Fair Value Accounting Vs Historical Cost Accounting: A Detailed Analysis

Fair Value Accounting

Discuss about the Fair Value Accounting For Financial Instruments.

Fair value accounting and historical cost accounting are two of the most widely used accounting procedures for valuing the assets and liabilities of the business ventures. Both these methods of valuing assets and liabilities of different organisations have been used for a very long time. One method focuses on employing the current market prices during the procedure evaluating In this project report two different cost accounting procedures have been discussed in detail which are Fair value accounting and Historical cost accounting technique. The prevalence of these two procedures in the current scenario, their usage have also been looked into in details. The meaning, nature, characteristics, importance and the primary differences between the two accounting methods have been explained. The relevance of fair value has been looked into from the perspective of the annual report of Wesfarmers Ltd, which is a leading Australian Conglomerate dealing in retail, fertilizers, chemicals, coal mining and industrial and safety products, has been done. The preferences of Wesfarmers in terms of choosing valuation methods out of historical and fair value.

Fair value refers to the actual cost of an asset or liability in accordance with their current financial market value prevalent in the market. In Fair value accounting, the current market value is used as the benchmark for identifying and recognizing various assets and liabilities (Blankespoor, et al., 2013). The fair value is actually the estimated price at which an asset can be sold or a liability can be settled in a proper transaction with a third party under current market conditions. Fair value accounting procedure is a major improvement over the primitive traditional cost accounting which is known as the historical cost accounting.  Under the old costing system, the original purchase cost of the concerned asset or liability is considered as the true indicator of its worth, consequently it ignores the current market value of the assets or liabilities. Whereas, under the fair value system, the current market value is considered while calculating the present costs of the assets. The theory of fair value is derived from the following conditions and theories:

Present conditions: The extraction of fair value is based on the current market conditions as on the date in which measurement will be done, and not on the initial transaction which had occurred at an earlier date. 

Intention: The intention of the holder of an asset or liability to continue to hold it is completely irrelevant to the concept of fair value. Otherwise such intent may change the actual measurement of fair value of the concerned asset or liability.

Historical Cost Accounting

Orderly and a proper transaction: Fair value can only be derived on the basis of a proper and an orderly transaction. An orderly transaction is that kind of a trade where there is no inordinate pressure to sell, as is be case in corporate liquidation (Magnan, Menini & Parbonetti, 2015).

An outside party: the estimation of fair value is based on the presumption of sale to an organisation which is actually a third party or is remotely associated with the dealer (Hodder, Hopkins & Schipper, 2014). Otherwise, a known and related-party transaction might change or alter the price paid.

Accurate valuation: The main merit of using fair value accounting is that it provides a precise and error free valuation of assets and liabilities continuously over a period of time. When the price of any asset is expected to increase, the company increases the value of the concerned asset and whenever, the company sees the value of an asset is poised to decrease due to the current market trends, it may mark down the value of the asset.

True income: The most important advantage of using the fair value accounting technique is that it stops the company from manipulating its financial statements. Sometimes a company may intentionally manipulate the valuation of its assets and liabilities to create a favourable position (Costa, 2013). While using fair value technique, timely changes occurring to any asset or liability is reported in no time as a result of which a fair income is stated in the financial statements.

Benefit to investors: Fair value accounting provides benefits to the investors as well. It is because; fair value technique shows assets and liabilities in their actual value, thus letting financial statements reflect a clearer picture of the company’s heath. This helps the investors in making prudent decisions about their investment alternatives within the company.

Historical Cost Accounting (HCA), is also known as conventional accounting. It is a traditional method of accounting. In this method, the transactions which are recorded in both the balance sheet and the profit and loss statement in their original costs as on the date of purchase. According to the historical cost principle, accounting records are to be maintained at their original transaction prices and these values must be retained throughout the accounting procedures to serve as the base for values in the financial statements. The historical cost principle is primarily based on the realisation principle which requires the recognition of revenue when it has been realised. The principle has major implications which affects the financial statements. It is evident in the balance sheet of the company, where the historical costs of the assets are held intact, until and unless they are sold off.

• The accounting data under historical costs are independently verifiable and are generally free from any kind of bias and are highly regarded by the investment fraternity. This is because, these data can be verified at any time with the help of relevant documents.
• There is low scope of the financial data being affected by personal bias and judgements of the people who generally prepare them. These data are based on actual transactions, which decreases the scope of any kind of bias being involved in these transactions.
• Historical cost accounting is legally preferred and is accepted for taxation, dividend declaration and other allied activities. Moreover, this method of valuation is the most cost effective one.

Analysis of Wesfarmers Ltd

The historical cost accounting technique has continued to suffer incessantly because of its failure to take into account the recent trends and changes taking place in the market. This technique neither makes any provision for any changes nor does it acknowledge any trends taking place in the market.

Wesfarmers Limited is an Australian conglomerate company which is based in Perth, Western Australia, with business interests majorly in Australian and New Zealand. The company has extensive operations spread over retail, chemicals and fertilisers sector. It also deals in coal mining along with industrial and safety products. It is the largest Australian Company in terms of revenue as per its 2016 financial report with revenues amounting $65.98 billion. Consequently it has overtaken Woolworths and BHP Billiton (Wesfarmers 2018).  The company is the largest private employer in the island nation of Australia and since its inception in 1914, it has grown into one of the strongest retail conglomerate in Australia.

Wesfarmers primarily is a retail conglomerate and has diverse range of business activities at its disposal. Fair value accounting or historical cost, both of these, have serious implications upon the investment options, choices and management decisions, with serious consequences for the aggregate economic activity (Wesfarmers 2018). The major reasons for the influence of fair value in the internal working of Wesfarmers have been explained below:

• Accurate view of investments: The investments undertaken by Wesfarmers have been accurately evaluated and measured with the help of fair value technique which has provided various stakeholders with accurate valuation and investment options.
• Ease of preparation Remuneration Report: restricted and performance shares have been provided to various employees under 2016KEEPP allocation. All these shares have been estimated in their fair value prices based on current market trends in the annual report of Wesfarmers.
• Ease of financial services: All the leading financial banks, investment banks and asset managers have widely been accustomed to using fair value in their daily business activities (Wesfarmers 2018). These activities include preparation of balance sheets for various risk management activities. This extensive usage of fair value by the leading financial institutions have shaped Wesfarmers preferences for fair value accounting.
• Increased gains: Generally Accepted Accounting Principles (GAAP) profits which have been defined on a fair value basis rather than on historical cost basis catalyses the identification and recognition of gains, specifically during periods of rising prices of assets. Managerial bonuses are usually based on GAAP profit numbers which helps executives to reap richer rewards in the fair value accounting approach.

The application of fair value accounting in the above mentioned activities by Wesfarmers have been explained below:

• Hedging: Hedging8 refers to particular kind of risk management strategy which is mainly used in limiting or reducing probability of loss which might occur because of fluctuations in the prices of currencies, securities and other commodities. It involves mitigating the risk without actually buying any kind of insurance (Chen, 2014). It involves employment of various techniques, most importantly taking opposite and equal positions in two different markets. Wesfarmers uses fair value in order to assess the current values of the various alternatives available for mitigating the risks. The value of the Hedging activities in fair value has been provided below:-

Wesfarmers primary currency exposure is to US dollars and it mainly arises from the sales or purchases by a division in currencies. Its operations are also exposed to US dollars and euros. The fair value of the foreign exchange contracts provides a clearer picture of the risk mitigating processes.

• Valuation of intangible assets: The valuation of the various intangible assets of Wesfarmers is periodically performed. The initial costs of all the intangible assets acquired are initially valued as per their fair value as on the date of acquisition. After initial recognition, intangible assets are taken forward at cost and after deducting amortisation and other impairment losses (Hodder, Hopkins & Schipper, 2014) Wesfarmers ensure that the value of the intangible assets are as per the current market prices at which they could be sold.

• Contingent liabilities: These liabilities are present obligations which generally arise from the past events might become actual liabilities in the future. These liabilities occur only on the happening of any contingent events in the future. The determination of whether any past event has occurred which might impact the occurrence of the contingent liabilities is a matter of judgement. These liabilities are based on a scenario based analysis. Wesfarmers strives to value contingent liabilities in accordance with fair value accounting with careful planning and implementation.

• Valuation of non-current assets: Wesfarmers non-current assets mostly include plants and machinery, deferred tax assets, goodwill, derivatives, investment in associates and various other joint ventures, properties etc. The company maintains all these non-current assets in their current market values. It helps the company to project a better financial position at the end of any given financial year. The figure below showcases the consolidated values of all the current as well as the non-current assets of Wesfarmers for the years 2016 and 2017. These figures have been valued using the fair value accounting techniques.

Wesfarmers are inclined towards fair value accounting techniques rather than historical accounting techniques. One of the biggest reasons which compels Wesfarmers to avoid historical accounting is the fact that it fails to take into account the recent changes in the value of the assets and the liabilities as per the new market trends and changes.

• There is no denying the fact that fair value accounting approach reflects current and updated information regarding the valuation of assets and liabilities on the balance sheet of any company (Christensen & Nikolaev, 2013) Whereas, information derived from historical cost accounting can be outdated.
• Usage of fair value accounting presents true income of each and every assets and liabilities of the company (Smith & Smith, 2014). For example, if the retail section of Australia is facing a crisis, the effect of it would consequently be reflected in the prices of the assets of Wesfarmers. The prices of the various assets would increase.
• Fair value accounting technique is accepted internationally and is used extensively across the accounting bodies all over the globe.
• In case of an economic downfall and crisis, the company which follows fair value approach would automatically make provisions for updating various assets and liabilities in accordance with the crisis trends presently ensuing in the economy.
• This procedure is helpful more easy comparability. It also assists in ensuring better equity analysis by providing the timely changes occurring in the equity market by regularly taking into account the various changes taking place in the markets.

Conclusion:

Fair value accounting and historical cost accounting are two of most widely used valuation approaches by companies all over the world. Gradually, the companies have shifted their approach towards fair value accounting avoiding historical accounting. The major argument which have compelled retail giants like Wesfarmers to adopt the former as an accounting procedure is recent trends and changes which are duly taken into account by fair value accounting technique. Historical cost accounting has been regarded as the traditional and a more conservative approach towards valuation. Outdated figures, incomparability and overstatement of figures have led to the demise of historical accounting as a viable approach of valuation. In the concerned report, the example of Wesfarmers Ltd has been taken to showcase its, bias towards the fair value accounting system. The company has a deep regard for the modern accounting approach such as the fair value technique which projects a more fair and accurate picture of the financial statements. In today’s uncertain and ultra-competitive business environment, the modern fair value approach is better, reliable and fully accurate. Thus, in order to survive and succeed in today’s business scenario, the use and adoption of fair value accounting is the need of the hour, which would ensure the long term success of the business.

References:

Blankespoor, E., Linsmeier, T. J., Petroni, K. R., & Shakespeare, C. (2013). Fair value accounting for financial instruments: Does it improve the association between bank leverage and credit risk?. The Accounting Review, 88(4), 1143-1177.

Chen, W., TAN, H. T., & Wang, E. Y. (2013). Fair value accounting and managers’ hedging decisions. Journal of Accounting Research, 51(1), 67-103.

Christensen, H. B., & Nikolaev, V. V. (2013). Does fair value accounting for non-financial assets pass the market test?. Review of Accounting Studies, 18(3), 734-775.

Costa, M., & Guzzo, G. (2013). Fair value accounting versus historical cost accounting: A theoretical framework for judgement in financial crisis. Corporate Ownership & Control, 11(1), 146-152.

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Hodder, L., Hopkins, P., & Schipper, K. (2014). Fair value measurement in financial reporting. Foundations and Trends® in Accounting, 8(3-4), 143-270.

Magnan, M., Menini, A., & Parbonetti, A. (2015). Fair value accounting: information or confusion for financial markets?. Review of Accounting Studies, 20(1), 559-591.

Smith, S. R., & Smith, K. R. (2014). The journey from historical cost accounting to fair value accounting: The case of acquisition costs. Journal of Business and Accounting, 7(1), 3.

Wesfarmers.com.au. (2018) Retrieved 3 April 2018, from https://www.wesfarmers.com.au/docs/default-source/default-document-library/2017-annual-report.pdf?sfvrsn