Historical Cost Versus Fair Value Accounting for Non-financial Assets - Essay Example

Historical Cost versus Fair Value Accounting For Non-Financial Assets Name Institution Course Professor Date In most cases, companies are currently using historical cost accounting as a measurement basis. However, a combination of the technique with other measurement bases is always a norm. Companies are free to choose between historical cost and fair value accounting. Christensen and Nikolaev (2013, p. 735) assert that the choice between historical and fair value accounting is among the issues that have been widely debated in the accounting literature. Under International Financial Reporting Standards (IFRS) framework, historical cost and fair value accounting can be selected freely for the groups of non-financial assets and intangibles including Property, Plant and Equipment (PPE). As a result, there are variations in valuation practices for PPE and intangibles. The concepts or principles to be used in the selection of a measurement basis for certain elements in the financial statements or in certain circumstances are not included in the IFRS Framework. The guidance, however, is provided by standards and interpretations of the individual companies. This essay evaluates the historical cost and fair value accounting for non-financial assets. The valuation practices of the three companies each listed on Dhaka Stock Exchange, New York Stock Exchange, and Australian Stock Exchange are identified and analyzed. Property, plant and equipment (PPE) are alternatively called fixed assets contribute significantly to the firm’s assets. Included in this category are long-lived assets that are needed by a company in conducting its business. For example, land, buildings, equipment, vehicles, and factories are needed for smooth operations in a firm. For a majority of the companies, PPE comprises a large part of its total assets. PPE are tangible and long-lived assets that a firm used in its normal business operations (Wahlen, Jones & Pagach 2015, p. 10-3). After a company had acquired PPE assets, it initially recorded them at historical cost. The asset is expected to offer economic benefits to the firm in a period greater than one year hence its cost is allocated as an expense by a firm in every period that it used and the benefits received by a company. Historical cost is the price at which an asset was exchanged for at the time it was acquired. It is a measurement of the asset cost that was either paid in cash or the estimated cash equivalent in case it was a non-cash transaction. The primary method used by companies in reporting the value of non-financial assets in its financial statements is the historical cost. Generally, after an asset is acquired by the company, it is reported in the financial statements at its historical cost (the price that has been exchanged for it) until another exchange is carried out. The company measures and reports assets such as PPE at their historical cost and are then adjusted for depreciation. It is often justified for a company to use historical cost as a basis for reporting PPE because of the benefits it provides. The historical cost and fair value is the same at the date that an asset is acquired (Wahlen, Jones & Pagach 2015, p. 10-3). The amount that a company pays on the day it acquires the asset is its fair value. The gains and losses that a company generates from holding an asset are recognized only when it is realized after a sale transaction is concluded (Nikolai, Bazley & Jones 2009, p. 470). In the financial statements, gains and losses are not shown until the asset is sold. The company does not recognize any profits or losses it has generated by just being in possession of an asset but profits or losses are transferred to the financial statements after the asset is sold. Historical cost is favored in valuing nonfinancial assets because it provides reliable information (Nikolai, Bazley & Jones 2009, p. 470). Historical cost, however, has been criticized by some users of the company’s financial statements when it is used for reporting PPE in the financial statements. It has been criticized for lack of relevance (Wahlen, Jones & Pagach 2015, p. 10-3). It is often pointed out that historical cost does not necessarily represents the company’s future cash outflows or inflows that it is likely to generate after the sale of an asset. For example, many users of financial statements are questioning the rationality for the continued use of historical cost to report land which was purchased several years ago and its current market value is more than its historical cost. By using similar reasoning, the asset net book value is not necessarily a reflection of its economic value since depreciation is a process of allocating cost and not valuation. Unlike stocks and bonds that always have prices that can be observed in the capital market, PPE is not often traded and are generally lacking market prices that can be observed and verified directly. Hence, generally accepted accounting principles (GAAP) require companies to report their PPE at depreciated cost. Nevertheless, under the United States GAAP and IFRS, when impairment of an asset occurs resulting in its book value being more than its fair value, a company is required to write down the asset to its fair value. As a result of the limitations that historical cost has and benefits of fair value accounting, sometimes FASB require companies to report PPE at their fair value. Fair value accounting is widely used for reporting PPE in the financial statements and has completely changed how companies present financial information. Under certain circumstances, the current fair value of an asset is often used as a basis of measurement for reporting PPE in the financial statements where it was previously based on historical costs. Judgment is sometimes required in measuring fair value as it introduces some level of subjectivity in the financial statements (Graham & Carmichael 2012, p. 24-3). In United States, under GAAP and IFRS, the trend towards increasing the amount of information that a company discloses in its financial statements at fair value still persists. Fair value accounting is an approach used in financial reporting requiring or permitting firms to measure and report assets at its selling price (Graham & Carmichael 2012, p. 24-3). This method depends on the principle that a firm should report an asset that it possesses at an amount that reflect the worthiness of the asset and not what it had paid for it. Indeed, fair value is the price received by a company in case it sells the asset. Fair value accounting has become a popular method for reporting PPE because of its benefits. For some time, arguments for and against fair value accounting have been going on in the field of accounting. It has been argued that fair value accounting offer a more up to date picture of the company’s financial situation than historical cost accounting (Zack 2009). This method provides investors and other users of financial statements with information that are of significant value. Proponents of fair value accounting stress that things should be told ‘as they are’ (Power 2010, p. 199) by companies. In this case, transparency is improved in the financial reports prepared by firms. Advocates of this method point out that fair value were capable of identifying problems that were facing North American loans and savings industry much earlier. In addition, fair value accounting provides meaningful aggregation of the companies accounting data (Strouhal 2015, p. 560). It also provides a consistent measurement basis. However, critics of fair value accounting argue that fair values cannot be relied upon because estimating them is very difficult. Moreover, they also believe that the temporary losses reported are misleading as they are likely to reverse (Graham & Carmichael 2012, p. 24-3). Currently, fair value accounting is a prominent method used in the presentation of financial statements despite criticisms. Companies have a choice to use either fair value or historical cost accounting when they are presenting PPE in their financial statements. It is a regulatory requirement for companies to disclose which of these two methods they used in their annual reports after IFRS was adopted. IAS 16 and IAS 40 require companies to revalue their assets each time that there is a difference between their book value and market value when fair value is used. IFRS 13 fair value provides various measurement concepts in relation to fair value accounting. In general, IFRS 13 define fair value; it is set in a single IFRS framework for measurement of fair value, and it requires companies to disclose fair value measurements (IFRS 2013). In the measurement of fair value, a firm assumes that market participants will be using the present market conditions when assets or liabilities are being priced. IFRS stipulate an entity to determine the particular asset to be measured when they are carrying out the fair value measurement. It should also identify appropriate valuation technique(s) to be used in measuring fair value. Moreover, the market in which the transaction is to be carried out for the asset needs to be determined (IFRS 2013). The intention of fair value measurements in the IFRS 13 is to improve consistency when fair value calculations are applied (Burton & Jermakowicz 2015, p. 50). Furthermore, it is designed enhance how fair value information can be compared by the users of financial statements. In IFRS 13, hierarchy used in the determination of fair value is provided. This hierarchy is supposed to increase consistency as well as comparability when measuring fair value and the related disclosures. The fair value hierarchy is categorized into three levels that would assist entities in measuring fair value. Quoted prices (those that have not been adjusted) in the active markets are given the highest priority hence are put on level 1 inputs. In contrast, unobservable inputs for either an asset or liability have the lowest priority and are put on level 3 inputs. Under IFRS 13, the valuation techniques that are used in fair value measurements of assets or liabilities belong to market, income or cost approach (Burton & Jermakowicz 2015, p. 54). Nonetheless, not all assets and liabilities will all the approaches be applicable. Above all, significant judgments are required when companies are undertaking measurement of fair values. Companies that are listed on a stock exchange are required to provide annual reports of their operations in accordance with the relevant regulations and standards. International Accounting Standards (IAS) requires entities to disclose the measurement basis that they used in the preparation of their financial statements. They are also required to provide significant accounting policies that they used in preparing the statements and are relevant for the understanding of financial statements by the users. Specifically, companies should disclose policies that they have selected from the various alternatives allowed by the standards and interpretations. In relation to PPE, they should disclose how they measure these groups of assets, that is, whether they use historical cost or fair value accounting. In general, accounting policies that would assist users of financial statements to understand how transactions and events reflect the financial performance and position of the company should be disclosed. In order to understand how listed companies undertake valuation practices in relation to historical cost and fair value accounting for PPE and intangibles, the ‘accounting policy’ sections in the 2014 annual reports of the three companies listed on Dhaka Stock Exchange, New Stock Exchange and Australian Securities Exchange are analyzed. The companies selected are Bangladesh Lamps Limited (BLL), Hewlett-Packard (HP) Company and Newcrest Mining Limited (NML). Bangladesh Lamps Limited is a Bangladesh company that is listed on Dhaka Stock Exchange. It manufactures electric bulbs and was incorporated in 1960 (Bangladesh Lamps Limited (BLL) 2014). Hewlett-Packard is an information technology company that is listed on NYSE. It was founded in 1939 by Hewlett and Packard (Hewlett-Packard (HP) 2014). Newcrest Mining Limited is an Australian based mining company that is listed on Australian Securities Exchange. It was established in 1966 and is currently among the largest companies carrying out gold mining in the world (Newcrest Mining Limited 2014). All the three companies provided their valuation practices in their 2014 annual reports. Bangladesh Lamps Limited sells electric bulbs in Bangladesh. In preparation of its 2014 financial statements, the company undertook this function according to the Bangladesh Financial Reporting Standards (BFRS). The 1987 Securities and Exchange Rules and 1994 Companies Act together with other applicable regulations were used (BLL 2014, p. 33). The basis of measurement in the preparation of the BLL 2014 financial statements is the historical cost convention. The only exception is when investment available for sale use fair value is used to measure it. BLL measured PPE at cost. In other words, it is valued by taking into consideration presence of accumulated depreciation and impairment losses. The costs included, in this case, pertains those of expenditures that can be directly attributed to the acquisition of PPE. Moreover, the costs that brought the assets to the location and condition that are necessary for their optimal functionality in the manner intended by management are factored in. The carrying amount represents the cost that was used in replacing part of PPE. In depreciating PPE, BBL used straight-line method and it is charged from the day they were acquired. After assets are retired, elimination of costs and accumulated depreciation from accounts is done. The measurement for intangible assets is done at cost and if there are any accumulated amortization and impairment loss, they are considered. HP is required to prepare its financial statements, according to the United States GAAP. The company measure PPE at cost and any accumulated depreciation is subtracted. Repairs, maintenance expenses, additions and improvements that have been incurred are capitalized. The method for depreciating assets is straight-line and their useful lives range from five to forty years for buildings and 3-15 years for machinery and equipment (HP 2014, p. 96). Intangible assets having finite lives are amortized by using straight-line method over their lives that range from one year to ten years. Intangible assets were estimated at fair value and they were largely unobservable. In this case, measurements for these assets were accordingly classified under level 3 of the fair value hierarchy. Newcrest mining limited trade their shares on ASX. It is required to prepare their annual financial statements according to the rules provided by ASX and other relevant laws and regulations. Its 2014 financial report was prepared using historical cost accounting except assets that are available for sale and derivative instruments that were measured at fair value. PPE is measured at cost and any accumulated depreciation and impairment costs are subtracted. The straight-line method is used in depreciating PPE over their estimated lives which range from 3 to 20 years. Depreciation is done from the day assets were installed and ready for use by the company. The valuation practices for PPE and intangibles are consistent across all the companies. Bangladesh Lamps Limited, Hewlett-Packard Company, and Newcrest Mining Limited all used historical cost accounting in the measurement of their assets. In all the companies, PPE is measured at cost and any accumulated depreciation and amortization are subtracted. Furthermore, they all use straight-line as a method of depreciation over their estimated lives. However, the estimated lives used for purposes of depreciation are slightly different. At HP, it ranges from 3 to 15 years for machinery and equipment while it ranges from 3 to 20 years at NML. Despite this slight difference, valuation practices across the three companies are generally consistent. The free choice between historical cost and fair value accounting for PPE and intangibles is a good move in my opinion. This is because companies are able to choose the method that best suits their circumstances and operations. They can also use the two methods together hence enjoy the advantages they both provide. Such a free choice should be continued because there are some classes of assets that cannot be measured significantly by fair value accounting and historical cost must be used especially non-financial assets. Moreover, both methods can complement each other hence providing a clearer and true picture of the entity’s financial situation. References Bangladesh Lamps Limited 2014, Annual Report 2014, retrieved 20 May 2015, > http://www.bll.com.bd/?wpfb_dl=38 Burton, F. G & Jermakowicz, E. K 2015, ‘International financial reporting standards: A framework-based perspective’, Routledge, New York. Christensen, H. B., & Nikolaev, V. V 2013, ‘Does fair value accounting for non-financial assets pass the market test?, Review of Accounting Studies, vol. 18, no. 3, pp. 734-775. Graham, L & Carmichael, D. R 2012, Accountants' Handbook, Special Industries and Special Topics 12th edn, John Wiley & Sons, Hoboken, N.J. Hewlett-Packard Company 2014, 2014 Annual Report, retrieved 20 May 2015, > http://h30261.www3.hp.com/~/media/Files/H/HP-IR/documents/reports/2015/hpq-annual-report-2014.pdf< International Financial Reporting Standards (IFRS) 2013, IFRS 13 Fair Value Measurement, retrieved 19 May 2015, > http://www.ifrs.org/IFRSs/IFRS-technical-summaries/Documents/English%20Web%20Summaries%202013/IFRS%2013.pdf< Newcrest Mining Limited 2014, Annual Report 2014, retrieved on 20 May 2015, > http://www.newcrest.com.au/media/annual_reports/FINAL_Annual_Report_2014_72dpi_web.pdf Nikolai, L. A, Bazley, J. D & Jones, J. P 2009, Intermediate Accounting, 11th edn, Cengage Learning, Mason, OH. Power, M 2010, ‘Fair value accounting, financial economics and the transformation of reliability’, Accounting and Business Research, vol. 40, no. 03, pp. 197-210. Strouhal, J 2015, ‘Historical Costs or Fair Value in Accounting: Impact on Selected Financial Ratios’, Journal of Economics, Business and Management, vol. 3, no. 05, pp. 560-564. Wahlen, J. M, Jones, J. P & Pagach, D. P 2015, Intermediate accounting: Reporting and analysis, 2nd edn, Cengage Learning, Mason, OH. Zack, G. M 2009, Fair value accounting fraud: New global risks and detection techniques, John Wiley & Sons, Hoboken, N.J. Read More