Historical cost versus fair value – why sweat the difference?

Comments on recent remarks by IASB Chair Hans Hoogervorst

As we discussed here, a large chunk of the IASB’s recent proposals to amend the conceptual framework deals with measurement, stating: “consideration of the objective of financial reporting, the qualitative characteristics of useful financial information and the cost constraint is likely to result in the selection of different measurement bases for different assets, liabilities and items of income and expense.” The document describes the characteristics of historical cost and of current value measurement bases, noting some of their relative strengths and weaknesses, but mostly leaves it to individual standards to prescribe how these factors play out in specific circumstances.

In a recent speech titled “Historical cost and fair value are not as far apart as they may seem,” Hoogervorst summarizes the situation, noting: “The fans of historical cost like it for its alleged objectivity and relative stability. They dislike fair value for the volatility resulting from changes in market prices and for the subjectivity needed when fair values must be estimated, which is called mark-to-model valuations. They also tend to believe that fair value accounting is more prone to abuse because of its allegedly subjective character when relying on model-based measurement.” He then sets out to explain “why I think the dichotomy between historical cost and fair value is not as stark as one would expect.” Here’s some of what he has to say:

  • “First of all, for many transactions, historical cost starts and ends with fair value (or values that come very close to it): the original purchase price and the selling price of an asset or liability. The dates of purchase and sale are when historical cost is most objective.
  • Secondly, despite its name, historical cost gets updated too, albeit less than fair value. The most common updating of historical cost is depreciating Property, Plant and Equipment, or PPE. Depreciation is an allocation of cost to reflect the consumption of an asset during its economic life. This is an assessment that is certainly not free from subjectivity.
  • Subjectivity in historical cost accounting is even more pronounced when an asset is deemed to be impaired and an estimate of its value-in-use needs to be made. That estimate is based on management’s estimates of future cash flows, which are certainly no less subjective than mark-to-model valuations. Because of this subjectivity, there is also room for abuse. Practice has shown many instances of ‘big bath’ impairments by new CEOs to bolster earnings in future years.
  • Thirdly, the alleged stability resulting from historical cost accounting can be extremely misleading. A classic example is the Savings and Loan, or S&L, crisis in the United States.
  • In the early Eighties, the S&L institutions were de facto bankrupted by a huge interest rate mismatch between their deposits and their outstanding loan portfolios. As Federal Reserve Chairman Paul Volcker increased interest rates dramatically, the S&L institutions had to pay a lot more interest on their deposits, while their interest income on long-term mortgages was largely fixed. Clearly, historical cost accounting did not show the full extent of the losses that were unavoidable. It gave a false portrayal of stability, which everybody knew to be untrue.
  • Finally, the stability of historical cost can be interrupted by steep cliff effects. Because measurement updates are less frequent and comprehensive, a creeping erosion of the balance sheet may remain unseen for a very long time. When problems finally erupt, they tend to do so with a vengeance. The stability of historical cost then turns into serious convulsions.
  • In conclusion, historical cost is to some extent based on fair value; it needs a degree of current measurement to maintain its relevance, it is not free from subjective updating requirements; and it is not necessarily stable. Moreover, historical cost is also vulnerable to abuse. In sum, all the vulnerabilities that are often attributed to fair value accounting can be equally pertinent to historical cost accounting.”

The intention of all this though isn’t to bury historical cost accounting, as the direction of the remarks might have led you to expect, mainly because “the current market price of many assets is not of primary importance if such assets are being used in combination with other assets to produce goods or services. For example, it may not be extremely relevant to know the present market value of the robots of a car manufacturer if the company intends to keep them to produce cars.” There’s also, of course, the old hang-up that “an entity’s performance could be clouded” by certain kinds of fair value measurement adjustments. But all this doesn’t amount to much of a case that historical cost would be actively worse than fair value in certain circumstances, only that its inferiority is plainer for some items than for others.

Historical cost and fair value are not as far apart as they may seem? Well, neither are circles and squares. Of course, sometimes, if you’re building a wheel for instance, one is probably superior to the other. But for other purposes, such as designing a coffee table, a few corners here and there may not be of primary importance, as long as you avoid tearing your leg on them. And, for another matter, day and night aren’t so far apart either, especially if you put yourself in a dark room and squint. You know, sometimes it’s a mark of leadership to find common ground. And sometimes it’s merely a mark of stagnation. Perhaps those two states, likewise, are not as far apart as they seem…

The opinions expressed are solely those of the author

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