Exploring Concerns over the historical cost measurement

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The recent unprecedented explosion in corporations has raised question on whether the use of historical cost measurement in the preparation of financial statement continue relevance and represent best estimate of reporting entity as a going concern Company. Pressure from various users of financial statements have brought about immense challenges to accounting standard setters to develop newer standards, principles, methodologies, tools and practices in the area of accounting especially on fair value measurement. In recent years, it is arguably that the International Accounting Standards Board (IASB), an accounting standard setter increasingly favours the use of fair value measurement. This is evidenced by introduction of fair value measurement on assets which later on extended to fair value measurement on both liabilities and equities. Therefore, this paper meant to explain the concept of fair value, examine the extent of fair value measurement versus historical cost measurement in a financial reporting, and outline the arguments for and arguments against fair value as compared to historical cost. The paper concluded with other issues and challenges in implementation of fair value measurement system.

The concept of fair value first appears under IAS 16 Accounting for Property, Plant and Equipment 1982 which defined it as 'the amount for which an asset could be exchanged between a knowledgeable, willing buyer and knowledgeable, willing seller in an arm's length transaction' (IAS 16, 1982). Subsequently, similar definition is extended to fair value for other assets classification. Besides that, the term 'buyer' and 'seller' are replaced with a more generic term called 'parties'. The IASC and IASB then further the fair value definition to financial assets, intangible assets, liabilities and equity instruments, which concluded the definition of fair value as 'the amount for which an asset could be exchanged, a liability settled or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm's length transaction' (IFRS 2.A). Under the SFAS 157, fair value is defined 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' (SFAS157, 5). Therefore, fair value equates the exit price. Based on David Cairns 2006, fair value measurement is a hierarchy divided into three layers. The top layer is fair value measurement based quoted price in active markets. If this is not available, the next alternative or the second layer is to use observable market prices for similar assets or liabilities. Otherwise, the third layer is to use other valuation techniques to calculate fair value of assets or liabilities. When markets are relatively perfect, fair value measurement arguably adds value to financial statements by providing the current market prices. However, during the financial crisis, fair value measurement arguably triggers further price fall. This is due to mark-to-market accounting results in huge impact to the income statement which may results in collapse in market confidences and that impact on the global financial system as a whole. Despite the fact, there is no single universal standard that is bullet-proof. Hence, it will be more appropriate to define a clear objective and choose a measurement method that best met the objective (Whittington, G. 2008).

According to the IASB Framework for the Preparation and Presentation of Financial Statements, the objective of financial statement is 'to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions' (IASB Framework, paragraph 12). In an effort to create a global accounting standards FASB and IASB then jointly developed a conceptual framework which defined 'the objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful in making decisions about providing resources to the entity and in assessing whether the management and the governing board of that entity have made efficient or effective use of the resources provided' (IASB Exposure Draft 2010, paragraph RE1). In short, the conceptual framework spells out two main objectives of financial statements: 1) to provide information useful for economic decision making and 2) to assess management's stewardship. Based on IASB Framework paragraph 24, information useful for economic decision making must comprise four qualitative characteristics which are relevance, reliability, understandability and comparability. Measurement method, being fair value or historical cost, whichever best met these characteristics and in turn meet the objectives of financial statement considered a more superior measurement technique.

First of all, 'relevance' criteria arguably achieved through use of fair value in measuring assets and liabilities in the financial statement. Fair value reflects the current economic conditions which becomes increasingly useful in the current rapid changing environment. In recent years, there is sharp increase in property market especially in Asia. Based on the Global Property Guide Index, Singapore's property index raised drastically despite government efforts to stabilize the market. The prices of landed properties rose by a 6.2% recorded in Q2 2010 and again 7.7% in Q3 2010 after. Therefore, if property continued to value at historical costs less depreciation, the net book value presented in the accounts become irrelevant for decision making as the book value varies significantly to its current market value. On the contrary, fair values do capture the market price at any measurement date which is relevance for economic decision making. Back to the definition by IASB Framework for the Preparation and Presentation of Financial Statements, relevance is 'when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations' (IASB Framework, paragraph 26). Information relevance is affected by its nature, materiality and timeliness (IASB Framework paragraphs 29, 30 and 43). Hence, eventhough fair value measurement is preferred in terms of 'relevance' criteria, the materiality and timeliness of information need to be considered too. For instance, if using fair value measurement takes a long time to figure out, then historical cost obviously would be preferred because by the time information obtained, it may not serve the current market value. In terms of 'materiality' where assets or liabilities have minimal price changes throughout years, it is easier to use historical cost measurement as it assumes the fair value measurement due to immaterial difference.

Another important characteristic to the content in financial information is 'reliability'. It is arguably that historical cost measurement is more reliable simply because it has been long established and that become a tradition for cost measurement. It is also arguably that historical cost is more objective and comprehensive which makes it easier for accountants to apply and for auditors to verify. On the contrary, fair value is more subjective and complicated, especially when judgement is required in determining the fair value of an asset or liability. The IASB Framework states that reliability comprises faithful representation, prudence, substance over form, neutrality and completeness (IASB, paragraph 13). Fair value supporters argue that fair value measurement represents faithful representation as assets or liabilities are quoted in a common market place, which is known to everyone. However, the level of information available to Companies or Industries may vary. Also, in real world phenomena, many assets and liabilities are not quoted in active market. Therefore, when valuation technique such as present value of future cash flow is used to determine fair value of asset or liabilities, it involves certain degree of estimation and judgement which subject to management discretion and auditors acceptance. Hence, it is argued that unless the assets or liabilities are quoted in active market, historical cost measurement is a preferred option. In terms of prudence concept, where the market value of asset or liability is more than its carrying value, historical cost captured it at cost but fair value capture it a market price (revaluation upwards). However, when carrying value is less than its market value, impairment recognised both under historical costs and fair value measurement. Therefore, it is arguably that historical cost measurement greater upholds the prudence concept.

Other important characteristics in presentation of financial information are understandability and comparability. Understandability enhanced through clearly aggregated and classified information which allows useful decision making to users of financial statement. Cost-based measurement arguably easy to understand as compared to fair value measurement which incorporates certain level of complexity and to an extent creates confusion. It is arguably that preparer of financial statement prefers historical cost measurement where applicable. For instance, IAS 16 Property, Plant and Equipment and IAS 40 Investment Properties allows option for revaluation of non-current assets to fair values but yet, many corporations are still using historical costs less depreciations. Fair value school of taught disputed this by proving that certain types of financial instruments can only be measured at fair values, i.e. the IAS39 Financial Instruments. Fair value supporters also argue that real world phenomena somehow incorporate inherent complexity and if these complex information are excluded from the financial statement, it hindrance completeness of information which then leads to misleading financial report. Therefore, the FASB Conceptual Framework states that 'Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information with diligence' (F QC30-QC32). On the other hand, comparability enhanced through consistent measurement and presentation of accounting information. Any changes in the accounting policies need to be disclosed and corresponding information for proceeding periods should be restated using the new policy, regardless of whether it is using fair value or historical cost measurement. Fair value arguably allows comparability across companies in different industries. Regardless of when assets or liabilities are acquired, they are valued at the market price at measurement date. For example, a manufacturing company bought 1000 shares of XYZ at £6 while a logistic company bought the same number of shares of XYZ at £8. At the end of the year assuming both these companies has the same financial year end, they both reflects investment at current market price, say at £9 each. However, if historical cost applied, manufacturing company will capture the investment at £6 each and the logistic company records its investment at £8. Therefore, fair value arguably allows comparisons but some opponents argue that fair value measurement disturb to the original benchmark which restrict comparison to initial purchase price. The counter argument is that if fair value is applied consistently, it can be benchmark against prior year's price level which is more appropriate because it truly reflect the gains or loss from price change in the reporting period.

Besides providing relevance, reliable, understandable, and comparable information, another main objective of financial statements is to assess management stewardship. It is arguably that fair value measurement makes it more difficult for the stakeholders to assess whether management has used the resources available to them efficiently and effectively. This is because fair value recognises gain or loss from external price change in the income statement, mixed with the internally generated trading profits or losses. As a result, it creates volatility in the income statement. Historical cost proponent argues that management stewardship should be judge based on internal factors only and not external factors as the external environment is beyond management control. However, the fair value group disputed that by saying if management made a decision to purchase (say an assets) which devalue in future, it shows poor management stewardship. Hence, it is the arguably that with recent introduction and implementation of Statement of Comprehensive Income which records the change in market prices separately from the internally generated profits, it is easier for stakeholders to judge management stewardship under fair value measurement. On the other hand, fair value arguably forces management to make real economic decision. Historically using cost-based measurement, accounts are subject to manipulation. For example, management may delay income earnings through income smoothing or bring forward future losses through provisions. However, IAS37 Provisions, Contingent Liabilities and Contingent Assets states that only specific provision is allowed. In the case of provision for doubtful debts, company must able to identify specific debtors whom expected to default or otherwise, no general provision for doubtful debts is permitted. With fair value measurement, assets or liabilities are captured at market prices which considered unbiased measure not subject to policies manipulation. It then forces management to make real economic decisions on whether to acquire, hold or dispose assets or to incur, owe or settle liabilities. However, the downside effect for use of fair value measurement is it encourages short sighted profits and ignores long term benefits which may results in loss of opportunities.

In conclusion, introduction of fair value measurement in the financial statements creates alternative and improvement to traditional cost accounting. It serves to achieve the duo objectives of financial statement which is providing useful information and assessment of management stewardship. The main criticism of fair value measurement is that it is too theoretical and academic to be of significant practical use. However, it is argues that in the long-term the quality financial information will improve with clearer guidelines and greater consistency. There has been further criticism recently that the IASB is pushing through an agenda which is detrimental to and against the wishes of commerce and industry. The IASB however believe that they have progressed with the general acceptance and co-operation of the financial community. The focus of financial statement is to provide useful information through mainly the balance sheet, income statement and cash flows statement particularly to investors, as providers of risk capital whom need relevant, reliable, understandable and comparable information to assess the inherent risks and potential return on their investments. Fair value measurement undoubtedly enhanced relevance of information through presenting up-to-date, predictive and confirmatory information which influences economic decisions. On the other hand, cost-based measurement proved reliability through faithful representation and prudent information which is free from material error and reflect true and fair view. In the current dynamic environment, a shift to fair value measurement is deemed more appropriate. The standard setter such as IASB has shift to focus to fair value measurement with recent development and introduction of fair value measurement standards. One of them are IAS 1 Presentation of Financial Statements - in order to minimise the volatility of profits as a result of price (from adoption of fair value measurement), IASB introduced 'other comprehensive income' which is at the bottom of a single performance statement of comprehensive income (or the income statement) to record any changes in fair value- separated from the ordinary trading profit or loss. This allows assessment of management stewardships through separating internally generated profits against external price change. After all, the implementation and adoption of fair value systems must be measured in terms of the costs versus benefits. In addition, it is assumingly straight forward when prices of assets and liabilities are quoted in an active market. Otherwise, for illiquid assets or liabilities where no active market in place, subjectivity came into play. Therefore, unless assets and liabilities prices are quoted in active market and that benefits outweigh costs, it appeals as challenges to standard setters to implement full fair value measurement systems.