Primary Valuation Alternatives: Historical Cost versus Fair Value
Historical cost is simply the cost the firm originally incurred to acquire an asset or the original (principal) amount of an incurred liability. Fair value, on the other hand, reflects the value of the asset or liability based on current market conditions. At the time of an arm’s-length transaction, the historical cost of assets and the original amount of liabilities are equal to their fair values. Over time, their fair values may change. In some instances, adjustments are made to reflect fair values on the balance sheet
Historical Cost
The historical, or acquisition, cost of an asset is the amount paid initially to acquire the asset. Such historical costs include all costs required to prepare the asset for its intended use, but does not include costs to operate the asset. At the time assets are obtained, acquisition cost valuations are ideal because they are relevant insofar as they measure the amounts that firms actually paid to acquire resources, and they are representationally faithful because they are unbiased, objective, and verifiable through invoices, canceled checks, and other documents that provide clear support for the valuation
For example, assume Mollydooker Wines paid employees $700,000 to oversee the growing of grapes in its vineyards, to harvest the grapes, and to process the grapes into wine. Depreciation on buildings and equipment pertaining to wine production totaled$250,000. Mollydooker also incurred other operating costs of $150,000 related to wine production. The historical cost of the wine in inventory prior to commencement of aging totaled $1,100,000 ($700,000 þ $250,000 þ $150,000). Mollydooker Wines will subsequently increase the inventory account in later periods by capitalizing additional costs incurred during the aging process, eventually recording all costs of producing the wine as inventory prior to eventual sale. One question that often arises concerns the costs to include in the asset amount.Should the acquisition cost of the wine include interest on funds that Mollydooker borrowed to finance production of the wine? Variation in practice exists, and accounting procedures for material amounts should be disclosed in the financial statement footnotes
A second question concerns the relevance of historical cost valuations to financial statement users. At the time a firm acquires an asset, historical cost valuations are timely and objectively measured, so are both relevant and representationally faithful to financial statement users. As time passes, however, the historical cost valuation retains representational faithfulness but can lose relevance if the valuation becomes dated and does not reflect current values.
Adjusted Historical Cost.
Historical cost is simply the cost the firm originally incurred to acquire an asset or the original (principal) amount of an incurred liability. Fair value, on the other hand, reflects the value of the asset or liability based on current market conditions. At the time of an arm’s-length transaction, the historical cost of assets and the original amount of liabilities are equal to their fair values. Over time, their fair values may change. In some instances, adjustments are made to reflect fair values on the balance sheet
Historical Cost
The historical, or acquisition, cost of an asset is the amount paid initially to acquire the asset. Such historical costs include all costs required to prepare the asset for its intended use, but does not include costs to operate the asset. At the time assets are obtained, acquisition cost valuations are ideal because they are relevant insofar as they measure the amounts that firms actually paid to acquire resources, and they are representationally faithful because they are unbiased, objective, and verifiable through invoices, canceled checks, and other documents that provide clear support for the valuation
For example, assume Mollydooker Wines paid employees $700,000 to oversee the growing of grapes in its vineyards, to harvest the grapes, and to process the grapes into wine. Depreciation on buildings and equipment pertaining to wine production totaled$250,000. Mollydooker also incurred other operating costs of $150,000 related to wine production. The historical cost of the wine in inventory prior to commencement of aging totaled $1,100,000 ($700,000 þ $250,000 þ $150,000). Mollydooker Wines will subsequently increase the inventory account in later periods by capitalizing additional costs incurred during the aging process, eventually recording all costs of producing the wine as inventory prior to eventual sale. One question that often arises concerns the costs to include in the asset amount.Should the acquisition cost of the wine include interest on funds that Mollydooker borrowed to finance production of the wine? Variation in practice exists, and accounting procedures for material amounts should be disclosed in the financial statement footnotes
A second question concerns the relevance of historical cost valuations to financial statement users. At the time a firm acquires an asset, historical cost valuations are timely and objectively measured, so are both relevant and representationally faithful to financial statement users. As time passes, however, the historical cost valuation retains representational faithfulness but can lose relevance if the valuation becomes dated and does not reflect current values.
Adjusted Historical Cost.
Often, firms adjust historical costs downwards. For some assets, the service potential is consumed gradually (like machinery that has a limited life) or immediately (like inventory, which provides all of its benefits when it is sold). As the service potential of an asset is consumed, the consumed portion is expensed (that is, the asset is reduced and an expense is increased). For machinery, the expense is depreciation; for inventory, the expense is cost of goods sold. Over the life during which a firm enjoys the benefits of an asset, the firm should either derecognize—that is, remove the asset from the balance sheet—the asset when its value has been consumed (for example, inventory) or ratably adjust the acquisition cost downward through systematic depreciation or amortization (for example, machinery).
Like historical costs, adjusted historical costs involve a trade-off between relevance and representational faithfulness. For example, consider a firm that acquires computer equipment for $5 million and depreciates it over four years to an estimated salvage value of $1 million. The valuation of the computer equipment at the end of the four years is based on a combination of a representationally faithful acquisition cost ($5 million) and a good faith estimate of the portion eventually realized through sale or trade-in of the used equipment ($1 million). These estimates attempt to provide valuations that are relevant. Even though the estimates are made in good faith, they are of uncertain amounts and may turn out to be incorrect.
Like historical costs, adjusted historical costs involve a trade-off between relevance and representational faithfulness. For example, consider a firm that acquires computer equipment for $5 million and depreciates it over four years to an estimated salvage value of $1 million. The valuation of the computer equipment at the end of the four years is based on a combination of a representationally faithful acquisition cost ($5 million) and a good faith estimate of the portion eventually realized through sale or trade-in of the used equipment ($1 million). These estimates attempt to provide valuations that are relevant. Even though the estimates are made in good faith, they are of uncertain amounts and may turn out to be incorrect.
Firms use historical cost valuations and adjusted historical cost valuations for nonmonetary assets those that are not characterized by fixed and determinable amounts of future cash flows. For example, inventories, land, buildings, equipment, and goodwill are examples of nonmonetary assets. When the future economic benefits of an asset are sufficiently uncertain, firms use historical cost and adjusted historical cost as a representationally faithful measure of the asset’s value.
Monetary assets and liabilities, on the other hand, represent amounts of cash the firm can expect to receive or pay in the future. Cash, accounts receivable, and notes receivable are monetary assets; accounts, notes, and bonds payable are monetary liabilities. Firms typically value monetary assets and liabilities using present values, although U.S. GAAP and IFRS permit firms to ignore the discounting process for monetary assets and liabilities due within one year.
Present Value.
Monetary assets and liabilities, on the other hand, represent amounts of cash the firm can expect to receive or pay in the future. Cash, accounts receivable, and notes receivable are monetary assets; accounts, notes, and bonds payable are monetary liabilities. Firms typically value monetary assets and liabilities using present values, although U.S. GAAP and IFRS permit firms to ignore the discounting process for monetary assets and liabilities due within one year.
Present Value.
Another type of historical cost is initial present value. If markets are not sufficiently active to provide reliable evidence of fair value, firms can use the present value of expected cash flows to approximate the fair value assets and liabilities.8 Present value methods are often used with receivables and payables. Selling goods or services on account to customers or lending funds to others creates either an account receivable or a note receivable for the selling or lending firm. Purchasing goods or services on account from a supplier or borrowing funds from others creates a liability (for example, accounts payable, notes payable, and bonds payable). Discounting the expected future cash flows under such arrangements to a present value expresses those cash flows in terms of a current cash-equivalent value. When the monetary asset or liability is first entered in the financial statements, the present value computation (if the cash flows span more than one year) uses interest rates appropriate for the particular financing arrangement at that time.
For example, assume Jordan’s Furniture sells a sofa to a customer on January 1, permitting the customer to delay payment of the $500 selling price for five years. An assessment of the customer’s credit standing suggests that 6% per year is an appropriate interest rate for this extension of credit (even though there is no explicitly stated interest rate to the customer). The present value of $500 to be received in five years, when discounted back at 6%, is $373.63. A strict application of the initial present value of cash flows valuation method results in reporting sales revenue and a receivable of $373.63 on January 1 and interest revenue and an increase in the receivable of $22.42 (0.06 3 $373.63) at December 31. The following year, interest revenue and an increase in the receivable of $23.76 [0.06 3 (373.63 þ 22.42)] would be recognized, and so on for the next three years, at the end of which the receivable would equal the $500 then due from the customer.
Because financing arrangements between sellers and buyers usually specify the timing and amounts of future cash flows, valuing monetary assets and liabilities at the initial present value of cash flows using historical interest rates is relevant and representationally faithful. Moreover, for multi-year collection periods, the relevance of the present values (versus nominal values) justifies the extra efforts to discount assets or liabilities to the present value of future cash flows. Some subjectivity may exist in establishing an appropriate interest rate at the time of the transaction. The borrower, for example, might choose to use the interest rate at which it could borrow on similar terms from a bank, whereas the seller might use the interest rate that would discount the cash flows to a present value equal to the cash selling price of the good or service sold. These small differences in interest rates usually do not result in material differences in valuation between the entities involved in the transaction
Fair Value
Because historical cost approaches to valuing assets and liabilities can lose relevance as valuations become old and outdated and do not reflect current economic conditions, the FASB and IASB have increasingly developed accounting standards that value assets and liabilities using current or fair value approaches, which emphasize relevance while retaining representational faithfulness. The FASB defines fair value as ‘‘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.’’10 This definition explicitly characterizes fair value as a measure of ‘‘exit price,’’ which is the amount for which a firmcould sell an asset or pay to settle or transfer a liability. The IASB defines fair value slightly differently, as ‘‘the amount for which an asset could be exchanged, or a liabilitysettled, between knowledgeable, willing parties in an arm’s-length transaction.’’11 This definition allows for the use of an exit price or an entry price (the amount for which a firm could buy or sell an asset or incur or settle a liability). Differences could arise between entry and exit price approaches, for example, when the market in which a purchase takes place is different from the one in which a sale takes place (such as a securities firm that transacts with retail customers, institutional investors, or other securities firms). In addition to the use of quoted market prices as inputs into current values, accountants sometimes use present value techniques to estimate certain current values (for example, Level 3 assets, discussed below).
Clearly, fair values are of interest to financial statement users, particularly in settings where fair values have diverged greatly from acquisition costs of assets or initial present values of liabilities. An obvious example is found in financial institutions, where the values of financial assets and liabilities change immediately with interest rates. Obtaining ‘‘the price’’ at which assets and liabilities can be exchanged can provide extremely relevant and representationally faithful measurements when they are based on observable prices in orderly markets for stocks, bonds, securities, commodities, derivatives, and other items. However, obtaining ‘‘the price’’ can require management estimates when there is no quoted price in an active market for an asset or a liability. Generally, prices are more readily available for financial assets (and commodities) and liabilities than for nonmonetary assets or liabilities, which is why the trend in financial reporting is to employ fair values for most financial assets and liabilities. Even among financial assets and liabilities, however, there is wide variation in the availability of quoted market prices. Accordingly, there is a three-tiered hierarchy within U.S. GAAP and IFRS that distinguishes among different sources of fair value estimates
Current Replacement Cost.
Because financing arrangements between sellers and buyers usually specify the timing and amounts of future cash flows, valuing monetary assets and liabilities at the initial present value of cash flows using historical interest rates is relevant and representationally faithful. Moreover, for multi-year collection periods, the relevance of the present values (versus nominal values) justifies the extra efforts to discount assets or liabilities to the present value of future cash flows. Some subjectivity may exist in establishing an appropriate interest rate at the time of the transaction. The borrower, for example, might choose to use the interest rate at which it could borrow on similar terms from a bank, whereas the seller might use the interest rate that would discount the cash flows to a present value equal to the cash selling price of the good or service sold. These small differences in interest rates usually do not result in material differences in valuation between the entities involved in the transaction
Fair Value
Because historical cost approaches to valuing assets and liabilities can lose relevance as valuations become old and outdated and do not reflect current economic conditions, the FASB and IASB have increasingly developed accounting standards that value assets and liabilities using current or fair value approaches, which emphasize relevance while retaining representational faithfulness. The FASB defines fair value as ‘‘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.’’10 This definition explicitly characterizes fair value as a measure of ‘‘exit price,’’ which is the amount for which a firmcould sell an asset or pay to settle or transfer a liability. The IASB defines fair value slightly differently, as ‘‘the amount for which an asset could be exchanged, or a liabilitysettled, between knowledgeable, willing parties in an arm’s-length transaction.’’11 This definition allows for the use of an exit price or an entry price (the amount for which a firm could buy or sell an asset or incur or settle a liability). Differences could arise between entry and exit price approaches, for example, when the market in which a purchase takes place is different from the one in which a sale takes place (such as a securities firm that transacts with retail customers, institutional investors, or other securities firms). In addition to the use of quoted market prices as inputs into current values, accountants sometimes use present value techniques to estimate certain current values (for example, Level 3 assets, discussed below).
Clearly, fair values are of interest to financial statement users, particularly in settings where fair values have diverged greatly from acquisition costs of assets or initial present values of liabilities. An obvious example is found in financial institutions, where the values of financial assets and liabilities change immediately with interest rates. Obtaining ‘‘the price’’ at which assets and liabilities can be exchanged can provide extremely relevant and representationally faithful measurements when they are based on observable prices in orderly markets for stocks, bonds, securities, commodities, derivatives, and other items. However, obtaining ‘‘the price’’ can require management estimates when there is no quoted price in an active market for an asset or a liability. Generally, prices are more readily available for financial assets (and commodities) and liabilities than for nonmonetary assets or liabilities, which is why the trend in financial reporting is to employ fair values for most financial assets and liabilities. Even among financial assets and liabilities, however, there is wide variation in the availability of quoted market prices. Accordingly, there is a three-tiered hierarchy within U.S. GAAP and IFRS that distinguishes among different sources of fair value estimates
Current Replacement Cost.
Another form of fair value usage is current replacement cost, which is the amount a firm would have to pay currently to acquire or produce an asset it now holds. By virtue of the term’s reference to an external market, this is a special case of applying the fair value approach. However, whereas straightforward fair values generally pertain to financial assets and commodities, current replacement cost generally applies to nonmonetary assets. The most common use of current replacement cost is through the application of lower-of-cost-or-market valuation of inventories. Current replacement cost valuations generally reflect greater subjectivity than acquisition cost valuations, but they are the least subjective and most representationally faithful when based on observable market prices from recent transactions in which similar assets or liabilities have been exchanged in active markets. For example, you could obtain reliable measures of current replacement costs of raw commodities by referencing spot prices in commodities markets. When active markets do not exist, as is often the case for inventory or equipment designed specifically for a particular firm’s needs, the degree of subjectivity increases. Thus, although replacement cost values are more relevant, subjectivity in estimating them in most markets reduces the representational faithfulness of such values. Nevertheless, users of financial statements may find current replacement cost valuations used occasionally and more relevant than out-of-date acquisition cost valuations.
Net Realizable Value.
Net Realizable Value.
A hybrid form of historical cost and fair value measurement is the use of net realizable value, which is the net amount a firm would receive if it sold an asset (for example, inventory for which current value has declined below cost). Net realizable value is another special case of a fair value approach, but it also shares features of adjusted historical cost valuation, because historical cost provides a reference point to determine whether net realizable valuation is applicable. Thus, this is a hybrid approach and the examples that will be discussed exhibit similarities with other valuation approaches (both historical cost and current value). We include net realizable value within our discussion of current value approaches because of the reference to exit prices. The difference is that rather than estimating the cost of acquiring a similar asset in a hypothetical transaction, the net realizable value approach focuses on the amount a firm is likely to realize given prevailing market conditions, offset by any pertinent selling costs.
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