Historical Cost Vs. Current Cost: Accountants Wrestle with Reporting Question

One of the foundations of American accounting is the so-called Historical Basis approach, under which assets are presented on the balance sheet at their value at the time of acquisition (generally represented by the purchase cost). But in an era marked by the widespread use of complicated financial instruments and risk management strategies that may render yesterday’s prices obsolete, some people are asking if historical cost should be abandoned or modified, and replaced by a current-cost system. It could lead to more accurate financial reporting. Or it could lead to chaos.

The issue has become more pressing recently because the Financial Accounting Standards Board is slowly modernizing Generally Accepted Accounting Principles (GAAP). In doing so, the industry’s standard-bearer may make financial statements more meaningful and, as a side effect, may help to bring America’s books in line with international standards. But FASB is finding that it’s caught between a rock and a hard place: Even as some users of financial statements clamor for changes, others say that instead of achieving greater clarity, FASB’s moves could spark new problems.

Here’s why. Under the historical cost doctrine, assets are generally carried on the balance sheet at their acquisition cost (adjusted for depreciation and, in some cases, impairment), and liabilities are usually carried at the prices at which they were incurred. For many years this model, which reflects the profession’s traditionally conservative approach, was sufficient.

In recent years, however, some accountants as well as investors and others who use financial statements have questioned this approach, asking if accuracy would be better achieved if selected assets and liabilities were valued under a fair market model that would reflect current valuations. While deliberations by the FASB, along with such other accounting standards boards as the International Accounting Standards Committee, do not suggest that all assets and liabilities should be valued at current market prices, the organizations are considering a model that would present an entity’s financial instruments at current value.

According to Diana Willis, a senior project manager at the Financial Accounting Standards Board, the organization’s long-term goal is to have all financial assets and liabilities recognized in statements of financial position at their fair values, rather than at amounts based on their historical cost.

FASB has already taken some tentative steps toward this goal. For example, back in June 1998, FASB issued Statement 133, “Accounting for Derivative Instruments and Hedging Activities.”

Effective for fiscal years beginning after June 15, 2000, Statement 133 requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. (Derivatives, such as futures contracts, are financial instruments that companies use in an attempt to protect themselves from price fluctuations by tying the price of a purchase or sales contract to a standard, like interest rates. Willis says that about half of the S&P 500 uses derivatives to reduce the risk associated with commodity prices, weather, interest rates and foreign exchange.)

In fact, buried deep within Statement 133, FASB outlines its goals for fair market valuation, noting that “the Board is committed to work diligently toward resolving, in a timely manner, the conceptual and practical issues related to determining the fair values of financial instruments and portfolios of financial instruments. Techniques for refining the measurement of the fair values of all financial instruments continue to develop at a rapid pace, and the Board believes that all financial instruments should be carried in the statement of financial position at fair value when the conceptual and measurement issues are resolved.”

Expanding on that theme, Willis observes that the valuation of financial assets and liabilities should be based on prices that reflect the market’s assessment, under current conditions, of the present values of the future cash flows embodied in an entity’s financial instruments.

“Fair values provide information about financial assets and liabilities that is more relevant than amounts based on their historical cost … The mixed-attribute measurement model cannot cope with today’s complex financial instruments and risk management strategies” she says. “It is time for a better model.”

It may indeed be time for a better model, but the one that FASB is working on may not be it, according to Wharton accounting professor Cathy Schrand. She notes that while FASB is moving to a “mark to market” – or market value – approach to accounting for assets and liabilities, it is doing so on a piecemeal basis.

“The result is that some assets and liabilities would be marked to market, while others would not,” she comments. “Such a hybrid approach could make it more difficult to compare companies that are in similar industries but have dissimilar financial instruments.”

She adds that the readers of financial statements may be confused about what items are presented at market value and which are not. Instead of bringing clarity, says Schrand, a partial mark-to-market approach could sow misunderstanding among investors and others.

“One of the concerns in mark-to-market accounting is that when assets and liabilities are recorded at fair values on the balance sheet, any change in value between periods must go somewhere, usually to the income statement,” she says. “But until any resulting income statement changes can be clearly accounted for and presented, I’m not in favor of partial fair market valuation.”

Schrand notes that some countries, like the United Kingdom and Australia, allow companies to adjust their balance sheets to reflect fair market values of fixed assets. “But in that model, the companies make appropriate disclosure, and present the write-ups or write-downs to market in a separate account in the equity section,” she says. “Perhaps the solution for the FASB lies in ensuring disclosure.”

She adds, however, that while some research indicates that the UK and Australian approach does provide useful information, other studies dispute its validity. “So right now, the verdict is mixed,” she notes.

In any case, Schrand points out another challenge that confronts attempts to report financial instruments and similar items at market value.

“How do you value financial instruments that do not have a ready market?” she asks. “While it’s true that companies could still use valuation models and appraisals to get a fair market estimate in these cases, it begs the question of the validity of the valuation, and may let companies manipulate the estimates, just as some of them have allegedly manipulated their reported earnings.”

Her comments seem to suggest that trusting companies with a fair market valuation method is akin to asking the proverbial fox to guard the chicken house. But in this case at least, the fox may not even want the opportunity. Because if the results of a market-value project undertaken by the American Institute of Certified Public Accountants (AICPA) are any indication, a lot of companies aren’t really interested in migrating to a mark-to-market approach.

“A while back, as part of a project considering fair market value accounting, the AICPA conducted a field test among some companies and asked them to write up their real estate to fair market value,” says Fred Gill, an AICPA senior technical manager of accounting standards. “We thought companies would clamor for fair market valuation for this class of assets, but surprisingly there was no great demand for it.”

Gill notes that since the AICPA did not request feedback from the participants, it’s tough to pinpoint the reason for their lack of interest in the model. He theorizes that companies may fear getting hit with higher property taxes if they reflect their real estate at current value.

“Disclosure of fair market value could lead to annual increases in tax assessments,” says Gill. “And consider the cost of an annual appraisal. Can you imagine, for example, getting an appraisal for the World Trade Center each year?”

One theme seems to recur as accountants consider fair market valuations: It’s a worthwhile concept, but such issues as cost and the difficulty of establishing standard measurements may impede the implementation.

Skip Braun, a metropolitan New York-area partner with Arthur Andersen’s assurance group, illustrates those concerns with a hypothetical example.

“From the viewpoint of the investment community, fair value is important,” he says. “But measuring fair market value can be difficult unless you’ve got a ready market of willing sellers and buyers. Often, though, there may be no benchmark, so a company may end up placing more judgements and estimates on the financial statements. In contrast, you know what you paid to produce inventory, and you know your accounts receivable.”

Eventually accountants may have no choice other than to change over to the new model but “eventually” can be a long way off. In March 9 web site update, FASB itself noted that “the Board has not yet made a decision about when, if ever, the fair value measurement would be required in the primary financial statements.”

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