i) Fair Value and Historical Cost Accounting
Historical cost accounting is an accounting method by which assets are valued based on the actual amount of money with which they are bought and as such no inflation adjustments applied. (Eipstein and Jermacowicz, 2007). Fair value accounting on its part deals with the fair market value of the asset. A number of definitions for fair value are provided by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). According to the FASB cited in Barlev and Haddad (2003)
“Fair value is the price for which a property could be sold in an arm’s length transaction between unrelated parties”. FAS 13 Accounting for Leases.
According to Rayman (2007: 213) citing FASB (2006, par. 5)
“fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”.
A similar definition is provided by the IASB in IAS 39 Financial Instruments, Recognition and Measurement:
“fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction”. (IAS 39. par. 9) (Bertoni and De Rosa, 2005; Epstein and Jermacowicz, 2007).
According to the IASB fair value can be defined as:
“the amount at which an asset could be exchange or a liability settled between knowledgeable willing parties at an arms length transaction”
The fair value concept is used in many accounting standards such as the IFRS covering certain areas like acquisitions and valuation of securities. A fair value is used in situations where the actual cost of an asset is not obtainable. Assets will need to be revalued from time to time for instance when the market value for securities change or when their purchase price is inseparable from larger transactions (as in the case with acquisitions). (Eipstein and Jermacowicz, 2007). The fair value can be determined by the following methods, in IFRS order of preference as such: If there are identical transactions in the market, assets and liabilities should be valued with reference to such transactions i.e. If identical transactions do not exist, but similar transactions exist, fair value should be estimated making the necessary adjustments and using market based assumptions If either of the above methods cannot be used, other valuation methods may be used. (Eipstein and Jermacowicz, 2007). Fair value often has a subjective element as so many valuations are likely to use the latter two methods.
ii) The Ideal Approach
The most suitable approach to valuing assets and liabilities is the fair value approach. According to Barlev and Haddad ( 2003) the IASB and FASB consider HCA-based financial statements as obscuring the real financial position and the results of operations of a firm thereby providing ample room for manipulation. Historical cost accounting book values of assets and liabilities provide managers some loopholes to conduct earnings management thus concealing their real activities. (Barlev and Haddad, 2003). On the contrary, fair value accounting on the other hand measures and records current values of assets and liabilities in the balance sheet therefore making the book value to be approximately equal to the market value. The fair value approach therefore increases the value relevance of the balance sheet. (Barlev and Haddad, 2003).The basic premise underlying the FASB’ s decision is that fair value of financial assets and liabilities better enables investors, creditors and other users of financial statements to assess the consequences of an entity’s investment and financing strategies. (Khurana and Kim, 2003).
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Carroll et al. (2002) investigate the value relevance of fair value accounting relative to the historical cost accounting for financial instruments held by closed-end mutual funds. The findings suggest that there is a significant relationship between stock prices and the value of investment securities as well as between stock returns and fair value securities’ gains and losses. (Carroll et al., 2002).
Despite the IASB and FASBs’ interests in the fair value approach, there are some inherent problems with the approach. The main problem with the fair value approach is determining the fair market value of assets that do not trade in active markets. According to Carpenter et al. (2008), this issue has been a subject of debate in the accounting profession. Accounting standard setters (the IASB and the FASB) recommend two solutions to this problem: (i) consult outside experts, for example, in the valuation of real estate, the services of a real estate expert should be sought; (ii) practitioners’ associations should develop valuation models. (Carpenter et al., 2008). However, despite these adjustments, Carpenter et al. (2008) suggest that there are still doubts as to whether skilled experts provide accurate and homogenous valuations. Analysing the consistency and quality of valuations provided by a sample of 43 business valuation experts who were asked to value a small high tech firm preparing for an IPO, Carpenter et al. (2008) provide evidence that skilled experts employ different methods and multiples even when they rely on the same guidelines. Moreover, there are significant variations in the fair market values for the same investment. (Carpenter et al., 2008). The evidence also suggest an upward bias in the fair market value of the high tech firm as compared to the actual value following the IPO. (Carpenter et al., 2008).
iii. Implications for Future Accounting Standards
The implications for future accounting standards is that the IASB and the FASB should develop more appropriate methods of determining fair value, especially for assets and liabilities for which there is not active market. By so doing the value relevance of the balance sheet will increase.
Barlev B., Haddad, J. R. (2003). Fair value accounting and the Management of the firm. Critical Perspectives on Accounting, vol.14, 383–415.
Benston, G. J. (2006). Fair Value Accounting: A Cautionary Tale from Enron. Journal of Accounting and Public Policy, vol. 25, pp. 465-484.
Carroll, T. J., Linsmeier, T. J., Petroni, K. R. (2002). The Reliability of Fair Value vs. Historical Cost Information: Evidence from Closed-End Mutual Funds. Journal of Accounting, Auditing, & Finance.
Carpentier, Cecile, Labelle, Réal, Laurent, Bruno and Suret, Jean-Marc (2008). Does Fair Value Measurement Provide Satisfactory Evidence for Audit? The Case of High Tech ValuationAvailable at SSRN: http://ssrn.com/abstract=1269743
Epstein, B. J., Jermakowicz E. K. (2007). Interpretation and Application of International Financial Reporting Standards. Wiley and Sons Inc.
Khurana, I K., Kim M. (2003). Relative value relevance of historical cost vs. fair value: Evidence from bank holding companies. Journal of Accounting and Public Policy, vol. 22, pp. 19–42.
Rayman, R. A. (2007). Fair value accounting and the present value fallacy: The need for an alternative conceptual framework. The British Accounting Review, vol. 39 211–225