair
value‟ accounting. There is without
doubt considerable momentum to move
toward fair value methodologies, but
there are also significant questions
about the practical and useful
application of that approach to certain
industries and firms.”
-- Paul A. Volcker, Chairman of the
Trustees, International Accounting
Standards Committee Foundation in a
statement before the Capital Markets,
Insurance and Government Sponsored
Enterprises Subcommittee of the U.S.
House of Representatives, Washington DC,
June 7, 2001
Both the Financial Accounting Standards
Board (FASB) in the United States and the
Current cost accounting versus historical cost accounting
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International Accounting Standards Board
(IASB) have been dealing with the issue for
a number of years and have promulgated a
number of standards requiring fair value
accounting for selected (largely financial)
assets and liabilities. Some of those
standards have been controversial, but the
discussion today also involves the question
of whether fair value accounting should be
extended to a wider set of assets and
liabilities now carried at historical cost. For
which types of assets and liabilities are fair
values appropriate and which are best left at
historical cost? A conceptual framework that
directs when fair value accounting is
appropriate is needed, and at present none
exists.
Overview of Historical Cost Accounting
Perhaps more than anything else,
misunderstanding of historical cost
accounting creates confusion in the discussion
of fair value versus historical cost. Historical
costs are said to be “old costs” not indicative
of current values, and fair value accounting is
often proposed as a remedy. However, far
from being a design flaw, this is a design
feature of a system that conveys information
for valuation and stewardship in a very
different way. Historical cost accounting is
said to be “backward looking,” but that too
ignores the design, in the form of accrual
accounting principles, that makes the
transactions history informative about the
future.
Historical cost accounting takes the view that
value is generated in business by purchasing
inputs (from suppliers), transforming them
according to a business plan, and selling the
consequent products (to customers) over cost;
in short, value is added by arbitraging input
and output markets for goods and services
according to a business plan. Historical cost
accounting does not report the (present) value
of possible outcomes from the business plan,
nor the (present) value of individual assets.
Rather, it reports on progress on execution of
the plan, recognizing value added (earnings)
only when it is actually confirmed with actual
transactions in input and output markets. The
equity analyst then makes an assessment of
the value of the business, via projections of
future earnings or cash flows based on the
historical record of the firm’s engagement
with markets. The term, “historical cost” is
unfortunately pejorative (and compares
unfavorably with the connotations of “fair
value”). A better term, that captures the
essence, is “historical transactions
accounting,” for the accounting reports a
history of transactions from engaging with
markets and the value added from that
engagement, with a recognition of the
principle that expenditure is cost.
Consequently, the income statement rather
than the balance sheet is the primary focus
under historical transactions accounting. The
income concept is key: income is the
difference between (market) value received
from trading with customers over value
surrendered by trading with suppliers.
Revenue measures the former and expense the
latter, with the difference yielding earnings. A
Current cost accounting versus historical cost accounting
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realization principle dictates revenue
recognition: Recognize revenue at exit market
value but only when there has been an exit (of
products) to market. A matching principle
dictates the recognition of expenses:
Recognize expenses that are incurred to
generate revenue and match those expenses
against revenue to yield net value added, that
is, earnings.
With an income concept being primary, the
balance sheet is the residual of the income
statement. Business assets and liabilities are
recognized on the balance sheet when there is
a timing difference between revenues and
expenses booked and the cash received or
paid. Assets are usually not at fair value, by
design, but rather arise as a product of
matching; assets are not viewed as something
that will produce future cash flows (from
customers) but as something that will be used
up in producing those cash flows (with the
consequent loss in value matched as an
expense). (The exceptions are assets, like
receivables, that arise from revenue
recognition). Liabilities such as accrued
expenses, unearned revenues, and deferred
taxes gaining legitimacy from the income
measurement process rather than necessary
representations of the value of obligations to
others. Adding financing assets and liabilities
(marketable securities that store excess cash
and obligations to those providing debt
financing) completes the balance sheet, with
the residual of assets over liabilities going to
equity.
Accordingly, effective historical transactions
accounting has the feature of providing
information for forecasting future earnings.
The balance sheet is deficient, so the analyst
looks to the income statement. Whereas the
income statement under fair value accounting
is uninformative about future earnings,
historical cost accounting statements, in
principle, are: If the matching of revenues to
expenses incurred to generate revenues is
done faithfully, current earnings indicate the
ability of the firm to add value from sales and
so indicate earnings from future sales. In
practice, current profit margins typically
predict future margins, and considerable
research documents that historical cost
information forecasts future earnings rather
well on average. The view that historical cost
information is “backward looking” is
somewhat misconceived. Rather, historical
transactions accounting, appropriately
executed with sound matching, projects
forward.
The Demand for Fair Value Accounting
and Historical Transactions Accounting
A demand for fair values could be imputed if
historical cost information were shown to be
deficient for valuation and performance
evaluation, with fair values providing the
remedy. Measurement problems (in
implementing revenue recognition and
matching) impose upon historical transactions
accounting in practice, as they also do on
practical fair value accounting (in measuring
fair values) in practice. To separate concepts
from measurement issues, it is helpful to
compare fair value accounting and historical
Current cost accounting versus historical cost accounting
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transactions accounting as products
implemented in their ideal form without
distortion introduced by imperfect
measurement.
Doron and Stephen (2008) suggest that; Ideal
fair value accounting reports a book value that
is sufficient to value a firm but earnings that
are uninformative for the purpose. Ideal
historical transactions accounting produces a
balance sheet that does not report value, but
earnings that are sufficient to value a firm.
They illustrate this using a simple accounting
equation and further concluded that:
1. It is not necessary to state the
balance sheet at fair value to satisfy the
valuation objective. Valuations can be
made from the historical cost income
statement.
2. Assuming that one knows the
required equity return, there is no
reason, in principle, to say that fair
value accounting is better than
historical transactions accounting. The
resolution must turn on how
measurement strays from the ideal.
Historical cost comes with considerable
measurement issues; does fair value
measurement provide a solution?
3. If one does not know the required
return (and we don’t!), fair value
accounting has a distinct advantage.
Valuation under historical transactions
accounting requires a required return
(to convert earnings, a value flow, to a
stock of value). Fair value accounting
delivers the value directly from the
balance sheet without relying on a
required return (as with the mark-to-
market investment fund). As a bonus,
realizations on value at risk are
reported in the income statement to
give an indication of what the required
return should be.
Principles Guiding the Adoption of Fair
Value Accounting and Historical Cost
Accounting
Going by the submission of Doron et al
(2008), five principles guide users on the
adoption of either method. The first three
principles pertain to the case where prices are
available in liquid markets and the last two
add considerations for the case where fair
values must be estimated.
 The One-to-One Principle
Fair value accounting is sufficient for
shareholder reporting when shareholder value
depends solely on exposure to market prices;
that is, assets and liabilities are appropriately
marked to fair value only when shareholder
value varies one-to-one with the market price
of those assets or liabilities. This principle
means that fair value accounting is not strictly
appropriate when a firm adds value to the
market price through its business enterprise.
So, for example, fair value accounting is
appropriate for a trading security where
shareholder value is determined, dollar-for-
dollar, by the change in its market price.
However, fair value accounting is not
appropriate for raw materials where the value
(to shareholders) depends not on the market
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price of the raw materials but on their use, in
combination with other inputs, to produce a
product that is then sold with value added
over the market price of the raw materials.
Core bank deposits do not satisfy this
principle because they are inputs in a business
model of arbitraging borrowing and lending
rates rather than liabilities whose value arises
solely from exposure to market prices.
 The Matching Principle
Value is generated for shareholders by
combining assets and liabilities together
according to a business plan and,
correspondingly, fair value measurement
applies at the level of the assets and liabilities
that work together as a combined business
group. Thus, just as an income-statement
matching principle guides historical cost
accrual accounting, so a balance-sheet
matching principle governs fair value
accounting. Appropriate fair value accounting
matches fair values of assets and liabilities in
the business group together to report their
total value for shareholders. So, for example,
marking down a firm’s debt to market in
response to a decline in credit quality is not
appropriate unless the value of (often
intangible) assets that gives rise to the change
in credit quality is also marked down. Nor is
the marking of bank loans to fair value
without the corresponding fair valuing of core
deposits (with their associated intangibles).
Violation of this principle results in a
mismatch of gains and losses in the income
statement; thus, while fair value accounting,
with the matching principle satisfied,
appropriately reports volatility, mismatching
reports “excess volatility.” This balance-sheet
matching principle is well appreciated in fair
value discussions (of the fair value option, for
example), but its interaction with the one-to-
one principle is not. So, marking bank loans
to fair value in response to changes in interest
rates requires fair valuing matched core
deposits also, but core deposits, with their
associated customer intangibles, are not
liabilities whose value fluctuates one-to-one
with interest rates.
 The Information Conservation Principle
Fair value accounting is appropriate, as an
alternative to historical cost accounting, only
when fair value does not depend on historical
transaction information. So, for example,
substituting fair values of insurance contracts
for historical transaction information about
premiums and losses is inappropriate if the
value of the insurance contracts depends on
the premium and loss history. Further, fair
value accounting is dysfunctional when it
brings bubble prices into the financial
statements, displacing historical cost
information that can challenge bubble prices.
So, for example, fair valuing investments in a
subsidiary with a bubble price (rather than
using the equity method or proportional
consolidation) loses information about the
underlying profitability of the subsidiary that
can be used as a check on the market price.
 The No-arbitrage Estimation Principle
This principle disciplines the use of estimates.
Marking to model (rather than marking to
market) is appropriate if the valuation model
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implies no -arbitrage with respect to observed
prices or other inputs. So, for example, an
estimated fair value of a stock option is
appropriate if that estimate is derived from a
model that implies no-arbitrage with respect
to the underlying stock price. Marking to
model is not appropriate where the firm
arbitrages prices in the model. So, for
example, present-value techniques such as
discounting cash flow are inappropriate for
they evaluate a firm’s ability to arbitrage
current (input) and future (output) transaction
prices with the possibility of reporting Day
One profits.
 The Truing-up Principle
Fair values settle up against actual
transactions, and appropriate fair value
accounting correspondingly trues up against
realizations. Accordingly, Last Day losses (or
profits) are reported and systematic biases in
fair value estimates are revealed.
Fair Value vs. Historical Cost Accounting
Fair value accounting is an improvement to
the traditional form of accounting –the
historical cost accounting. Under historical
cost accounting, the initial price paid by the
company during the purchase of the asset or
incurrence of the liability is the one that
matters. The price reflected on the balance
sheet either is the purchase price or at a
value reduced by obsolescence, depreciation
or depletion (Nobes, 1997). For a financial
asset, the price on the balance sheet does not
change until the security is liquidated.
Historical cost accounting is easy to
understand because it is based on a fixed
price that is always completely known,
specifically the actual price that a company
paid. Historical cost accounting is generally
easier to follow since it is based on fixed
and certain inputs. While this eliminates
uncertainty from the initial valuation
decision, it creates uncertainty in future
periods about the true value of assets
(Meunier, 2012). In both fair value
accounting and historical cost accounting
methods, the value of assets depicted on the
balance sheet is always lower due to the
depreciation, depletion and obsolescence.
In the financial industry, for example,
certain assets, such as securities that have
been labeled “trading securities” or
“available-for-sale securities” may either
appreciate or depreciate according to market
movements and have always been subject to
market-based pricing. However, the values
can only decline for securities labeled as
“held-to-maturity securities”. In addition,
these debt securities are reported as an
amortized form rather than depreciation
(Stickney, Well, Schipper & Francis, 2006).
Such securities include bonds and leases.
Accounting rules require firms to determine if
certain assets, such as goodwill, have been
impaired. If the value of an “impairable” asset
falls and is not expected to recover, the firm
must record a charge for which lowers the
value of the asset on the balance sheet. This
OTTI charge is permanent and cannot be
reversed even if the asset eventually recovers
its market value (Goldman Sachs Asset
Management, 2008). However, the firm
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(a critical review)
would still be able to benefit from the
recovery in value by either collecting the cash
flows from the asset or selling the asset at the
higher price and realizing a capital gain.
Generally, it is anticipated that when an
entity bases its financial statements on fair
value accounting method, the value or
amounts will fluctuate from time to time
compared to when historical cost accounting
is used. The value of items that are accounted
for using historical cost method change at a
lower rate, thus, it is considered less volatile.
In fair value accounting, the recognized
values change from time to time, hence,
higher volatility. This volatility emanates
because this accounting method summarizes
“the stream of expected future cash flows: a
change in expectation relating to any of the
cash flow changes in the fair value” (Barth,
2004). The volatility within the financial
statements does not imply that there is a
flaw in financial reporting rather it is one
that is always anticipated. The proponents of
fair value accounting consider the historical
cost accounting less volatile not because it is
superior but because it provides a company’s
results that are not based on possible
subjective appraisals or some other valuation
methods.
Effects on Balance Sheet
Under FAS 159, the choice of accounting
treatment for recording certain financial
assets, which do not required adherence to
specific fair value accounting rules, can
result in a dramatic impact on the balance
sheet, especially for companies with large
investment portfolios such as insurance or
bank holding companies. In amortized cost,
financial securities held up to maturity and
notably debt securities are always carried on
the balance sheet at the acquisition price
paid by the entity. Thus, from one quarter to
another there will be no volatility in the
prices of individual securities. On the other
hand, with fair value accounting, the price of
EXHIBIT 1. The Balance Sheet
Net assets employed in the business:
Net assets exposed to price movements:
Assets at fair value
Liabilities at fair value
Net exposure to price movements
Net assets involved in trading with customers:
Business assets at historical cost
Business liabilities at historical cost
Net business assets at fair value
Net deferred gains on net business assets carried at fair value
Total net business assets
Net assets in financing activities:
Marketable securities (excess cash) at fair value
Financing debt settled at contractual amounts (at historical cost)
Financing debt settled at market price (at fair value)
Shareholders’ equity
debt security is adjusted with accordance to
the market price at a given time. Such
gyrations noted in fair value accounting
would have significant impact on the daily
operation of the business.
Since a balance sheet is a measure of a
company’s any business entity. For instance,
the law requires financial institutions
(banks) and insurance companies to
maintain certain level of equity –usually
Current cost accounting versus historical cost accounting
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portrayed on the balance sheet (Zyla, 2010).
Standard accounting defines equity as the
difference between assets and liabilities.
Thus, as these two figures vary, equity also
varies –increases or decreases. Because
banks rely on leverage ratio, a small
variation in the value of their assets will
have a greater impact on their size of equity.
For example, during the 2008-2010
XXX
XXX
XXX
(XXX)
XXX
XXX
(XXX) XXX
XXX
XXX
(XXX)
(XXX) XXX
XXX
economic meltdown, there were financial
crisis that led to the decline of asset values
(Zyla, 2010). In turn, as the value of assets
declined, the equity of banks declined. The
position of many banks as shown on the
balance sheets deteriorated. This situation
called for financial institutions to raise more
equity in order to bring their balance sheet
back to position required by government
regulations. Assets and liabilities have a
very different interpretation under fair value
accounting, so balance sheets should
distinguish those at fair value from those at
historical cost. The division is between
assets and liabilities where shareholder
value comes from exposure to the market
prices, and those where assets and liabilities
are inputs into the productive process. See
Exhibit 1.
Effects on Income Statement
Fair Value Option (FVO) election choice
may have a substantial effect on income
statement and earnings. Whilst certain
changes in values are only reflected on the
balance sheet, Other-Than-Temporary
Impairment changes that flow through income
statement have a direct impact on net income;
for instance, the value of available for sale
securities. FAS 115, states categorically that
trading assets are held with an aim of
disposing them in the near future (Laux &
Leuz, (2010). Securities like bonds and
treasury bills are marketable securities thus
they are reported at fair value whereby the
changes noted are recognized in the income
statement. Thus, considering other-than-
temporary impairment charges, some negative
but significant impacts on earnings may
emanate from this rule. Therefore, many firms
are hesitant to take these charges unless
regulators or auditors force them.
The accounting system reports
comprehensive income, but historical cost
income has a very different interpretation
than fair value income, so the two must be
reported as distinct components of
Current cost accounting versus historical cost accounting
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comprehensive income. A dollar of fair
value income is worth a dollar, but that from
the productive process takes on a multiplier.
The following presentation makes a clean
separation:
EXHIBIT 2. The Income Statement
Income from trading with customers:
Revenues XXX
Expenses incurred in generating revenue (XXX)
Matched recognized gains and losses on fair
value
assets utilized in trading with customers XXX
Net income from trading with customers XXX
Income from exposure to market prices:
Fair value gains XXX
Matched fair value losses (XXX) XXX
Net income from business activities XXX
Income from financing activities:
Fair value gains (losses) on mkt. securities XXX
Interest expense on contractual debt (XXX)
Fair value gains and losses on debt
settled at market price XXX XXX
Comprehensive income XXX
Effects on Cash Flow Statement
Unlike the balance sheet and income
statement, the use of fair value accounting
does not have a direct impact on the
statement of cash flows of an entity. The
entities will eliminate any OTTI charge that
applies under fair value accounting back into
their income statements as part of operating
cash flow. In securities, FASB defines credit
loss as specific changes in the cash flow;
that is, if bond quality declines, the resulting
decline in market value does not constitute a
credit loss, unless if the expected amount to
be received is less compared to the
contractual amount of the cash flow
(Deutsche Bank Group, 2009). Thus, the
statement of cash flows only reflects the
interest payments, dividends, and realized
gains from selling securities that are already
included in net income. The change to the
statement of cash flows is indirect in that the
net income figure will be different, creating
a cosmetic difference between the two
methods. When using fair value accounting,
the cash flow statement will most likely start
with a lower net income figure; then, OTTI
charges are added later. However, the net
results shown by the statement of cash flows
of either methods –historical cost and fair
value accounting are generally similar.
The statement of cash flows is however
affected by taxes. Tax rules add a layer of
complexity to arriving at the level of OTTI,
since the Internal Revenue Service (IRS) does
not view all impairments equally. For publicly
traded securities, the IRS does not allow an
OTTI deduction to be taxable income. The
appropriate reduction in taxes will occur when
that loss is realized, usually by selling the
security in question (Moran, 2010). For a
bank taking an OTTI charge on a loan that is
likely to default, the IRS does allow an
immediate tax deduction. Essentially, the IRS
makes a distinction between credit losses,
which are deductible, and unrealized market
losses, which are not deductible. In some
instances, accountants may be able to argue
that a portion of the loss on a security is
attributable to credit losses and a portion is
Current cost accounting versus historical cost accounting
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(a critical review)
attributable to market losses. If a company
does qualify for a deduction, cash taxes will
be lower using fair value accounting rather
than historical cost accounting, leading to
higher operating cash flow under the fair
value method (Moran, 2010). This tangible
improvement in cash flow through lower tax
payments is just one advantage of fair value
accounting. This situation implies that the
company with higher cash flows generally
compiles higher valuations.
Area of Disagreement over Fair Value
Accounting and Historical Cost Accounting
Although the debate over fair value
accounting grew louder in the wake of the
2008 financial crisis, the debate actually has
historical origins that long predate the current
episode of financial turmoil. In fact, the
current framework of accounting standards
and bank regulation that has emerged through
recent decades is in part a reflection of a much
longer-running debate over the wisdom of fair
value accounting versus historical cost
accounting. For persons previously unfamiliar
with the accounting standards and their
history, the questions invited by the long-
running debate are: Why have people been
engaged in a decades-long argument over
something so esoteric? What are some of the
major underlying differences of opinion and
assumption that have contributed to the
debate? In turn, how do those key points of
disagreement tie back to the relationship of
the accounting standards to systemic risk?
The different areas of disputes are further
treated below.
  Valuation of Assets
Fair value accounting and historical cost
accounting, as applied to assets, focus on
different basic snapshots of valuation. Each is
subject to different problems and limitations.
Fair value accounting, by definition, involves
establishing the current value of an asset, or
the price at which the asset could be sold for
today, based (whenever possible) on
observable market prices. Fair value
accounting is maximally relevant with regard
to assets that are likely to be sold in the near
term, and in connection with portfolios of
securities that trade on liquid markets, when
the clearing prices for the assets are easy to
observe and to document. fair value
accounting becomes far more complex, and
less easily verifiable, as applied to illiquid or
non-market-traded securities, when valuations
are based on finance models rather than
markets, and when the assumptions that go
into generating an fair value accounting
“price” may be obscure or of questionable
validity. Fair value accounting may also be
less relevant as a valuation method when
applied to an asset that the owner has no
intention of selling in the near future.
By contrast, historical cost accounting
involves valuing an asset based on a historical
price, defined by what the owner of the asset
originally paid to acquire it. Historical cost
accounting is backward looking, and it does
not involve adjusting the book value of an
asset to reflect transient volatility or
fluctuations in the market, nor for unrealized
appreciation over time. Historical cost
accounting valuations are, however, supposed
Current cost accounting versus historical cost accounting
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(a critical review)
to be adjusted to reflect other-than-temporary
impairments to the value of an asset, as when
credit defaults in a portfolio of mortgages
degrade the future flow of revenue that will be
realized from those mortgages. Because of the
nature of historical cost accounting valuation,
the approach enjoys the advantages of being
less volatile, less responsive to liquidity
shock, less vulnerable to speculative run-up in
asset prices, and less assumption-dependent
than is sometimes the case for fair value
accounting valuation. For these reasons,
historical cost accounting may provide
particularly useful information in pricing the
assets of a “going-concern” business, in which
the intent is to hold the assets for a long
period of time, and in which there is no
likelihood of an insolvency that would compel
a sale of the assets. Historical cost accounting
valuations may become misleading, however,
when these assumptions are violated, or when
the impairment of assets to reflect non
temporary credit problems has been
inaccurate or misleading.
 Financial Information Provided
A central underlying point of dispute in
arguments about fair value accounting is
whether one or the other of these approaches
provides “better” financial information, and if
so, better for whom? Implicitly, investors who
have a short time horizon on assets (as often
applies to securities held for trading) will tend
to be more interested in an fair value
accounting approach to understanding the
value of the assets. The same is likewise true
for investors seeking to assess the financial
position of a firm or institution, when the
latter faces a serious potential for insolvency.
On the other hand, for investors seeking to
assess the status of a going-concern business
in which there is no risk of bankruptcy,
historical cost accounting is sometimes
viewed as a better index of the fundamental,
long-run value of the assets of the firm:
particularly so when the firm has no intention
of selling or trading the assets in question, and
when liquidity effects distort short-run prices
in trading markets. In other words, different
kinds of investors may have different
perspectives about whether fair value
accounting or historical cost accounting is
more useful or appropriate, depending both on
the assets and the firms involved and on the
investment context in which the financial
information is going to be used. Both
accounting approaches may offer useful (and
non-duplicative) information in some
circumstances.
 Users of Accounting Information
Another implicit point of disagreement
centers on for whom the accounting
information is actually being generated, and
the primary purposes for which the
information is going to be used. In practice,
there clearly can be lots of different users of
accounting information, including banks and
financial services firms themselves (in
tracking their own status and managing
portfolio risk), contractual counterparties (in
assessing the solvency of their partners in
financial transactions), and equity analysts
and economists (in assessing the financial
Current cost accounting versus historical cost accounting
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(a critical review)
status and risk of particular companies,
market sectors, etc.), to name just a few. But
in principle, two of the most important
categories of users arguably overshadow most
of the other groups and potentially have
somewhat different perspectives and needs in
how they use accounting information, and
consequently different views about fair value
accounting and historical cost accounting.
Those categories are investors (and
particularly, investors in public company
securities and stock) and regulators,
respectively.
 Investors
The investor community relies on accounting
statements and financial information. Given
that public company investors are some of the
primary intended recipients of accounting
information, one question that follows is, Is
there reason to believe that those investors (as
a group) are better served by an fair value
accounting or historical cost accounting
approach to the assets on firms’ balance
sheets? The answer is both yes and no: Some
investors appear to prefer fair value
accounting information, while others prefer
historical cost accounting. Many accounting
experts and investor advocates have argued
that an fair value accounting approach
provides more transparency in firms’ financial
statements, and therefore is generally more
consistent with promoting investor welfare.
Others, however, have disputed those
arguments, particularly by challenging
whether fair value accounting, as applied to
non-liquid, non-trading assets, really does
provide much incremental transparency.
 Regulators
The regulatory community comprises a
second key group of consumers of accounting
information. Several bank regulatory
agencies, the Federal Deposit Insurance
Corporation (FDIC), and the Office of the
Comptroller of the Currency (OCC), rely on
accounting information (and on the
accounting standards) as a basic resource in
over-seeing the status and solvency of banks
and other financial institutions. The
institutional role of these prudential agencies
is very different from that of investor
protection (which is the focus of the SEC):
Their focus is instead on safeguarding the
solvency of banking institutions, the interests
of depositors, and/or protecting the stability of
the banking system as a whole. Prudential
regulators, too, make use of accounting
information about financial services firms, as
an important resource in helping to ensure
institutional solvency and monitoring risk.
 Asset Volatility
Another serious point of disagreement
between partisans of fair value accounting and
historical cost accounting often involves their
perspectives on volatility in asset prices, and
their views on whether or not such volatility
provides useful information for understanding
asset (and firm) values. Because fair value
accounting involves periodically updating
asset values based on current prices in liquid
markets, fair values for assets will fluctuate
with the market on a periodic (perhaps
quarterly, perhaps daily) basis. For some
Current cost accounting versus historical cost accounting
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(a critical review)
kinds of assets, such as trading securities,
those fluctuations may be highly
consequential and meaningful. In particular,
trading of securities is a business in which
daily entry and exit from particular positions
is the basis for generating revenue, and daily
prices are the metric for deciding whether to
buy or sell assets. For firms that operate in
this way, and for assets that are typically
traded, volatility in prices is a basic part of the
information that is needed to under-stand the
financial position of a firm at any given point
in time. Put another way, fair value
accounting provides a window on the most
up-to-date and accurate values that are
available concerning these sorts of assets, and
the firms that own them, at any designated
point of observation.
Critics of fair value accounting sometimes
have a very different perspective on volatility
they argue that volatility in spot prices for
assets, and particularly for assets that the
banks have no intention of selling, is
fundamentally misleading as an indicator of
asset values in the hands of those banks. Here
again, the argument is made that where the
expressed intent of the bank is to hold a long-
term asset in order to realize a stream of
future income (as with a mortgage loan), then
market prices based on liquidating the asset
may be irrelevant or misleading as applied to
valuation on the bank’s balance sheet.
The question about whether fair value
accounting-induced volatility is
fundamentally important and a reflection of
value in its own right or instead a nuisance in
financial measurement that may be costly to
track but is largely immaterial, ties back to
several of the points already raised above.
Who is the prospective user of the accounting
information? What do they plan to use the
information for? What is the business model
of the firm that is holding the asset, and what
is the time horizon of the investment at issue?
Stakeholders with different answers to these
basic questions tend to have very different
perspectives on volatility, and on the relative
merits of fair value accounting and historical
cost accounting. And often those stakeholders
find themselves in disagreement about which
accounting approach is “better,” and about the
appropriate contours for applying fair value
accounting and historical cost accounting.
Arguments For and Against Fair Value
Accounting
Some of the following quotes are those
reported in the press and the context is not
always apparent. In particular, the extent of
the application of fair value accounting that
the speaker has in mind is not always clear.
So there is some risk of misconstruing the
statements.
Arguments Offered for Fair Value
Accounting
The Board believes fair values for financial
assets and financial liabilities provide more
relevant and understandable information than
cost or cost-based measures. The Board
considers fair value to be more relevant to
financial statement users than cost for
assessing the current financial position of an
entity because fair value reflects the current
cash equivalent of the entity‟s financial
instruments rather than the price of a past
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transaction. With the passage of time,
historical prices become irrelevant in
assessing an entity‟s current financial
position.
---FASB Exposure Draft, The Fair Value Option
for Financial Assets and Financial Liabilities—
Including an Amendment of FASB Statement No.
115 (January 25, 2006, page 8; Appendix A,
section A3).
I think it is hard to argue with the conceptual
merits of fair value as the most relevant
measurement attribute. Certainly, to those
who say that accounting should better reflect
true economic substance, fair value, rather
than historical cost, would generally seem to
be the better measure.
---Robert Herz, Chairman of the Financial
Accounting Stands Board in CFO Magazine,
February 2003, page 40, quoting from a speech at
a conference of Financial Executives International.
I know what an asset is. I can see one, I can
touch one, or I can see representations of one.
I also know what liabilities are. On the other
hand, I believe that revenues, expenses, gains,
and losses are accounting constructs. I can‟t
say that I see a revenue going down the street.
And so for me to have an accounting model
that captures economic reality, I think the
starting point has to be assets and liabilities.
--- Thomas Linsmeier, Member of the Financial
Accounting Standards Board, in “Will Fair Value
Fly?” on CFO.com, September 20, 2006.
How do we take control of the reported
numbers out of the hands of corporate
management? We do it by requiring that the
reported numbers for assets and liabilities,
including guaranties and commitments, be
based on estimated current market prices –
current cash selling prices for assets and
current cash settlement prices for liabilities.
…………I recommend that there be a sense of
the Congress resolution that corporate
balance sheets must present the reporting
corporation‟s true economic financial
condition through mark-to-market accounting
for corporate assets and liabilities.
---Walter P. Schuetze, former Chief Accountant,
Securities and Exchange Commission, in testimony
before the United States Senate Committee on
Banking, Housing, and Urban Affairs, February
26, 2002.
Conceptually, fair value is a market-based
measurement that is not affected by factors
specific to a particular entity. Accordingly, it
represents an unbiased measurement that is
consistent from period to period and across
entities.
---FASB Exposure Draft, Fair Value
Measurements, Proposed Statement of Financial
Accounting Standard (June 23, 2004, page 27;
Appendix C, Section C2.
Information about fair value better enables
investors, creditors, and other users to assess
the consequences of an entity‟s investment
and financing strategies, that is, to assess its
performance.
---FASB Statement of Financial Accounting
Standards No. 107, Disclosures about Fair Value of
Financial Instruments (December 1991, page 17,
paragraph 41).
Fair value provides important information
about financial assets and liabilities as
compared to values based only on their
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(a critical review)
historical cost (original price paid or
received). Since fair value reflects current
market conditions, it provides comparability
of the value of financial instruments bought at
different times. In addition, financial
disclosures that use fair value provide
investors with insight into prevailing market
values, further helping to ensure the
usefulness of financial reports.
--- The Bond Market Association, International
Swaps & Derivatives Association, Securities
Industry Association, Explanation and Benefits of
Fair Value Accounting (March 26, 2002, page 3)
Fair value information in the only
information relevant for financial decision
making ... Fair value measures reflect the
most current and complete estimations of the
value of the asset or obligation, including the
amounts, timing, and riskiness of the future
cash flows attributable to the asset or
obligation.
--- A Comprehensive Business Reporting Model:
Financial Reporting for Investors.
(CFA Institute, Center for Financial Market
Integrity, October 2005).
It is axiomatic that it is better to know what
something is worth now than what it is worth
at some time in the past…Historical cost itself
is in reality historic market value, the amount
of a past transaction engaged in by the firm
…Historic cost data are never comparable on
a firm-to-firm basis because the costs were
incurred at different dates by different firms
(or even within a single firm). There is no
financial analyst who would not want to know
the market value of individual assets and
liabilities.
--- Financial Reporting in the 1990s and Beyond
(Association for Investment Management
Research, 1993), page 39.
Where feasible, fair value provides the best
information to investors. Obviously, this can
involve assumptions if there are no fair-
market prices [available]. But if all the
assumptions are disclosed, that brings a good
deal of light to the process.
--- Rebecca McEnally, Vice-president of advocacy
for the CFA Institute, in CFO magazine, February
2003, page 40.
Argument against Fair Value Accounting
If markets were liquid and transparent for all
assets and liabilities, fair value accounting
clearly would be reliable information useful
in the decision-making process. However,
because many assets and liabilities do not
have an active market, the inputs and methods
for estimating their fair value are more
subjective and, therefore, the valuations less
reliable. Research by Federal Reserve staff
shows that fair value estimates for bank loans
can vary greatly, depending on the valuation
inputs and methodology used…
..The FASB statement on the proposed fair
value standard suggests that reliability can be
significantly enhanced if market inputs are
used in valuation. However, because
management uses significant judgment in
selecting market inputs when market prices
are not available, reliability will continue to
be an issue…In our role as a bank supervisor,
we have observed that minor changes in a
number of assumptions in a pricing model
can have a substantial effect. Generally, we
are comfortable with the fair value
measurement process for liquid trading
instruments that financial institutions have
had significant experience in valuing.
However, we believe that for less-liquid
assets and liabilities, reliability is a
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(a critical review)
significant concern.
--- Governor Susan Schmidt Bies, to the
International Association of Credit Portfolio
Managers General Meeting, New York, November
18, 2004.
Reliability of information is to be determined
on the basis of faithful representation of the
economic reality rather than the legal form of
transactions, and should be prudent, complete
and free from bias. While active and liquid
markets may exist for many financial
instruments, principally debt securities,
equities and certain derivatives, there is no
market of any substance for loans and
deposits…The fair value measurement of own
debt would mean that a deterioration in a
bank‟s credit rating would result in an
accounting profit reflecting the fall in the
discounted value of its liabilities…Full fair
value measurement is perceived to be
necessary because of the subjectivity caused
by the mixed attribute approach and problems
associated with similar instruments being
measured on two different bases. The division
between trading and non-trading activity in
banks, however, is clearly understood, is fully
documented and has proven operable and
capable of audit throughout the 1990s. By
contrast, the fair value measurement of the
banking book is dependent upon the
estimation of value in the absence of market
information and involves assumptions about
liquidity, credit standing, collateral and
customer behavior. It is difficult to see how it
can be described as being more objective than
the current measurement base.
--- “Fair Value Accounting: an Industry View,”
Paul Chisnall, Director, British Bankers’
Association; Financial Stability Review, December
2000.
Potential disadvantages - Fair Value:
Difficulty in measuring. The calculation of
reliable fair value adjustments may be a
difficult task, and may not always be possible;
Greater estimation reliance. Fair value
accounting systems increase the number of
estimates underlying the reported financials.
This raises questions as to potential
estimation error, and even manipulation of
estimates; Volatility in earnings. Liabilities
held at fair value may show much greater
volatility, due to changing yield curves and
risk adjustments, versus undiscounted or
conservatively discounted liabilities. This
additional volatility may provide more noise
than information to capital providers and
other users of financial statements; Cost.
Implementation and maintenance of a fair
value accounting system will cost time and
resources. There may be other alternatives
that cost less, and do not have all the
disadvantages mentioned above, while still
maintaining many of the advantages of fair
value accounting; Uncertainty. Fair value
accounting has never been implemented for
insurance liabilities, or other liabilities for
which there are no active markets. There will
inevitably be some unintended or unexpected
consequences from its implementation.
--- CAS Task Force on Fair Value Liabilities,
White Paper on Fair Valuing Property/Casualty
Insurance Liabilities, Casualty Actuarial Society,
page 9, 2002, available at
http://www.casact.org/research/tffv l.
Applying the fair value option to the reporting
entity‟s liabilities poses a particular problem,
especially from a prudential point of view. As,
under the fair value option, fair value
measurement is not restricted to market
developments (e.g. market interest rate
fluctuations or changes in the exchange rate
parities), but is all-encompassing, i.e. it also
Current cost accounting versus historical cost accounting
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(a critical review)
includes fluctuations caused by changes in the
reporting entity‟s credit rating, a
deterioration in the reporting entity‟s credit
rating and the resultant devaluation of its own
liabilities leads to an increase in its capital.
From a prudential point of view, this is
unacceptable.
--- Deutsche Bundesbank, Banking and Financial
Supervision Department Frankfurt am Main,
Comment Letter on Exposure Draft of Proposed
Amendments to IAS 39 Financial Instruments:
Recognition and Measurement, “The Fair Value
Option,” 30 July 2004.
There are serious doubts that an adequate
fair value can be determined for bank loans,
which are non-negotiable instruments
precisely because they embody elements that
cannot be easily quantified in a standardised
manner. First, there are, by definition, no
secondary markets for these instruments. This
is particularly true where credit risk markets
do not appear to be sufficiently deep and
liquid for the purpose concerned.
---European Central Bank.
There are a number of complex measurement
issues that first need to be explored. In order
to ensure that the „fair value‟ was one
recognised by banks, measurement of value
for unmarketable assets would have to rely
heavily on internal processes. Although this
would raise issues about validation and
consistency across banks, a fair value that the
banks did not recognise could create marked
distortions in behaviour.
---“Fair value accounting, capital standards,
expected loss provisioning, and financial stability”,
Financial Stability Review, June 2000. Patricia
Jackson and David Lodge, Regulatory Policy
Division, Bank of England, page 122.
The fourth drawback is the potential
disruption to market discipline caused by the
reduction of comparability and reliability of
financial statements across financial
institutions. Under FAIR VALUE
ACCOUNTING, when there is no observable
market value then valuation models are used.
Fair values obtained by these models should
be based on inputs from liquid markets in
order to reduce the scope for possible
manipulation. At present a variety of
valuation models coexist with varied inputs
and assumptions, and this may significantly
reduce comparability if used indiscriminately
across banks and across balance-sheet items.
Furthermore, it should also be mentioned that
the date and purpose of the valuation is
critical in establishing a fair market value. A
valuation is determined for a particular point
in time, and generally should not be relied
upon for other dates. In the same vein, a
valuation is usually performed for a
particular purpose and generally may not be
appropriate for another purpose… Moreover,
given the current state of the art, particularly
with regard to credit risk models, reliability in
financial statements could be negatively
affected. Indeed, fair values do not always
convey precise information concerning a
bank‟s risk profile, thus hindering market
discipline that requires reliable information in
order to be effective. Misjudgement can
trigger overreaction, which can have a
negative impact on the financial situation of a
firm.
---European Central Bank, Occasional Paper
Series, No. 13, April 2004, Fair Value Accounting
and Financial Stability, pages 7-9.
Current cost accounting versus historical cost accounting
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(a critical review)
Summary
The study has critically reviewed one of the
current most argumentative topics in
accounting profession. The issue of the right
method of measurement to be adopted given
different situation remains a topic of discuss
to the regulators, users and preparer of
accounting information the world over.
The advocate for fair value measurement had
been on top gear in recent years. However,
some firms still stick to the historical cost
based mode of measurement while some
adopts both methods.
This study have been able to justify the use of
either methods and by extension, discussed
the argument in favor and against the adoption
of fair value accounting.
Summary of findings
The following are some of the findings:
1. Regulators have not been advocates for
expanding the application of fair value
accounting to new categories of assets on
bank balance sheets. In fact, the agencies
collectively have tended to oppose increased
application of fair value accounting
principles: In particular, they issued an
opinion letter opposing FASB’s 2009 fair
value accounting proposal to this end. . In their
opinion letter, the prudential agencies asserted
that for purposes of banking oversight, the
volatility associated with fair value
accounting could be highly problematic, and
by implication, that historical cost accounting
standards provide more useful and more
stable information for their purposes.
2. Different types of users of accounting
information have fundamentally different
informational needs and agendas to pursue,
those differences surely contribute to
subsequent disputes about the relative merits
of, and appropriate contours for, fair value
accounting and historical cost accounting.
3. Fair value accounting-based valuation
models may sometimes be vulnerable to
manipulation by firms, and particularly so
where the consequences of asset valuation
may have very high stakes for the continued
solvency of a firm.
Conclusion
Many of the traditional arguments about the
merits of fair value accounting and historical
cost accounting involve advocates and
stakeholders who appear to be arguing past
each other rather than with each other. In
other words, different stakeholders often start
from very different assumptions in reaching
their own views about the competing merits of
fair value accounting and historical cost
accounting. Even the answers to basic
questions about who the key consumers of
accounting information are and for what
purposes accounting information is going to
be used can lead respondents to very different
conclusions about fair value accounting and
historical cost accounting and about the
evolving contours of accounting policy. On
the bright side, one implication is that there
may be greater commonality of opinion across
the two sides of the debate than is typically
recognized.
Current cost accounting versus historical cost accounting
Page 21
(a critical review)
Despite the fact that those preferences may
superficially appear to be in conflict, it may
well be that both fair value accounting and
historical cost accounting have important
roles to play in structuring financial disclosure
and ensuring that needed information is
available to different groups of users.
Recommendation
1 Regulators should advocate for
expanding the application of fair value
accounting to new categories of assets on
bank balance sheets to forestall the volatility
associated with fair value accounting.
2 Users of accounting information have
fundamentally different informational needs
and agendas to pursue, a balance need to be
strike to know what method of measurement
suits the user of the financial information
being prepared. For the purpose of
stewardship the end user of the information
should be given preference as to the method
that best gives the precise and most accurate
information that may be needed
3 Vulnerability to manipulation by firms
adopting FAIR VALUE ACCOUNTING-
based valuation models should be eliminated
particularly so where the consequences of
asset valuation may have very high stakes for
the continued solvency of a firm. This can be
done by way of issuing standards which to
curb the menace.
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