Historical Cost Vs Fair Value Accounting: A Comparative Analysis

Background on IASB Framework and Measurement Concepts

The conceptual framework of IASB provides the accounting provisions which underlie the manner of formation and presentation of financial statements so that appropriate information can be provided to external users (Cannon and Bedard, 2016). Present report revolves around the IASB Framework and measurement concepts relating to historical cost and fair value accounting.  The foremost objective of the present report is to assess the better option between fair value accounting and historical value for PPE and Intangibles. In order to present appropriate analysis assessment of three companies, i.e. BHP Billiton, A CAP Resources Ltd and AAR Corp has been made relating to valuation practices followed by them regarding PPE and Intangibles. By considering annual report of companies comparative evaluation is done to determine whether all three companies are having same valuation practices or not.

According to the recent framework of the international accounting standard board, there are different principles and concepts of accounting. The historical cost of accounting is based on the thought that liabilities and assets are calculated and reserved as per the original price of acquisition (Magnan, Menini and Parbonetti, 2015). However, the assets which tend to have an important change in value over a period of time because of the change in technology and land will result in improper measurement. In accordance with the IFRS, while measuring historical costs, the assets are required to assign value in the books of accounts. The cost has clearly offered measurements that are reliable, verifiable and objective in their results (Glover, Taylor and Wu, 2016). In the new standard of accounting the convention of historical cost requires the asset to be recorded at the historical value till it is sensible to identify a value lower than it due to impairment. The historical cost is not applicable and cannot be measured in various assets like investments in shares, trade receivables and cash

The cost of asset is a base of measurements of the elements in the financial statements. The process of measurements is determined on the basis of the financial amount on which the features of financial statements are identified and are carried in the position statement and profit and loss account (Yao, Percy and Hu, 2015). There are generally four bases of measurements such as historical cost, realizable value, present value and current cost. It is used in combination with another base of estimation. For instance, the inventories are generally considered at lower of cost and net realizable value, while on the other side securities are considered at market value, and companies prefer to take pension liabilities at the current value.

Comparative Analysis of Three Companies

In accordance with the IFRS, the fair value is a set of the framework which is used to measure the value of the assets and also disclose the facts about the measurements of fair value. This concept is measured when the other model allows the calculation of fair value of the assets. The IFRS also defines fair value as the amount which will be obtained at the time of selling an asset or paying for the transferring of the liability (Singh, 2015). The transactions take place among the participants and the market at the date of measurement. The fair value is measured under a situation when the company will use assumptions at the time of pricing the liability or asset under the recent condition of the market (Magnan, Menini and Parbonetti, 2015). This is done among the market and its participants on account of the level of risk.

Recently the IASB has completed a mutual project with the FASB on the measurement of fair value system. The outcome of it was the IFRS 13 for fair value measurement. It assumes that all the transaction of transferring and selling of the assets and liabilities occur in the principal market and in the absence of this market the process cannot be implemented (Müller, Riedl and Sellhorn, 2015). The principal market is one having the highest volume and high level of activity for the liability and asset which can be accessed by the company.

IFRS 13 additionally sets out certain valuation ideas to aid the assurance of fair value. Only for non-financial resources, fair value is chosen in view of the most elevated and best utilization of the advantage as dictated by a market member (Laux, 2016). The fair value of an obligation or the company’s own value accepts that it is exchanged to a market member on the estimation date. Regularly there is no noticeable market to give estimating data and the most elevated and best way to utilize. The fair value is then in light of the point of view of a market member who holds the indistinguishable instrument as an advantage. But if there is no comparing resource, a valuation strategy is utilized, just like the case with a decommissioning action.

Firstly the principle of historical cost automatically requires the account of every single transaction of the past. The market estimation of goods cannot be learned without knowing how the merchandise was really produced (Watts and Zuo, 2016). But there is no real way to decide the historical cost of the products without a record of how the items were really delivered and how the materials and work that added to the generation of the merchandise were really acquired.

Advantages and Disadvantages of Historical Cost Accounting

In this way, verifiability of money related statements under historical cost is a supporting record of every single real transaction previously (Magnan, Menini and Parbonetti, 2015). There is no such confirmation when money related statements are organized under a valuation strategy other than historical cost.

Secondly, historical cost is fundamental for the best possible working of responsibility, the idea upon which the modern financial society is manufactured (Basu and Waymire, 2017). Without historical cost information, a supervisor will have a troublesome time exhibiting that he has legitimately used the assets endowed to him by the investors.

 Thirdly, extraordinary valuation strategies could be reliable regarding their impact on execution estimation of business undertakings. The imperative issue concerning resource valuation is whether the economic performance of the company should be calculated on the basis of the historical cost method.

The financial statements which are prepared in accordance with the historical cost accounting are basically the statements of facts of history. The modifications in the money value are a result of a change in the price level of the asset and liability which is not being taken into account (The Conceptual Framework for Financial Reporting, 2010). Hence, the process gets fails in order to provide a fair and true status of the issues in the company.

In accordance with the principle of historical cost accounting, non-current assets are recorded at the price on which it was purchased. Future changes in the value of the asset are not reflected in the books of account.  

Inadequate provision for Depreciation on asset

Provision of depreciation is made to charge reducing value of asset as an expense over the years to generate funds for its replacement.  In approach of historical cost, depreciation is charged on the basis of the historical cost of the concerned asset, not at the value on which cited it was purchased initially. Further; the provision made in the form of depreciation will be charged on the original cost of the asset and same will not be appropriate for the purpose of replacement of assets.
Unrealistic Profit

In a situation where income statement is formed by considering accounting principle of  historical cost accounting then it does not show an actual profit of the business. It is because;  business revenues are recorded as per current value while associated expenses are shown at historical cost (Magnan, Menini and Parbonetti, 2015). Due to this factor; profit of the business is overstated, and a factor of inflation is not reflected.

Advantages and Disadvantages of Fair Value Accounting

Reduced tax payable

Under the method of fair value accounting, the net income of the company decreases whenever there is a reduction in the value of the asset. The same happens if there is a rise in liabilities. Net income represents the bottom line of the income statement of the Company. This is the amount that reflects the total income tax to be payable by the Company. Thus, this proves as an advantage for the Company because a low net income will mean low taxes.

Realistic financial statements

The companies which report under this method have financial statements more precise as compared to the companies which do not use any fair value method. The assets and liabilities are reflected in their actual value which makes financial statements more accurate (Müller, Riedl and Sellhorn, 2015). This method requires the companies to disclose any changes made in the financial report. These disclosures are done by the companies in the form of notes to accounts. This also makes the evaluation much easier and allows the Company to make wise decisions.

Benefit for investors

The accounting through fair value is beneficial for the investors as well. This is because with fair value accounting the assets and liabilities reflect the true status of the financial health of the Company. This makes easier for investors a take wise decision regarding their investment. With the help of notes to accounts, the investors can evaluate the impact of any changes in the assets and liabilities.

Frequent changes

Today’s market is highly volatile, and changes in the value of item occur more frequently as compared to previous times. This results in fluctuations in the earnings of the Company. The losses are written against the earnings of the Company (Müller, Riedl and Sellhorn, 2015). This fluctuation in value makes it difficult for investors to judge the financial position of the Company and hence it makes it a complex situation for Public Limited Companies. Along with this, the fluctuations also result in audit problems due to incorrect valuations.

Less reliable

Many accountants find fair accounting value less reliable than historical cost valuation. This is because to find out the fair value; market factors are taken into consideration. Thus similar assets may reflect different status in different companies. This may result in discrepancy and incorrect valuations.

Inability to Value specialized assets

Businesses that have special assets consider it problematic to value them on the value prevailing in the market. This is because of lack of information available for these assets.

Historical cost accounting and fair value accounting are two valuation methods which are applied to record assets in books of accounts. Historical cost method evaluates the value of the original cost of the asset; however fair value method measures the current value of the asset. The first method ascertains the value of assets through ascertaining the price at which asset was purchased, and the other method ascertains the market value of the asset in order to ascertain the value on which asset is required to be recorded in books of accounts (Nicholas,  2014). Presently, the companies have the choice to follow the most appropriate method of valuation in accordance with the asset whose valuation is to be done by the company. The valuation practices followed by the specified three companies have been analyzed below in detail:

BHP Billiton	AIR New Zealand	A cap Resources Limited
· The cost of the asset is the fair value at a time when the asset was acquired including the cost which was incurred by the Company for bringing the plant in working condition (BHP, Annual Report 2017). · The part of the cost of PPE which is not capitalized is categorized as exploration cost. · The PPE is recorded at a cost after deducting accumulated depreciation and charges of impairment. · A regular review is undertaken to determine to carry forward costs of PPE. The Capitalization cost is carried forward to the limit that is anticipated to be recovered. If the Company does not expects the same to be recovered.	· The company records Property Plant and Equipment is recorded at cost or deemed cost reduced by accumulated depreciation. The amount attributable to the acquisition of an asset and bringing the asset to location is also included in the cost of the asset (Air New Zealand, Annual Financial Report, 2017). · Financial lease asset is evaluated at an amount which is lower of the present value of lease payments at the completion of the lease or the fair value of the lease.  Moreover, fair value is measured on a reliable basis.	· The company measures the PPE on the basis of cost method after deducting the amount of depreciation. The Carrying amount of PPE is reviewed on a regular basis by the management to ensure that the book value is not more than the recoverable amount (Annual Report, A-cap Resources Limited, 2017). .

Figure 1: Notes of BHP Billiton relating to PPE

(Source: BHP, Annual Report, 2017)

Figure 2: Notes to accounts of PPE relating to AIR New Zealand

(Source: Air New Zealand, Annual Financial Report, 2017)

BHP Billiton	AIR New Zealand	A Cap Resources Limited
· The amount paid for acquiring intangible assets is capitalized by the Group. The intangible assets include software, licenses and acquisition of mineral assets when it is anticipated that these assets will benefit the Company in future (BHP, Annual Report 2017). These are noted at fair value in the balance sheet after reducing the accumulated amortization. · The assets are depreciated on a straight-line basis over the useful life, not more than 8 years.	· The intangibles are valued through capitalized in accordance with the cost incurred for acquisition and bring to use the asset, i.e. computer software. · The asset has a finite life and is depreciated on the straight-line basis as per the probable useful life of three to six years (Air New Zealand, Annual Financial Report, 2017).	· At the end of accounting period, the Group undertakes regular review regarding the recoverable amount and fair value of their impairment (Annual Report, A-cap Resources Limited, 2017). · The recoverable amount is the greater of the fair value of the asset. · If the asset’s carrying value is more than the recoverable amount, the expense is recorded in the P&L account. · If the recoverable amount cannot be estimated, the Group estimates the recoverable amount of the CGUs to which the asset belongs

All the Three Companies recognizes Property Plant and Equipment at a cost reduced by depreciation as well as an impairment loss. Cost is ascertained after considering fair value paid for the asset at the time of purchasing the asset, and it comprises cost which has been paid for making the asset used for the objective for which it has been acquired (IFRS, 2018). The financial statements of the Company revealed that the assets are measured on historical cost in case appropriate historical cost is available, and the assets whose historical cost is not known are measured at a fair value like on non-current and financial assets (AACA, IAS 16- property plant and equipment, 2009). The assets are amortized at cost using effective interest method. The fair value is determined on the basis of prices of current bid for quoted investments. Thus this policy indicates that the carrying value of intangible and tangible assets are used to determine the impairment if the recoverable amount is less than the asset’s carrying value. Thus, all the above mentioned three companies are consistent with their valuation policy and value their physical assets according to their convenience. Market conditions play an important role in determining fair value. The financial statements of BHP Billiton are mostly prepared on the basis of historical cost except for the financial instruments and other physical assets which are held for sale. After analyzing the financial statements BHP it can be assessed that in case of lease assets are valued at lower of the fair value of the leased asset or the present value of the lease (BHP, Annual Report 2017). The leased equipment is also measured at the end of the year for ascertaining the estimated present value of minimum lease payments. Thus, the study depicts that valuation policy of all the three companies differentiate regarding lease asset and for acquired PPE historical method has been adopted by all the three specified companies. In case of Air New Zealand, the plant and equipment are treated at deemed cost less accumulated depreciation. This cost also expenditure that can be directly traced to the asset and also the transfers from equity and cash flow hedges in case the asset is purchased in foreign currency (Air New Zealand, Annual Financial Report, 2017). Where the plant and property have the definite useful life, they are accounted separately.

In the case of specified companies have acquired any identifiable intangible asset that each of the company has accounted the asset on the amount paid for the asset. Thus, it can be assessed that in case of an acquired intangible asset, companies follow same valuation method. However, in case of BHP Billiton, the difference between the amount paid for the acquisition and fair value of relating asset and liabilities is accounted as goodwill. It is the only difference which can be analyzed in valuation method adopted for goodwill (BHP, Annual Report 2017). The intangible assets are initially measured at fair value after adding any transaction cost except in cases where the transaction cost are capable of being separated from the asset; these costs are recognized in the Profit and loss account (The Conceptual Framework for Financial Reporting, 2010). A Cap Resources Limited measures the non-monetary items at a fair value of the exchange rate if the combination is done across geographical borders (Annual Report, A-cap Resources Limited, 2017). BHP Billiton follows the policy of impairing intangible assets at annual average historical prices except for goodwill. If the fair value of goodwill exceeds the consideration paid for acquiring the goodwill, the difference is treated in the profit and loss account. The company does not amortize its goodwill and is measured at cost after deducting the impairment expenses. Other intangibles such as software have a finite life (not more than 8 years) and are recorded at fair value less accumulated amortization (charged on a straight-line basis) and charges of impairment. Fair value less cost of disposal is the main valuation policy of the Company. The value in use is calculated according to the estimated future cash flows. Air New Zealand amortizes their intangible on a straight-line basis with a useful life of 3-5 years (Air New Zealand, Annual Financial Report, 2017).

IAS 16 deals with the provisions of the accounting treatment of PPE which are to be complied by the companies. The standard does not specify any valuation method; however, the cost which is to be included for capitalization purpose has been explained in an appropriate manner (AASB, Australian Government, 2017). IAS 38 provided detail relating to criteria for valuation and required disclosure relating to Intangible Assets. The standard asserts that it is necessary for the intangible asset to meet the definition specified in standard in order to be recognized as an asset (IFRS IAS 38 Intangible Assets, 2014). In my opinion, the free choice is necessary to be provided to the companies because each asset cannot be measured on a historical basis or on fair valuation method (Silvia, 2014). As per the provision of applicable accounting standards, companies have to provide appropriate reason following any valuation method as well as in case they change the method of valuation of assets. Both the methods are appropriate at their own place; because it is not possible to ascertain or measure the historical cost of every asset. The free choice option should be continued so that companies could be able to measure their assets in an appropriate manner. In case the option is not available or abandoned than a variety of difficulties will be faced by the companies to measure assets such as intangible asset and due to the same reason, financial statements will not provide a true and fair view to its users.

Conclusion

The main objective of Conceptual Framework is to provide uniform standards for better financial presentation of information. The above study depicts aspects covered by the conceptual framework that assist in better presentation and disclosure of financial information. All the three companies have appropriately complied with the valuation method relating to PPE and Intangibles. The study depicts that companies have applied fair valuation method in case it is not possible to evaluate the exact value of the asset on any other basis. Moreover, the freedom relating to adopting a method of valuation, i.e. historical method or fair valuation method is necessary to be provided because it is not possible to measure or value each asset on the basis of one valuation method.

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