Fair value measurements applied in the US

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The recent financial crisis has led to a vigorous debate regarding the Fair Value Accounting FVA. Fair value measurements have been extensively applied in the US Generally Accepted Accounting Principles and International Financial Reporting Standards. This debate has managed to highlight the pros and cons of Fair Value Accounting and its principles. In recent years, FASB and IASB have intensified research on fair value measurements and planned to further expand the scope of applicability of fair value measurements. However, organizations responsible for formulating the principles, enterprises, social bodies and academia are locked in a dispute over the advantages and disadvantages of fair value measurements, and no consensus has been reached yet.

However, there has been much discussion about fair value accounting. Disclosing assets at their fair value as opposed to their historical cost is preferred by some but opposed by others. The use of fair value accounting has been around for decades primarily for financial assets. There are many issues involved with fair value accounting. Some argue that fair value is beneficial to investors when they are trying to evaluate risk, return and valuation of a business. If a company marks to market, does it not give an investor a better understanding of that company's current value? Some may say that this method can help the company in times of economic trouble and credit problems, and others feel that it is merely a band-aid on a wound that needs stitches. To some people, it is a problem to have to interpret financial statements to understand what is listed at fair value and what is listed at historical cost. Switching to one method would mean that there would be no more implementing both methods for different assets. Would that more truthfully represent a company? Would this valuation system be beneficial to banks lending money to these companies?

The historical cost principle follows the accounting quality of reliability since everyone can agree on the original purchase price of an asset. However, the historical price is not necessarily relevant information. Land that was purchased 20 years ago could be worth much more than the balance sheet shows. Likewise a building purchased many years ago and recorded on the balance sheet at the original cost does not reflect the current market price.

For this reason, many accountants and users of financial statements argue that the market price or fair value should be used when reporting financial information. The fair value is more relevant, but is not necessarily reliable. Selling the same item at different auctions will lead to a wide range of winning bids for the same item, and even professional appraisers will value an asset at a range of prices instead of a set value.

Differences can involve the future use of the asset, assumptions about its useful life and output, and opinions and professional judgments that result in a range of values for an asset. Like other professions, professional appraisers balance opinions and judgments with verifiable data. So although the market price or fair value of an asset may be more relevant, it is less reliable.

According to GAAP, assets and liabilities have been recording through historical cost accounting: a system where assets and liabilities are recorded and presented at the monetary amount paid or the consideration given at the time of their acquisition. This is so conventional method that people are familiar working with it. But it possess some strong flaws in context of the contemporary business environment which have made accounting bodies, especially FASB & IASB, to search for a number of alternative accounting methods. One of these alternatives is market (fair) value accounting that has been thinking as the best alternative to the historical cost accounting. The market value of an asset is the amount at which that asset could be bought or sold (incurred or settled) in a current transaction between willing parties. The strongest argument for a move to market value accounting is that investors need to know what an asset is currently worth is rather than is worth when it was acquired. However, the supporters of historical cost have strongly disagreed with this movement to market value accounting. Therefore, there is an ongoing debate between historical cost and market value accounting.

Conceptual Framework:

This paper explores the arguments for and against historical cost and market value; and tries to find out whether market value is superior to historical cost. The dissertation will also analyze accounting issues, like the trade-off between relevance and reliability. There are several other issues regarding fair value and historic cost accounting. These are shown in Fig.1 where other issues impact is described. Standard setters and the government will always face these issues i.e. cost and benefits when deciding on setting a specific accounting standard. Therefore, it would be necessary to evaluate whether fair value accounting or historic cost accounting is relevant or reliable. However, this dissertation will only consider the issue regarding the Relevance and Reliability of fair value and historic cost accounting methods.

Fig.1 A comparison of Fair value and Historic cost accounting regarding different issues


Historical Cost Accounting

Fair Value Accounting

Relevance and


The reliability of the reported

values is arguably more important

than any lack of relevance of

Historical cost figures. Historical

costs based on ad hoc allocations

may be irrelevant.

The relevance of fair value

estimates arguably compensates

for any lack of reliability. Fair value

estimates based on inactive

markets may prove to be unreliable.


Conservatism results in early

recognition of losses and a higher

threshold of verification for

reporting gains, potentially leading

to credible earnings numbers.

However, the voluntary nature of

asset impairment write-downs has

sometimes resulted in more

aggressive accounting practices

Fair value approach is expected to

result in more symmetric

recognition of gains and losses.

Ideally, the symmetric recognition

should maintain (and possibly

improve) the conservatism in loss

recognition, but could lower the

verification standards for gain




Earnings are measured at discrete

points when the revenue

recognition criteria are met, using

the matching principle to measure


Earnings could be measured more

continually, based on changes in the economic values of rights and





Historical cost system selectively

records certain rights and

obligations based on observable

historical costs.

Ideally, a fair value accounting

system would impose discipline on

the corporation and its accountants

to identify, measure, and disclose

all the rights and obligations that

are embedded in complex business



Historical cost system reports

arms' length historical transaction

prices. However, subsequent

measurements may be based on

ad hoc allocations.

Reported values in fair value

accounting may range from market

prices in actively traded markets to

values based on valuation

techniques such as DCF and option

pricing models.



It is sometimes argued that the

historical cost system focuses

more on the income statement

with the balance sheet being

relegated as a holding place.

The fair value model being

developed is balance sheet

focused, with limited discussion of

income statement reporting.

There are also some areas of Fair Value accounting that will not be analysed in this dissertation. The areas which will not be taking into consideration are the following;

Treatment of differences between USGAAP and IFRS fair value.

Disclosure requirements

IFRS treatment of future premiums

USGAAP treatment of "Service Contracts"

"market" assumptions

Credit adjustment for liabilities at fair value

Incorporating adequate controls

Management communication (communicating results with management)

China's view on Fair Value Accounting

Methods which are not analyzed in this dissertation

This dissertation also does not analyze any subjective form of Fair Value Accounting. "Adjusted" fair value method is valuing assets according to the "average" market practices. Temporary phenomena such as excessive volatility, market illiquidity are thus averaged out. This brings some more stability to the accounts, but then they depend on assumptions and estimates that might be flawed.

Fundamental value (mark to model)

This method uses the present value (discounting projected cash flows).

This takes indirectly into account not only physical assets but also the estimated economic goodwill.  There also could be controversies about the assumptions and criteria used in the model and the subjectivity of the cash flow projections.

Market-based valuation (or relative valuation)

This method is using comparative market criteria (Price / earnings, yield...) with assets that are seen as similar. But what is really similar?

Potential structural market value

This is a method that takes into account the fundamental value (see above) and adjusts it  with average market behaviour criteria (see stock image).This also depends of estimates that might be controversial.

Data Analysis:

The data analysis technique that is applied is hermeneutical analysis because the paper is not going give my views to the reader but it will look at academic texts and apply them to the companies. The difference will be highlighted and the inconsistencies will be brought to the reader's attention. The main aim of the dissertation is not to make the reader believe what I believe but to make the reader aware of the actual situation, leaving the reader to decide what to believe. It will include analytical induction analysis, giving the best method for measuring child labour impact in most cases. Data mining technique will be use to transform Data into information. Data mining will be use to uncover patterns in data, but will be carried out on samples of data (Secondary Research).

Secondary research will be carried out before the primary research, because it will help me establish what is already known about a subject, before starting my own investigation.

The dissertation will be a mixture of both Consultancy-based and Library-based activities.

Data Sources:

The sources of data used are: Internet, academic journals, company websites, company accounts, different accounting methods for environmental costing, Books, theories and models.

Literature review:

The debate between historical cost & market value accounting is ongoing and will not end soon. Because clients of historical cost accounting argue that it is a best measure than fair value accounting by identifying the flaws of market value. In contrast, proponents of fair value accounting argue that historical cost accounting is meaningless in today's complex business environment due to its several significant limitations and they think that market value is the best approach to replace traditional historical cost accounting.

Against HCA:

Christian (2009) suggests that historic cost accounting has a set of problems worse, than the problems with the fair value accounting. Christian (2009) argues that the historical cost model lacks of transparency and do not reflect the current value of an asset either. The strongest argument against historical cost accounting is it does not provide information that irrelevant to investors. Critics have pointed out the following significant flaws & disadvantages in historical cost accounting: Historical Cost Accounting values can relate to transactions that could be a year old or 10 years old. So, the acquisition value may be out of date and thus balance sheet represents out of date values.(Williamson: 2003) Historical cost accounting is only interested in cost allocation and not in the value of an asset. So, it discloses the acquisition cost of an asset and its depreciation in the following year, but ignores the possibility that the current market value of the asset may be higher or lower than the disclosed amount.

Historical Cost Accounting has also flaw in terms of inflation. It is based on the assumption that the purchasing power remains same over a period of time. But in reality, an asset purchased at the current point of time may be more expensive in future due to inflation. Historical cost financial statements are unadjusted for this inflation. As a result, in the time of high inflation, profits are inflated and thus the tax bill tends to increase. Hague and Willis (1999) argue, when an entity's financial instruments are concerned, the historical cost prices reflect both new and old interest rate and an out of date assessment of the amounts, timing & uncertainty of future cash flows. Intangible assets acquired outside of business combination (internally generated e.g. Goodwill) are not reported in historical financial statements.

Historic cost accounting measure assets in the balance sheet by reference to their original cost and liabilities are entered at their monetary value irrespective of when the debt is due to be repaid. From this point of view Niall (1993) argues that the problem caused by historic cost accounting arises because costs and values may change between the time of original purchase and the time of sale of the finished goods. The concept of continuity requires that the stock of raw materials used in production will be replaced and new fixed assets will be purchased when the old ones expired. Nail (1993) argues that this process requirement makes historic cost accounting so misleading in the time of inflation.

Shim & Larkin (1998) show the deficiencies of historical cost financial statements through this illustration: A company reports its inventory on the balance sheet at a historical cost of $ 10,000. The fair market value (FMV) of this inventory may be is only $7,000. On the other hand, a corresponding current account payable of $10,000 appears as a liability on the credit side of the balance sheet. It is likely that the "FMV" of the liability is at or near $10,000. From an historical cost perspective, the debit balance (Inventory) and the credit balance (accounts payable) are offsetting. However, from a market value perspective, the debit balance of $7,000 (inventory) is less than the offsetting credit balance (accounts payable) of $10,000.


Despite of having several limitations & flaws in historical cost accounting, its patrons still think it as the standard form of accounting due to its several unique features and conventions. They believe that historical-cost financial statements are more reliable than market value statements. The supporters of historical cost accounting think it possess the following unique advantages:

As historical cost accounting is based on actual transactions, the recorded amounts are reliable and

verifiable and free from management bias.

Historical cost accounting leads to absolute certainty and it fits in perfectly with the cash flow statement. It tells exactly what has been paid or received and therefore there is no doubt about balance sheet amounts. Williamson (2003) argues that historical cost helps the managers to forecast future operational cost based on past data. Without knowing the original cost, future projections are almost hampered.

Under historical cost accounting, there is no scope for manipulation, because the data is supported by sufficient evidences such as: invoices, receipts etc. For fixed interest debt, historical cost accounting measures financial instruments at its issuance yield to maturity over its life, regardless of market yield movements. This constant yield to maturity approach produces a smooth and predictable interest cost or return outcome and valuation.

Against FCA

The market value dissenters argue that the information provided by market value financial statements is unreliable; because it is not based on arm's length transactions & there is a huge possibility for management to manipulate the bottom line. They contend that if the information is unreliable, it should not be used to make financial decisions. Yuko and Tatsuya (1998) are concerned that the precipitous adoption of market value accounting will have adverse effect on both banks and the financial system as a whole. They believe that earnings based on market values for investment securities are likely to be more volatile than those based on historical cost.

Critics have pointed out the following flaws of market value accounting:

Ramanna and Watts (2007) argues that market values are basically based on unverifiable subjective estimates of managers. Agency theory suggests that managers will take advantage of this unverifiability to manage financial reports in order to extract rents.

Short ridge et al (2006) recommend that it is important to develop reliable methods for measuring market value in order to increase the reliability and credibility of investors in the information reported in financial statements are too critical, especially in the light of recent scandals in financial reporting.

Jackson (2000) suggests that when quoted market price for an asset or liability is not available, the market value based measurement could be estimated by using the best information and techniques available in the circumstances. But most often difficulties occur when making estimates of market value by using inappropriate models like cash-in method or using appropriate models inappropriately, e.g., using assumption that doesn't reflect the risk in the underlying asset.

Although market value is able to provide relevant and reliable measures of impairments of an asset or a liability, it can't provide the same relevant & reliability in case of measuring the appreciation.

Valuing tangible and intangible assets at market value is extremely difficult and time consuming. Some one who accepts the market value for balance sheet measurement of financial instruments has faced greater difficulty in accepting the performance reporting effects. (Hague: 1999)

Although historical cost accounting has some distinguishing features for which its patrons think it better method for measuring assets and liabilities, it can't provide relevant information to investors. Market value accounting can able to eliminate this limitation by providing current and inflation adjusted information to investors. Therefore, market value is the best alternative to historical cost. But there are also several significant problems within market value accounting in its current application which make more users reluctant to use market value in measuring assets and liabilities.

As investors are the major users of financial statements, priority should be given to their wants, that is, which measurement they prefer- historical cost or market value. Empirical evidences show that investors want both measurements. They want reliable and transparent market value information to determine the actual value of their investment. They also want historical cost information that helps them to determine whether management has discharged the stewardship entrusted to them. Therefore, assets and liabilities should be measured and reported at market value and these measurements must be reliable, verifiable &transparent and these measurements should not be at the cost of abandoning historical cost information.

A process can be created and implemented whereby historical cost and market value information is reported side by side, which will enhance relevance, reliability and comparability. In addition, some actions should be taken to eliminate the current limitations in market value accounting. These may be:

Establish more robust accounting, valuation and auditing guidance.

Provide more education to preparers, auditors and users about market value accounting.

Therefore, it will not be good for any one if the debate between the two approaches will be ongoing. Rather, Focus should be given to implement market value accounting in reporting all assets or liabilities to reflect their true value without eliminating historical cost accounting

It has been argued that fair value accounting information is more relevant but less reliable then the historic cost model. Benzon and Joshua (2003) argue that historic cost accounting based financial statements obscure real financial position and the results of operations of a firm provide ample room for manipulation. Benzen and Joshua (2003) furthered criticize by suggesting that the historical book value of assets and liabilities has only a remote association with market values. This situation will permit the management to manipulate reported earnings ad hide their lack of accomplishments. This shows that in Benzon and Joshua opinion the historic cost accounting is less relevant then the fair value accounting method.


Scenario 1

Company XYZ purchase land for $220,000

The market price of the land is $260.000

Company XYZ can sell this land for $310,000 Less $20,000 (Legal Fees)

Comparable land sales data:

13,000 sq ft

Avg Sale Price= $21.55 per sq ft

Low sale price= $20.06 per sq ft

High sale price= $24.78 per sq ft

From the above data, the company XYZ could report the land on their balance sheet by using four different cost accounting methods.

Replacement cost method:

If the company use the replacement cost then it would show the value of $260,000.

Net Realisable value:

Under this method the company XYZ would show the value of $290,000.

Historical cost method:

Under this method the cost would be shown at the value of $220,000.

Fair Value accounting method:

Under this method the cost would be shown at the value of $280,150.

Companies valuations:


Basis of financial statements:

The financial statements have been prepared in accordance with applicable accounting standards, under the historical cost convention, and are in accordance with the Companies Act 1985.


Stocks comprise goods held for resale and development properties and are valued at the lower of cost and net realisable value. Stocks in stores are calculated at retail prices and reduced by appropriate margins to the lower of cost and net realisable value.

Money market investment:

Money market investments are stated at cost. All income from these investments is included in the profit and loss account as interest receivable and similar income.


Plant, equipment and fixtures and fittings which are the subject of finance leases are dealt with in the financial statements as tangible assets and equivalent liabilities at what would otherwise have been the cost of outright purchase.


The expected cost of pensions in respect of the group's defined benefit pension scheme is charged to the profit and loss account over the working lifetimes of employees in the scheme. Actuarial surpluses and deficits are spread over the expected remaining working lifetimes of employees. 


Assets and liabilities in foreign currencies are translated into sterling at the financial year end exchange rates. Profits and losses of overseas subsidiaries are translated into sterling at average rates of exchange.


Derivative financial instruments are recognised and stated at fair value. The fair value of derivative financial instruments is determined by reference to market values for similar financial instruments, by discounted cash flows or by the use of option valuation models. Where derivative do not qualify for hedge accounting, any gains or losses on remeasurement are immediately recognised in the profit and loss account.

British Airways:

Basis of Financial Statements:

These financial statements have been prepared on a historical cost convention except for certain financial assets and liabilities, including derivative financial instruments and available-for-sale financial assets that are measured at fair value. The carrying value of recognised assets and liabilities that are subject to fair value hedges are adjusted to record changes in the fair values attributable to the risks that are being hedged.


Inventories, including aircraft expendables, are valued at the lower of cost and net realisable value. Such cost is determined by weighted average cost method.

Derivatives and financial instruments:

Under IAS 39 'Financial Instruments - Recognition and Measurement', financial instruments are recorded initially at fair value. Subsequent measurement of those instruments at the balance sheet date reflects the designation of the financial instrument. The Group determines the classification at initial recognition and re-evaluates this designation at each year end except for those financial instruments measured at fair value through the income statement.

Other investments (other than interests in associates) are designated as available-for-sale financial assets and are recorded at fair value.