Key Difference – Historical Cost vs Fair Value
Historical cost and fair value are two key methods of recording non-current assets and financial instruments. For non-current assets, companies have the discretion to use historical cost or fair value whereas financial instruments are generally recorded at fair value. The key difference between historical cost and fair value is that while the value of noncurrent assets is valued at the price spent to acquire the assets under historical cost, assets are shown at an estimate of the market value when using the fair value.
CONTENT:
1. Overview and Key Difference
2. What is Historical Cost
3. What is Fair Value
4. Side by Side Comparison – Historical Cost vs Fair Value
5. Summary
What is Historical Cost?
Historical cost is a measure of value used in accounting in which the price of an asset on the balance sheet is based on its original cost when acquired by the company. The historical-cost method is used for assets under Generally Accepted Accounting Principles (GAAP).
E.g. ABC Company bought a property including land and buildings for $200,250 in 1995. Its market value today approximately is $450,000. However, the company continues to show this asset at $200,250 in financial statements, which is its original value.
Irrespective of the measure used for subsequent measurement, all non-current assets should be initially recognised at cost. For noncurrent assets, the following costs also are included in its original value in accordance with IAS 16-Property, Plant and Equipment.
- Cost of site preparation
- Cost of installation
- Cost of shipping, transport and handling
- Professional fees for architects and engineers
Under the Historical Cost method, the asset is carried at the net book value (cost less accumulated depreciation)
Historical Cost method of recording assets is less complicated as the original asset value is not subjected to change, resulting in limited price volatility. However, this does not provide an accurate picture of the value of company assets as they are understated.
What is Fair Value?
This is the price at which a seller and a buyer can enter into a transaction under normal market conditions. All assets that are subjected to market fluctuations have a fair value. However fair value should be able to be measured reliably to record assets according to this method. Accounting treatment for fair value is governed by IFRS 13-fair value measurement. ‘Exit price’ is the price at which the asset can be sold off subjected to the market conditions. Considering the above example, ABC Company may decide to record the land and buildings at $450,000 in case the asset is valued at fair value.
According to this method, the non-current asset is carried at the fair value less depreciation. To practice this method, the fair value should be able to be measured reliably. If the company cannot derive at a reasonable fair value, the asset should be valued using the cost model in IAS 16, assuming that the resale value of the property is zero as stated in IAS 16.
Marketable financial instruments are held at fair value. These are very liquid in nature (can be easily converted into cash through the sale of the security); thus, should be recorded at fair value. Some examples of such securities are,
Treasury Bills
This is a short-term security issued by the government to fulfil short-term financing needs. Treasury bills do not carry interest, however, are issued at a discount to its original value.
Commercial Paper
Commercial paper is a short-term unsecured debt issued by a company usually with a maturity period ranging from 7 days to 1 year. This is typically issued to finance short-term debts of the company.
Certificate of Deposits (CDs)
CD is a security issued with a fixed interest rate and a fixed maturity period which can range from 7 days to 1 year.
When assets are valued at their fair value, this represents the current price at which they can be sold. This provides a more reliable value compared to using historical cost. However, calculating fair value has to be done regularly and is costly and time-consuming.
Figure_1: Commercial papers are commonly used marketable securities
What is the difference between Historical Cost and Fair Value?
Historical Cost vs Fair Value |
|
| Historical cost is the original price spent to acquire the asset. | Fair value is the price at which the asset can be sold in the market. |
| Accounting | |
| Guidance is available in IAS 16. | Guidance is available in IFRS 13. |
| Asset Value | |
| Historical cost is understated and obsolete | Fair value reflects the prices in line with current market value |
Summary – Historical Cost vs Fair Value
The difference between historical cost and fair value primarily depends on the accounting treatments. While the management has the discretion to select an appropriate method, they should be careful not to overstate the value of assets if fair value method is considered which will give assets an unrealistically high value. Even though the use of historical cost is a fairly straight forward method it does not reflect most recent value of the assets.
Reference:
1. “IAS Plus.” IAS 16 – Property, Plant and Equipment. N.p., n.d. Web. 16 Feb. 2017.
2. “IAS Plus.” IFRS 13 – Fair Value Measurement. N.p., n.d. Web. 16 Feb. 2017.
3. “Fair Value.” Investopedia. N.p., 21 Sept. 2016. Web. 16 Feb. 2017.
4. “Historical Cost.” Investopedia. N.p., 23 July 2015. Web. 16 Feb. 2017.
Image Courtesy:
1. “United States Commercial Paper 2001 to 2007 titles” By 84user – created using data from the United State’s Federal Reserve Board Commercial Paper – last released Friday, October 31, 2008 (Public Domain) via Commons Wikimedia
