Why historical cost accounting makes sense

Strategic Finance, August, 2008 by Tim Krumwiede

ALLOCATION OF FAIR VALUE

As a practical matter, it would seem unusual for cash flows to be measured on an asset-by-asset basis. It's more common that cash flows are measured for a group of assets related to the production of one or more products. Furthermore, given the externalities from joint and common production, separation of the cash flows isn't conceptually possible. Accordingly, a DCF approach in the measurement of fair value requires grouping assets together. Once the fair value for an asset group is determined, an allocation of the asset group's fair value to various assets within the group could prove challenging.

To illustrate practical considerations, let's look at a manufacturing operation that includes property, plant, equipment, and intangible assets. Measurement of the fair value for each individual asset or asset category isn't always practical or possible. For example, a company may tailor and modify equipment and machinery to meet specific manufacturing needs. In addition, robots used in the manufacturing process are typically programmed for specific purposes. Once a company has modified these assets and used them for several years, it's probable that no market observations exist for identical or similar assets. Furthermore, market values for intangible assets are generally not available. Even if market values are available for some assets in a group, a DCF approach may be necessary to measure the fair value of the asset group because market values aren't available for other assets in the group. Consequently, DCF will often become a necessary valuation technique for a group of assets, and allocation of estimated fair values among asset categories will be necessary.

In addition to the subjectivity in determining a value for a group of assets, allocating a fair value measurement to assets within a group of assets is an inherently subjective process. This use of judgment could provide opportunistic or dishonest management a chance to manipulate earnings. For example, assume a company allocates a fair value measurement between assets that aren't subject to cost recovery (land and certain intangible assets) and assets subject to cost recovery. If the subjective allocation results in an understatement of values assigned to assets subject to cost recovery, future depreciation and amortization will be lower than it should be, resulting in increased future earnings.

Similar concerns can arise with goodwill. Conceptually, the estimated fair value of goodwill is a residual value--the difference between the fair value of a reporting unit and the fair value of the identifiable net assets of the reporting unit. The identifiable assets and goodwill, however, work in tandem to produce cash flows. Thus, if a company uses a DCF model to estimate fair value of a reporting unit, how easily can the fair value be separated between the goodwill and the identifiable net assets? If reliable market observations are available to measure fair value of most assets and liabilities, the subjectivity in the process can be mitigated; as a practical matter, however, reliable market observations for identical assets and liabilities won't be available. Hence, the allocation will require significant judgment. It would seem that the allocation would be especially problematic for an entity with a significant number of intangible assets other than goodwill.