Group 12 1

Should financial statements be based on historical costs

or fair values?

Should financial statements be based on historical cost or fair

values?
Group 12
Warren Cannon, Nikolaus Martys,
Ilja Kuznetsov and Bekbolot Keldibekov

Cost accounting methods aid in the valuation of assets and liabilities.

Although historical cost accounting is the most popular method in use,
many companies have adapted fair value in the past years (Thomas &
Ward 2009). Historical cost accounting records sales at their agreed sales
value and purchases at the agreed price of acquisition. Fair value reflects
these items at their economic value, which is the price received if the
asset would be sold, and is obtained from the market value, replacement
cost or present value (ibid). Both historical costs as well as fair values
have advantages and disadvantages that affect the quality of information
presented. This essay will compare these methods (historical cost and fair
values) by their advantages and disadvantages and demonstrate the
difficulties from switching from historical to fair value. When analyzing
each method, we will concentrate on the four attributes of a financial
statement; understandability, reliability, relevance, comparability.
One advantage of historical cost accounting is that it is reliable, by serving
as a stable valuation method in a volatile market, determined through
transactions occurred, benefiting the different stakeholders. The financial
statement can be created through all the business transactions during the
course of the accounting period (Thomas & Ward 2009). The assets and
liabilities are valued from their transactions and are less prone to
manipulation in comparison to accounts that are established through fair
values (ibid). Thus the qualitative characteristics of accounting,
faithfulness and understandability are provided in historical accounting.
This is useful for the shareholders as they can be more certain that the
accounts have the costs established through dealings of the business.
Furthermore, the public and the government benefit from historical cost
accounting as it is more verifiable which decreases the ability to
manipulate. Conversely, in historical cost accounting the owner has the
ability to decide on investment, as the stewardship is greater (Bence
2013). Another advantage of historical cost is shown in a volatile market,
because the values of assets remain constant. In a volatile market the
prices change quickly over time, and would have to be continuously
changed in fair value accounting, whereas in historical cost accounting the

Warren Cannon, Nikalous Martys, Ilja Kuznetsov and Bekbolot Keldibekov

Group 12 2
Should financial statements be based on historical costs
or fair values?
prices would be unaffected (Way, 2007). In order to show the decrease in
value of an asset depreciation is used in historical accounting. A historical
cost smoothened through depreciation over time will be a continuous
decrease in value of the asset, but is unaffected by the current market
price. Thus, in a volatile market the assets will not be affected making it
more beneficial for the business in presenting their financial status, as it
doesnt have to be changed often. Moreover, the investors and lenders
prefer the stability of a business, which would be provided through
historical cost accounting.
Another advantage of historical cost
accounting is its simplicity (Bessong et al, 2012). As the values only come
from transactions and relevant depreciation, it provides understandability.
Customers, employees, and the public place great value in
understandability because they are not as qualified to understand
complex financial reporting methods, historical cost accounting avoids
due to its simplicity. Overall, through its simplicity, verifiability, and
reliability, historical cost accounting depicts qualitative characteristics
that aid different stakeholders in dealing with the business.
Although historical accounting is widely used, there are some
disadvantages with this method, which triggered a movement away to fair
values. The main problem with historical accounting is that over time the
accounts start to become inaccurate (Thomas & Ward 2009). Upon
acquiring an asset, it will be represented by the market value and be
comparable to other assets on the market. However, the values start to
become different to the actual market and in the long run can be
significantly diverse. This can be very misleading for future investors as
well as for the business itself, as the values lose their resemblance to the
market. Also, inaccurate values lose their relevance and make it
impossible to compare with other assets from the market. This not only
harms investors, lenders, and the shareholders, but also the managers in
the company, because the values become useless for decision-making
and planning. Another problem of historical cost accounting occurs when
there is inflation. As the price level rises in the economy, the values would
stay unaffected subsequently leading to an overstatement in profits (U.K
essays, 2013). An overstatement of the profits contradicts the qualitative
characteristic faithfulness, because the accounts do not represent a true,
accurate value. Although an overstated profit might seem good for a
company, it will mislead investors, lenders and even the tax office leading
to higher tax payments. Another disadvantage of historical costing is
depreciation. The expected life of an asset is established when obtaining
the asset, but the usefulness could change over the years leading to an
inaccurate value (ibid). Furthermore as assets are recorded in the financial
statements at their original cost they may be out of date but would still be
used in profit measurement (Thomas & Ward, 2009). This also harms the
matching principle, where the measurement of profits and costs should be
based on the revenue generated at the time when it arises, as sales can
be made above the original purchase price but below the current
replacement price. This is a problem for the business, as it misleads the

Warren Cannon, Nikalous Martys, Ilja Kuznetsov and Bekbolot Keldibekov

Group 12 3
Should financial statements be based on historical costs
or fair values?
owners, and a profit could be stated on the sale of goods (ibid). Another
problem that occurs with incomparable figures present in historical cost
accounting are ratio analysis, because figures from different time periods
may be used to calculate a present ratio. This useless figure can mislead
the shareholders, like investors and lenders that rely on such information.
Therefore, the time factor in historical counts harms the relevance,
timeliness and faithfulness of the accounts portrayed and led to many
companies switching to an alternative method of valuation.
One advantage of using fair value cost accounting is that it best
represents the value of the company at the time of measurement.
Businesses using this method would therefore have a much more accurate
and reliable valuation to replace or sell assets in their portfolio. This will
therefore help with crucial business stages such as planning for future
projects and also in setting relevant contingency provisions. For example,
Delta Airlines (Delta 2012) use fair value cost accounting within their
financial reports which can help them set relevant contingency provisions
for replacement of aircrafts, or plan for the sale of assets which could be
seen when companies need to avoid bankruptcy. Certain long-term assets
such as land and buildings (such as houses) which appreciate with time, is
also beneficial for a business using fair value cost accounting. House
prices alone have increased in value over 273% since 1959 (Halifax 2010),
therefore businesses operating for longer time periods, under fair value
accounting policy will experience significant increases in asset value and
therefore increased equity with no cost.
Fair value accounting policy also plays a key role in providing
comparability between assets bought at different times as it ignores an
impact of inflation within the time period each asset was bought. This is
especially noticeable with financial instruments, such as stocks, bonds,
options and futures, which are becoming a larger proportion of a
businesss asset and liability portfolio. Fair value accounting provides
comparability between the instruments bought at different times and
improves the insight to the market, and usefulness of financial reports to
investors (ISDA 2002).
It is being criticised by many economists, who find concern in its reliability
and verifiability due to the measurement system based on three levels,
where the third level, usually referred to as mark-to-model, is actually
based on assumptions with estimations (Abdel-khalik 2008). Where there
is no active market for a certain asset or liability, the reliability of the
value can be little. Since the economic downturn, validity of invoked
assumptions and the reliability of estimations of fair value measures were
the main targets of critics. In the case when there is an overall price
decrease in the market, large losses will have to be recognised under this
accounting methodology, which can lead to an increased volatility of
reported profits (FASB 2006). Abdel-khalik (2008) suggested that there is a
potential for dividends to exceed actual realised earnings, due to
fluctuations of asset worth. After the Financial Accounting Standards

Warren Cannon, Nikalous Martys, Ilja Kuznetsov and Bekbolot Keldibekov

Group 12 4
Should financial statements be based on historical costs
or fair values?
Board issued a new standard FAS 157 in September 2006 and even more
since the onset of the liquidity crisis and recession, fair value accounting
became further doubtful. Many banks and financial companies, such as
Merrill Lynch, Citigroup, and UBS suffered enormous losses by measuring
their value through fair value concept (Katz 2008).
Price movements can also impair the comparability between financial
reports year-to-year when there are price movements in a given market.
The assets an entity holds could rise and fall in value, yet it is hard to tell
whether this change in value is due to the acquisition of new assets, or
due to a rise in the market price for the current assets.
In volatile markets true representative values of a replacement or sale
price can be hard to establish. Price movements in assets that will be held
over a long period of time can cause unreliability (Laux and Leuz 2009).
This can lead to inefficient actions of investors as there will be pressure to
sell long term assets, due to a down trending market, whereas they should
be focusing on the long term targets (this is especially relevant for
financial instruments) whereas it would be beneficial for the firm to keep
these assets in the long term.
Switching from historical cost accounting to fair values as a method of
valuation exposes unrealized gains as well as a lower profit. An empirical
study in Nigeria showed that the profits of companies using historical
accounting were higher in comparison with their profit after switching to
fair values (Bessong et al, 2012). Thus firms who were making a profit in
historical cost made a loss after they switched to fair value. Apart from the
business being dissatisfied the shareholders will get less return, lenders
will worry about getting their money back, and lower tax will be paid to
the government. Another problem with switching from historical cost to
fair value are unrealized gains. If land would be revalued after switching to
fair value, then this gain will be reported in the balance sheet as
revaluation reserve, and in the income statement as other comprehensive
income. These are unrealized holding gains, as there is an increase in
value, although the property isnt sold, so goes against the prudence
principle (Bence, 2013). A reason for switching from historical cost to fair
value is to improve the relevancy of the accounts (Donker, 2005). In order
to be consistent it requires several IASB standards, such as IAS16, IAS2,
and IAS19 to be changed. Although the changes improve the ability for
investors to make decisions, it is a demanding procedure for the firms to
undertake. However, as Bessong et al. (2012) shows managements
interest not to change from historical cost to fair value as it deflates the
profit. That said, Bence (2013) suggests that investors are knowledgeable
and and the share price will stay constant, as it is based on business
performance. Therefore, a business should not be worried about changing
to fair value accounting as it will not significantly affect the share price of
a company.
It is clear that both accounting methods have their advantages. We can
see from the theory and empirical data that fair value policy is clearly

Warren Cannon, Nikalous Martys, Ilja Kuznetsov and Bekbolot Keldibekov

Group 12 5
Should financial statements be based on historical costs
or fair values?
stronger in providing comparability whilst also reliability and relevance of
values. Historical cost accounting will always provide understandability to
each stakeholder as it provides simplicity, yet when managers need to
plan, or make business decisions, fair value policy will provide the easiest
methodology to acquiring the relevant information in forming their plans.
Essentially, financial statements should be based on fair values because it
provides significantly higher levels of reliability and resemblance to the
market, relevance to the business true value and greater comparability to
the market.
Word count on essay: 1999
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Warren Cannon, Nikalous Martys, Ilja Kuznetsov and Bekbolot Keldibekov

Group 12 6
Should financial statements be based on historical costs
or fair values?
ca/AboutCGACanada/CGAMagazine/2005/Sep-Oct/Pages/ca_2005_0910_ft2.aspx [Accessed on 17,3,2013]
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Warren Cannon, Nikalous Martys, Ilja Kuznetsov and Bekbolot Keldibekov

Group 12 7
Should financial statements be based on historical costs
or fair values?

Warren Cannon, Nikalous Martys, Ilja Kuznetsov and Bekbolot Keldibekov