Fair Value vs. Historical Cost - Research Paper Example

 Fair Value vs. Historical Cost Introduction ‘Fair value’ is a valuation model that moves with economic and other changes in the business world. . On the other hand ‘historical cost’ model represents a settled issue. The cost once incurred for an asset or agreed upon for a liability cannot be changed under historical cost concept. “Valuation at historical cost implies that assets are carried at the cost of acquisition or manufacture, net of depreciation and any diminution in value, extraordinary or otherwise.”(H Beckman, page 39)i Though IFRS 2 has defined the term ‘fair value’ as “the amount for which an asset could be exchanged, a liability settled, or an equity instrument could be exchanged, between knowledgeable, willing parties in an arm’s length transaction” but even this definition is not conclusive. This is so because fair value of an asset or a liability can only be true for a point of time. Fair value gets changed even in next moment when the circumstances surrounding the asset or liability change. IAS 40 permits a choice between fair value and the actual cost after the initial recognition of assets but this option has a number of implications particularly when fair valuation is opted out. With this background the two valuation concepts are discussed in detail in this paper especially the impact they make on the analysis of performances of different entities. Literature Review Fair value disclosures in some cases become necessary in order to highlight the limitations involved in the cost model. “Under the fair value model, the investment property is valued at fair value, with changes in fair value recognized in profit and loss. The cost model follows the guidelines established in IAS 16 for measurement subsequent to initial recognition. If the cost model is used, the fair value of investment property needs to be disclosed, if it cannot be determined reliably, which is a rebuttable presumption pursuant to paragraph 53 of IAS 40. Accordingly companies that hold investment properties are generally required to determine fair value of these properties, regardless of accounting policy adopted.”(Maria K. Davis, page 63)ii There is a feeling that fair value model is a subjective issue. This makes the presumption of knowledgeable and willing parties as envisaged in IAS 40 a complete farce when any party can be manipulative enough to change the fair valuation. That is why “fair value determinations should not be the effects of internal synergies between the property and other assets, tax benefits, or other factors unique to the owner. Nor should it factor in any elements of the owner’s financing arrangements or other factors that would not have bearing on what knowledgeable and willing buyers and sellers would consider in negotiating a value.” (Gerard M. Jack, page 114)iii Fair valuation of assets or liabilities makes serious impact on profit and loss of the entity. The changes in fair valuation from one period to the other are required to be included in the profit and loss. Therefore, during inflationary period profits unduly impact earnings per share resulting into high market valuation of such shares that has no relevance to the operative performances of the entity. The reverse happens during deflationary period and this may bring any economy to a breakdown point as was reflected in the recent recession that occurred world over. Fair valuation fluctuations impacted assets and liabilities heavily and in fact added fuel to the already worsening situations. The economic collapse was so severe that certain economies are still finding difficult to come out of worst recessionary effects. Data Analysis Silic was using historical cost model in order to protect itself from unpredictable downward or upward movements in the valuation of properties. Silic did not opt for fair valuation offered by IAS 40 but made appropriate required accounting disclosures. Investors found it difficult to compare the valuation reflected by Silic with other companies in the industry that opted fair valuation. But on following the recommendation of accounting body Silic opted for fair valuation in 2003. With the result the valuation in 2003 increased by 70% when compared to 2002 and naturally impacted profit and loss and market valuation of shares. On adopting fair valuation Silic faced cultural, sectarian, and strategic dilemmas. The valuations were too high in 2005 and 2006 as compared to earlier years. The operative income of Silic represented a marginal increase whereas valuation impact was dramatic. Silic was afraid of impact of valuation when fair values would be coming down. This happened finally and such dramatic fluctuations in valuation gave negative impacts which were not there when Silic was adopting historical cost valuation. Same thing happened with other entities and in some cases companies collapsed because of the fluctuations in fair valuation of assets and liabilities. On the other hand Land Securities Group opted for fair valuation as per IAS 40. With the result revenues from operations were mingled with capital appreciations due to valuation fluctuations. In 2005 net profits increased from £774 million under UK GAAP to whooping £1450 million under IFRS basically because of increase of £800 million in fair valuations of properties. But the management was prudent to introduce adjusted EPS devoid of capital appreciation impact. Whatever might have been the intension of the management it is clear that fair valuation not only reflect the market touch but can be presented to bring a true and fair picture as was reflected by Land Security Group. Conclusion The choice between fair valuation and historical valuation is a complex issue, but has to be considered in right perspective as was appreciated by the management of Land Security Group. Fair valuation model keeps the presentation of financial statements near and true to reality. Whereas, the historical cost model is like dreaming in the past. That is why FAS 157 emphasizes that fair valuation model is “a market based measurement, and not an entity specific measurement. The valuation techniques used for measuring the fair value of assets or liability has not changed, but in the FAS 157 frameworks are applied from market participant’s perspective rather than from reporting entities perspective.”(Malvern J. Gross, page 173)iv It must also be noted that fair valuation is not always responsible for negative impacts leading to recessions and deflationary trends. In fact continuous use of fair value model brings out the reality to the fore. On the other hand historical valuation model is not impacted by changes in the business and economic world and thus remains an insensitive financial tool devoid of real business happenings. The Silic Company did the right thing by changing to fair value on suggestions of standard making body after initially opting for historical cost valuation model. Word Count: 1184 References: Read More