Why historical cost accounting makes sense

Strategic Finance, August, 2008 by Tim Krumwiede

As the Financial Accounting Standards Board (FASB) continues to march toward fair value accounting and away from historical cost accounting, it's a good time to consider the flaws of fair value accounting. Enron's demise, after all, has been partially blamed on fair value accounting. In addition, it has been suggested that the use of fair value accounting for securities backed by subprime loans has exacerbated the current credit crises. The difference between historical cost accounting and fair value accounting? In many cases, only historical cost accounting produces reliable, verifiable information.

At the crux of the raging debate are reliability and relevance--the two cornerstones of financial reporting. Those opposed to fair value accounting believe it provides unreliable information. Proponents of fair value reporting, however, believe it provides more timely and relevant information despite its increased use of estimates and judgments.

Undoubtedly, financial information must contain varying degrees of relevance and reliability to be useful. These two attributes are the primary focus of this article, which will tackle the potential expanded application of fair value measurements to long-lived and intangible assets. Although the focus will be on long-lived and intangible assets, we can easily extend the points made to analyze other applications of fair value accounting. Rounding out the article will be a look at the direction of the FASB, a comprehensive fair value model, fair value measurements and allocation, the criticisms, and how investment analysts use financial statements.

TOWARD FAIR VALUE ACCOUNTING

Generally, long-term and intangible assets are reported on a balance sheet at historical cost or historical cost adjusted for depreciation or amortization. Exceptions, however, exist under Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets," and SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," for impaired assets. These Standards require impaired assets to be measured at and written down to fair value. More recent guidance issued by the FASB suggests fair value accounting could be further extended to long-lived and intangible assets.

To establish clear, consistent guidelines for fair value measurements and provide for fair value disclosures, the FASB issued SFAS No. 157, "Fair Value Measurements," in September 2006. On the heels of this Statement was SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities." Although this Standard didn't extend to nonfinancial assets and liabilities, the Board suggests in the background information for Statement No. 159 that it will continue to consider additional fair value elections.

This progression toward fair value is also evident in the Exposure Draft on the conceptual framework that the FASB issued on May 29, 2008 ("Conceptual Framework for Financial Reporting: The Objective of Financial Reporting and Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information"). In general, the exposure draft appears to emphasize the balance sheet instead of the income statement, which ultimately implies the extended use of fair value measurements. This emphasis differs from a more traditional view the FASB expressed in Statement of Financial Accounting Concepts (SFAC) No. 1, "Objectives of Financial Reporting by Business Enterprises," issued in 1978:

  The primary focus of financial reporting is information about
  earnings and its components. Financial accounting is not designed to
  measure directly the value of a business enterprise, but the
  information it provides may be helpful to those who wish to estimate
  its value. (Paragraph 3)

This view from SFAC No. 1 is consistent with the view that the traditional income-statement approach should be emphasized. The income-statement approach uses historical cost accounting and a transaction approach that minimizes the use of estimates and judgments. This traditional approach, which companies have used for several hundred years, provides information that has a sufficient level of reliability and is verifiable. On the other hand, a balance-sheet approach, which potentially would incorporate an extended use of fair value measurements that often aren't grounded in market observations, can result in information that is potentially unreliable and not easily verified. Think Enron here.

A COMPREHENSIVE FAIR VALUE MODEL

The most unyielding proponents of fair value accounting would be in favor of extending it to all assets and liabilities. In such a model, the income statement could simply represent the changes in the values of an entity's assets and liabilities during a period to the extent the changes aren't attributable to transactions with owners (for example, payment of dividends and capital contributions).

Consider Company A with $500 in operating assets and $400 in long-term debt originally borrowed to finance the operating assets. Assume that poor economic conditions result in a reduction in the future utility and fair value of the operating assets. At year-end, the fair value of the assets is estimated to be $200. Now assume the same conditions decrease the creditworthiness of the company and thus the fair value of its long-term debt. Assume the long-term debt has a market value of $300 at year-end. In summary, the assets have decreased in value by $300, and the liabilities have decreased in value by $100. The decrease to equity from the fair value measurements is the net of the two, or $200.