Fair Value v. Historical Cost

Financial statements are the end-products of the accounting process which serve the financial information needs of various interested parties. The financial statement should be a faithful representation of the economic activities of the business.

While a full description of the actual economic activity of the organization is not possible, the financial statement should contain as full and as faithful a representation as feasible. The report should be accurate and timely, consistent with preceding statements and containing the adequate amount of disclosure.

The degree to which the financial statements accurately present the economic status of the company depends to a large extent upon the assumptions and procedures inherent in the accounting process (Kimwell, 2005, p.50).

The balance sheet gives one input that is helpful information in determining the degree of financial risk. The most important thing to remember in preparing financial reports for management use is that a report prepared in accordance with generally accepted accounting principles may not be useful for decision-making. This means that the conventional balance sheet may have to be adjusted before it can be helpful to management.

The balance sheet is important to the extent that it provides a comprehensive overview of the financial position of the business. This attempt at comprehensiveness also accounts for the principal limitations. Despite the usefulness of the information furnished by the balance sheet, there are limitations and criticisms leveled against the statement.

The balance sheet reflects only those activities that can be reduced to monetary terms. Many items which are of financial value to the company are not shown in the balance sheet. For instance, such items as market position, superior products, capable personnel, favorable location, high credit standing, are not quantified in the balance sheet. Estimates enter into the preparation of the balance sheet. The estimates are significantly pronounced in the matter of reporting receivables, plant and equipment, inventories and intangibles and certain liabilities.

The balance sheet does not show the current value of the company assets and of the company itself. The assets are generally shown at cost, and very often, there is a significant difference or variation between historical cost and current market values. Thus, the net worth of the company is not also measured accurately. It may be overstated or understated because assets are not in conformity with current values.

In view of these limitations, proponents of fair value accounting consider that the most relevant appraisal for financial reporting is fair value. However, others argue that since fair value is based on estimates, it may not be reliable and confirmable, thus historical cost is more valuable in measuring the economic status of the business.

Further, it is contended that a dynamic and sheer market is not available for numerous assets and liabilities. Thus, gauging fair value will be subjective thus; appraisal will also be less dependable. When market prices are not available, reliability of financial reports will remain to be an issue whenever management will use fraught judgment in choosing market data (“Fair”n.d.).

The major concern now is management bias that it possibly exists. Management preconception has the effect of unreliable financial information and measurement of fair value estimates. Earnings management happens even under the historical cost accounting measurement. Thus, without a reliable basis for fair value estimates, the possibility of misstatements of accounting data will even be more expectant.

In recent years, there were cases of over valuation of some assets when there were no active market prices and substantial reduction in the book values of these over valued assets resulted in failure of some financial institutions and businesses (Bies, 2004, p. 27)

It is difficult to verify estimates based on management judgment. Significant effort has to be exerted by financial users including auditors in comprehending on how the accounting information was measured. The reliability of these data is also a problem when making decisions based on this valuation. Fair values contemplate estimates and there result in non transparency of financial information.

Financial statements must be transparent. To serve the purpose of fair value estimates, as it is now increasingly suggested by users of financial information as a basis of measurement, additional disclosures are necessary.

SFAS No. 107 (FASB 1991) requires entities to disclose fair value estimates for many of their financial instruments (e.g., loans, securities, derivatives, receivables, payables).

SFAS No. 119 (FASB 1994) amended SFAS No. 107 to require that the fair value estimates be presented together with the related book values and without combining the fair value of derivative financial instruments with the fair value of non derivative financial instruments (Nissim, 2003, p.356).

With these accounting standards, users of financial reports can now compare the fair value estimates with the accompanying book value, thus serving the purpose to make the information more reliable and relevant.

Relevancy and reliability is the debatable issue in fair value over historical cost accounting. Fair value advocates strongly argue to move to fair value accounting because financial statements generated by historical cost do not provide investors with relevant information they need.

“The fact that the market value of publicly traded firms on the New York Stock Exchange is five times their asset values serves to highlight this deficiency” (Shortridge, Schroeder,& Wagoner, 2006, n.p.). According to proponents of fair value accounting, historical cost financial reports are not relevant as current values are not presented.

Even if the information is less reliable, they contended that fair value measurement is still appropriate as they are relevant to decision-making. Fair value accounting generates information that are more representative of the company’s worth.

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