Entertainment magazine fans probably see the same popular celebrities in issue after issue. Similarly, those who stay up-to-date on current accounting issues probably stumble upon a new article about the fair value standard almost every week. The reason for this increased focus is relevance. The question constantly posed by accounting practitioners, academics, and users of financial statements is “Which is more useful– historical cost or fair value?”
The Notoriety of Historical Cost and Fair Value
Fair value accounting is the method of capturing changes in asset and liability values over time. Its alternative in valuing assets is historical cost accounting– used under the generally accepted accounting principles (GAAP). As the name implies, historical cost accounting measures the value of an asset based on what it originally cost the company to buy it.
Fans of historical cost prefer reporting assets at their purchase price and liabilities at the acquisition price. One of the cons of this method is that it focuses on the past and, as a result, may become obsolete. However, historical cost reporting is a cost-effective mechanism for determining value. By contrast, those favoring fair value believe that understanding the value that a company could receive in an arm’s length transaction for its assets – as well as knowing the company’s actual liabilities – yields the best useful decision-making information. A noteworthy con with fair value is that preparing or receiving annual appraisals to obtain it is both time-consuming and expensive.
The Price of Fame: The Hybrid Financial Reporting Model
Recognizing the cost-benefit of both accounting methods, the current reporting model contains elements of both historical cost and fair value. For instance, property, plant, and equipment (PPE) is one of the asset classifications on the balance sheet that is currently stated at historical cost. Even so, there are two primary scenarios when a company may report assets in this category at fair value:
a) if management intends to sell the PPE, or
b) when an event has occurred that leads management to believe that the PPE will not be used for its intended purpose.
Areas of a balance sheet requiring fair value reporting include
- investments (primarily equity investments), and
- accounts receivable.
Other items qualify as financial instruments, but these three are by far the most common. Much of the accounting literature relating to fair value pertains to financial instruments.
Let the “Famous” CRI Team Help Guide Your Understanding of Financial Reporting
We expect fair value to be the more and more important to future accounting reporting models. If you need assistance with understanding and preparing for the transition to this type of reporting, then please contact CRI. We are more than happy to help!