Fair value versus historical cost Accounting
Measurement is a central concept in accounting and financial reporting. Financial reporting is centered on reporting a firm's state of affairs and its performance over a period through the use of numbers. As noted by CIPFA (2010), financial reporting has as its major objective the 'production of accurate, complete, relevant, timely and reliable financial information to demonstrate and maintain accountability, to meet statutory reporting requirements, to account to an organization's stakeholders for its financial performance and to support decision-making' (CIPFA, 2010, p. 24). ICAEW (2006) posits that there are five different bases of measurement that serves the purpose of accrual accounting. These bases include historical cost, value to the business (current cost or deprival value), fair value, realizable value and value in use (p. 21). The ICAEW argue that the choice of a measurement methodology should be based firstly its 'cost effectiveness' and its 'fitness for purpose' (P. 21) and then next on its 'relevance' and 'reliability'. Alexander et al. (2006) notes that there is a general preference for current value measurement methods (current cost, fair value, realizable value and value in use) when compared with historical costs methods and there is a particular preference from fair value accounting.
This opening paragraph highlights the potential for controversy that lies in the choice of measurement basis for assets and liabilities. To further exacerbate this controversy there are no clear standards or guidance to date either from the IASB or the FASB on what the appropriate measurement basis is. The develop of this standard can be considered as a work in progress, with the IASB noting that the completion of this process and the institution of a standard to cover fair value accounting is not in sight (Nikolaev and Christensen, 2009; Shortridge et al., 2007). The debate has been brought to life by numerous view points from academics and practitioners. The final 'straw that broke the camel's back' was the recent global financial crisis and the potential role that fair value accounting played in intensifying the crises. This project sets out to review the merits and demerits of fair value accounting in the face of its backdrop (historical cost accounting). It will also assess whether historical cost information remains useful in amidst the implementation of fair value accounting. The role of fair value accounting in the global financial crisis will be evaluated and recent developments on fair value accounting by the IASB will be highlighted. Core sources of information for this evaluation will be publications for standard setters (IASB and FASB), professional accounting bodies (ACCA, ICAEW, CIPFA and ICAS), opinions of business leaders and empirical research propositions from academics.
Merits and demerit of fair value (as opposed to historical cost) accounting
Fair value accounting (also known as Marked-to-market accounting) is basically financial reporting 'at fair values'. IAS 39 defines fair value as 'the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm's length transaction' (Alexander et al., 2007, p. 395)
The IASB's Fair value accounting policies are encompassed in IAS 39: Financial Instruments; Recognition and Measurement (Alexander et al. 2007). The standard prescribes that financial assets and liabilities should be initially measured at cost. Alexander et al. (2007) noted that the IASB has also introduced an option for firms to 'designate financial assets and liabilities at fair value through profit or loss account and measure it at fair value for the whole period of its recognition' (p. 413). The gain or loss from subsequent measurement is transferred to the equity and income account depending on the asset type (Alexander et al., 2007). Initial measurement of fixed assets (property, plant and equipment- PPE) is at historical costs (IAS 16), while a firm has two options for subsequent measurements: '-an item of PPE shall be carried at its cost less any accumulated depreciation and any accumulated impairment loss; -an item of PPE whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment loss' (IAS16, Par. 30-31)
Relevance versus reliability
The main debate around the historical cost versus fair value accounting seems to be on how they adhere to accounting principles and philosophies notably the principles of relevance and reliability. Shortridge et al. (2006) argue that the issue is a philosophical debate were supporters of historical cost accounting posit that fair value accounting is unreliable while proponents of fair value account argue that historical cost accounting is irrelevant.
Relevance is an accounting principle which argues that financial reports should provide useful information to meet the needs of stakeholders (Alexander et al., 2007). Shortridge et al. (2006) contend supporters of fair-value accounting argue that measurements at fair value are more relevant to decision makers even if they are less reliable. Balance sheets presented fair values are more likely to represent the true state of the company (Christensen and Nikolaev, 2009). Historical cost information becomes irrelevant as the values of assets change over time which is often the case. Shortridge et al. (2006) argue that historical cost accounting does not allow stakeholders to gain important information about changes in asset values that may arise either from depreciation or appreciation.
Reliability refers to the principle of financial reporting that asserts that 'users should be able to have a high degree of confidence in the information' provided by financial statements (Alexander et al., 2007, p. 9). The widely held belief in the business world is that fair value accounting is markedly unreliable. Historical cost accounting warrants that assets are reported at their historical costs adjusted for accumulated depreciation (Nikolaev and Christensen, 2009). This means that there is less opportunity for unscrupulous management to tamper with asset values. Fair value accounting however requires that asset values be ascribed based on management appraisals, valuations and estimates. More worrying is that fact that gains from subsequent valuations (using any of the many valuation techniques available) can be transferred directly to the income statement (Alexander et al., 2007). This provides an opportunity for dangerous earnings management. Worse still, Martin et al. (2006) noted that effective auditing of fair value accounting statements requires special skills which auditors do not have.
Fluctuation
Fair-value or marked-to-market accounting results in instability in financial reporting. Fair values change constantly because by definition they depend on the current market price of assets. This was the case during the recent global financial crisis. Boyer (2007) argues that fair values are disruptive as they incorporate the instability of financial markets into financial reporting. Asset values plummeted significantly from one financial quarter to another implying that the value of a firm's assets fluctuate significantly and earnings reported will be significantly subject to the choice of balance sheet date. Ramesh and Graziono (2004) contend that fair value accounting presents a new opportunity for continuous reporting where firms report their earnings on a more continuous basis as opposed to the current discrete (quarterly, semi annually and annually) reporting systems under historical cost accounting.
Simplicity
By definition fair values change constantly and for fair value reporting to be effective, accountants must continuously monitor the market value of each asset and constantly upgrade their accounts. This is not a simple process or cost effective process for firms. The contrary argument is that it that historical cost reporting does not make valuation simpler for investors either (Ramesh and Graziono, 2004; Shortridge et al., 2006). If the firm does not report at current values, investors are forced to decipher such statements in their bid to correct value the firms to make their investment decisions. Ramesh and Graziono (2004) noted that historical cost accounting is income statement focused while fair value accounting is more balanced sheet oriented. None of the models therefore makes reporting simpler for firms or for investors.
The measurement problem
Some assets are not traded frequently and therefore a market price for them will be hard find. Consider for example a bespoke machine design and constructed to suit the needs of a particular coal mining firm. This machine will actually not have a market value because it unique to this firm and can therefore not be traded in an arms length open market transaction. The best guide to the value of that machine is its historical cost. The lack of suitable comparatives is therefore a major problem in arriving at fair values for many firms. This is not the case with financial assets which are highly tradable. The fact that they are highly liquid means that the best valuation for them is not their historical cost but the price that the market is willing to pay to acquire such assets (Ramesh and Graziano, 2004). Ramesh and Graziono (2004) commend historical cost reporting for initial recognition but noted that 'subsequent measurements are based on ad hoc allocations' (P. 6)
Book values versus market values
It is not unusual to find a firm whose market value is significantly greater than its book value. What this implies in an efficient market is that the book values of the assets do not actually reflect the fair values of the assets. The message is therefore that book values (derived from historical costs) cannot be overly relied upon-irrelevance. The use of fair value accounting is bound to drive book value closer to market values thus improving the significance of financial reporting in general. Boyer (2007) how ever noted that market values actually constitute unrealized gains. The pressure to move towards fair values means that firms will frequently report unrealized earnings and with increasing pressure from investors, such unrealized earnings will be distributed. This is against the accounting concept of prudence. Again Boyer (2007) noted that fair value accounting relies strongly on the efficiency of financial markets which another subject for debate. In the past, accounting values were rather used to assess the validity of market values and market efficiency (see Lee et al., 1999).
The impairment versus appreciation controversy
The IASB in its IAS 36: Impairment of Assets, mandates that asset impairment be tested by considering whether the historical cost of the asset outstrips its recoverable value [1] . If this is the case, a firm is required to recognize and impairment loss. This is an aspect of the prudence concept. There is therefore little justification and a large inconsistency if firms are not allowed to recognize asset (revaluation) gains based on the fair value concept.
The relevance of historical cost information amidst fair value accounting
Historical costs still remain relevant amidst the drive towards fair value accounting. One reason for this is that assets have to be initially reported or recognized at historical cost as this presents the best estimate of the assets fair value at the date of inception.
The role of fair value accounting in the global financial crises (2007-2009)
As noted above fair value accounting has been 'under fire' since the start of the global financial crisis. Boyer (2000) contends that fair value accounting spurs banking crisis. It does so through several ways; 'it gives banks an incentive to hedge, securitize or shift risk to less informed actors, it places an emphasis on short term results as opposed to long term customer relationships, it reduces the ability for banks to reduce inter-temporal shocks, it increases the pressure for banks to distribute unrealized gains from assets, it increases the cyclical pattern of bank lending thus reducing lending to SMEs and it reduces comparability amongst banks' (P. 792). These are characteristics that both started the crisis (securitization) and alleviated the crises (reduction of lending). Magnan (2009) reviewed different bank failures including Credit Suisse and Lehman Brothers and from his evidence, came to the conclusion that fair value accounting did not only accelerate and exacerbated the crisis but was also one of the main underlying causes. In his earlier study with Cormier, Magnan asserted that fair value accounting is a trend advocating the move from accounting to 'forecounting' which he defined as 'estimating expected future cash flows and incorporating into financial statements' (Magnan and Comier, 2005, p. 250). He noted that the global financial crisis can be attributed to such 'forecounting' (Magnan, 2009).
Analysis of the recent developments of fair value accounting by the IASB
Deloite (2010) traces the development of fair value accounting. It asserts that IAS 39 was enacted and effective from 1 January 2001; It was revised to reflect macro hedging in Match 2004; Other amendments were made to incorporate a fair value option, financial guarantee contract, and cash flow hedges; These amendments came into effect in January 2006.
Currently there is a new revision program in place amidst all the controversy arising from the recent financial crisis. The IASB has published a new exposure draft (ED/2009/5) as of May 2009 titled fair value measurement. The IASB in the opening statement notes that fair value accounting has been in development since when its predecessors were in charge of standard development. They also contend that to date there has been no clear guidance is incomplete and neither provides a 'clear measurement objective nor and robust measurement framework' (ED/2009/5, p. 5). One notable development is the new draft is the new definition of fair value; 'the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction [2] between market participants at the measurement date (an exit price)' (P. 5). The board goes on to state 'In the absence of an actual transaction at the measurement date, a fair value measurement assumes a hypothetical transaction in the most advantageous market [3] for the asset or liability' (p.5).
The draft is essentially geared at providing guidance towards measurement with the hope of improving comparability between companies and reducing the chances of earnings management. The statements underlined can be seen as reactive adjustments arising for the recent financial crisis. According to the current rules, massive write downs were warranted and this is argued to have exacerbated the global financial crisis. By imposing restrictions of 'orderly transaction' and 'most advantageous market' (defined in the footnotes), the IASB effectively mitigates the problems introduced by fair value accounting in a declining market. However, I argue that this position does not conform with the principle of prudence as it allows firms to present the 'most optimistic' picture of their state of affairs.
Conclusion
In principle, fair value accounting provides a more useful system of financial reporting. The major problem however seems to be on the reliability of management self reported valuations. Historical cost accounting is advantageous in this aspect as it relies solely on hard evidence and not on managerial 'estimates'. Several valuation techniques mean that effective comparability across firms, under a fair value accounting perspective, becomes difficult and hindered. Further developments in this area should therefore consider the development of reliable valuation methods to be used across all firms. The use of fair value accounting does not invalidate the usefulness of historical cost measurements. At the recognition stage, the cost of an asset represents its fair value. Historical cost will always serve as a guidance of the assets value and I will advocate that the historical cost of each asset should still be reported in the notes to the accounts. Fair value accounting has also been criticized as playing a role in the global financial crisis and empirical evidence discussed in this project finds that such criticism is not unfounded. While the IASB has continued to develop and improve guidance on fair value accounting, I find that such guidance is reactive (to the financial crises) and is extensively imprudent.
