Fair Value vs.

Historical Cost
Kelcey Footer
October 29, 2014
Intermediate Accounting III
Terry Bechtel, Ph.D., CPA

Fair Value vs. Historical Cost

In the United States, accounting standards traditionally use the historical cost basis. In
the early 20th century, accountants held the standard practice of using current values or
appraised values for assets. Mark to market otherwise known as fair value accounting has
been a topic of controversy for quite some time. Under the fair value approach certain assets
and liabilities show up on the financial statements at their market value. Leading to a
fluctuation in the way the financial statements look. They often demonstrate a cyclical
pattern of fluctuation due to the swinging of the market. The argument for historical cost and
fair value goes back for quite some time and there are pros and cons for both sides. By
evaluating the definitions of Fair value as well as historical cost an accurate decision can be
made regarding which valuation method should be the standard.
The purpose of financial accounting is provid[ing] information to parties external to
the business. Financial accounting is essentially scorekeeping for the stewardship of
management (Carole B. Cheatham 1993). With transparency and comparability being the
goal a company should account for things in a way that shows them in the most accurate
manner. Historically, financial accountingwas directed toward helping the
owner/manager make day to day operating decisions (Carole B. Cheatham 1993).
Financial accounting relies on valuation methods. They are, so intertwined that valuation is
actually a matter of accounting; valuation involves performing an accounting on a firm, an
accounting for value (Penman 2011). This means that the controversy between fair value
and historical cost is deep rooted in accounting. This makes the impact of the decision vital
and widespread through the accounting world.

Fair Value vs. Historical Cost

The Financial Accounting Standards Board (FASB) Statement no. 157 , is arguably
the most controversial of a series of accounting directives on fair value accounting issued by
the standard setter (Curtis 2009). This laid the ground work for the way Fair value would be
handled and superseded a number of directives that were put into place. The centralized
focus of FAS 157 was a three tiered valuation method.
Level 1, where an asset can be marked to market based on simple
price quotes in an active market for the asset;
Level 2, where an asset is subject to mark to model, meaning that
there are no quoted prices available for the specific assets and
valuations are derived from an estimate based on observable inputs
in the form of similar assets with quoted prices or observable proxy
data measures such as yield curves, exchange rates, and certain
empirical correlations; and
Level 3, where an asset is so illiquid that its value is based entirely
on managements best estimate derived from complex mathematical
models.Level 3 valuation is also sometimes called mark to matrix.
(Curtis 2009).

When it comes to deciding on a cost valuation basis like fair value or historical cost
the first step is to understand both sides of the argument. In doing that, one fundamental key
of information is knowing exactly what it means by valuing assets at fair value or historical
cost. The Financial Accounting Standards Board, (FASB), issued statement number 157 with
the following thought on fair value. This Statement (no. 157) emphasizes that fair value is a

Fair Value vs. Historical Cost

market-based measurement, not an entity-specific measurement. Therefore, a fair value
measurement should be determined based on the assumptions that market participants would
use in pricing the asset or liability. (FASB n.d.).
Fair value is stated to be, accounting for the value of an asset or liability based on
the current market price instead of book value (C. R. Harvey 2011). Fair value has also been
referred to as mark to market accounting. Mark to market, is defined as accounting for
the value of an asset or liability based on the current market price instead of book value. (C.
R. Harvey 2011). Both of these definitions as shown are exactly the same making the terms
synonymous. Using this cost basis literally means that one accounts on their books using the
price or value that the market determines. This valuation system allows for ups and downs
in the value of your assets and liabilities.
The argument for the use of fair value is that it better presents the economic reality
of transactions and therefore tends to provide more useful and relevant information than does
historical cost financial reporting (Said 2007). This approach is also in favor of portraying
the economic reality of the firms rather than a snap shot summary of past transactions.
Meaning, this approach argues that it is advantageous to see what things are worth now
versus what the company paid for them in the past. The proponents of fair value hold that
using fair value is relevant for decision making. They believe that fair value accounting also
provides a better measure of efficiency. Fair value, accounting gives a better measure of
efficiency of the company [because it] provides a separation of profit into that part which
arises from holding assets before they are sold.

Fair Value vs. Historical Cost

Proponents against fair value accounting argue the issue of reliability. Fair value
relies on swaying market data which makes the fair value merely an estimate. In terms of
reliability that makes the estimate obtained a very unreliable number. Critics of fair value
accounting have raised concerns that Level 2 and Level 3 valuations can suffer from
problematic inconsistencies across various firms (Curtis 2009). The inconsistencies are said
to be derived from the subjective nature of the models, inputs and assumptions that enter into
such valuations. It is also said that an unintended consequence of fair value accounting is
that in forcing financial institutions to recognize losses, it has also impaired their capital and
triggered fire sales of assets that reverberate across may firms with related assets. This
leads to the proponents concern of creating a market that is cyclical causing it to rise and fall.
Fair values critics argue that the existence of procyclical economic spillovers is a legitimate
concern (Curtis 2009).
Historical cost on the other hand is defined as, the aggregate price paid by the firm
to acquire ownership and use of an asset, including all payments necessary to obtain the asset
in the location and condition required for it to provide services in the production or other
operations of the firm (Said 2007). This gives the firm a more concrete number to use when
valuing their assets and liabilities. The value assigned to their books is the value actually
paid at the point of sale, or agreement. This gave rise to the terminology historical cost
because the value is a snapshot of what took place at that point in history.
The proponents for historical cost hold onto one thing, reliability. Historical cost can
be verified. Generally the cost at the time of purchase is documented in some way. Meaning
there is a paper trail that can be used as hard factual evidence of the valuation of the asset.

Fair Value vs. Historical Cost

Historical cost is the current requirement under Generally Accepted Accounting Principle
(GAAP). This means that all financial statements must be based upon original cost.
Proponents agree that historical cost is less subject to manipulation (Said 2007). Meaning
that, the value used in historical cost accounting is concrete and based on actual, not
hypothetical transactions. The purpose of accounting is to account not to present opinions
of value (John D Rossi III 2013). Those in favor of historical cost agree that fair value
accounting, is making reporting more dynamic and less consistent (Henk Langendijk
2003). They also state that the use of fair value, cannot be regarded as an improvement and
the valuation of assets will become pure guesswork. (Henk Langendijk 2003). Historical
cost is also used by management to forecast for future operational costs based on past data.
Under the historical cost valuation method there is no room for managerial manipulation.
Arguments against the use of historical cost valuation pivot around the idea that
historical cost only considers the acquisition cost of an asset and does not include or
recognize the current market value. GAAP profits defined on a fair value basis rather than a
historical cost basis accelerate the recognition of gains, particularly in periods of rising asset
prices. (Ramanna 2013). The idea is that historical cost does not give an accurate
representation of the current value of a company and therefore distorts the way the financial
statements appear because they are old values. A hindrance to the historical cost cause is
the fact that historical cost does not accurately report internally generated assets(assets
acquired outside of business combination). Also, reliable forecasts of the future effects of a
financial instrument are not likely to be possible from the simple examination of past gain

Fair Value vs. Historical Cost

and loss situations based solely on historical cost data. Historical cost valuation does not
account for the effects of inflationary periods.
For five decades economists and accountants have
debated the relative merits of historical-cost, fair-value and
other accounting measures. Recent market events do not
demonstrate that Mark to Market should be abandoned but
rather that other measures should be used to a greater degree
alongside. Widely-used single measures can and will be
arbitraged, and certainly played a role along with too many
simplifying assumptions and too much liquidity in the
meltdown. In my experience the desire to simplify
accounting, risk and return views and to produce single
answers played a significant role in numerous financial
losses. Tanya S. Beder Chairman, SBCC Group Inc.
(Curtis 2009)
The solution to a complicated issue is never simple. As is evident with the
controversy between fair value and historical cost. As stated above by Tanya S. Beder, as a
financial society the solution should not have to be black and white. It should be a
combination of both as to provide the best resource of accurate financial data. To address the
issue of FAS 157, there are some ambiguities as to some of the guidelines.
First, FAS 157 does not provide clear guidance about how to
evaluate inputs when valuing an asset in a time of changing or

Fair Value vs. Historical Cost

disrupted market conditions. Guidance to aid in determining
when a market is active or inactive, or when a particular
transaction would be considered a distressed or forced sale
not constituting evidence of fair value, would assist in
exercising judgment in this area. Second, while FAS 157 creates
a valuation method based first on principles and then provides
certain examples in its appendices, providing more specific
examples of the fair value measurements of various types of
assets and liabilities under varying assumed market conditions
would be very useful. Third, additional guidance on presenting,
in financial statements and notes, the periodic changes in asset
valuation would be helpful to provide more useful information
to investors. (Curtis 2009)
My proposal as to valuation method you should use is neither. My recommendation would be
to use a combination of both methods. Use the historical cost method to properly show the
cost acquisition of assets. Alongside that, show the current market value of your assets giving
you a better perspective, or running tally of what your assets were purchased at and what
they are worth now. This will give management an idea of what assets are worth when
they are sold to avoid the issue of fire sales. I think restricting the financial world to one
single sided valuation method leads to unnecessary controversy. A company should know
what they acquired things for and what they are worth. The current reporting model in the
United States and across much of the world includes both historical cost measurement and

Fair Value vs. Historical Cost

fair value measurement. (Curtis 2009). Companies are wise to apply fair value for available
for sale securities as well as held-to maturity debt securities because they are able to
write them down due to the impairment test if they have become impaired due to the market.
However, notes and loans which make up the bulk of financial assets for banks, should be
carried at amortized cost (historical cost valuation) that are subject to bad debt allowances
that are not subject to fair value standards.

Fair Value vs. Historical Cost

Works Cited
Carole B. Cheatham, Leo R. Cheatham. Updating Standard Cost Systems. Westport,
Connecticut: Quorum Books, 1993.
Curtis, James W. "Mark to market and Fair Value Accounting: An Examination." (Nova Science
Publisher, inc. ) 2009: 11-14.
FASB. Fair Value Measurements. Vol. Statement No. 157. n.d.
Gullette, Michael. American Bankers Association. 2014.
http://www.aba.com/Issues/Index/Pages/Issues_FairValue.aspx (accessed October 28,
2014).
Harvey, Cambell R. Fair Value Accounting. 2011.
Harvey, Campbell R. Mark to Market Acccounting. 2011.
Henk Langendijk, Dirk Swagerman and Willem Verhoog. Is Fair Value Fair? Chichester, West
Sussex: John Wiley & Sons, 2003.
John D Rossi III, CPA. "Historical Cost vs. Fair Value." CPAnow. July 15, 2013.
Penman, Stephen. Accounting for Value. Chichester, West Sussex: Columbia Business School
Publishing, 2011.
Ramanna, Karthik. "Why "Fair Value" is the rule." Harvard Business Review , 2013.
Said, Nur Barizah Abu Bakar and Julia Mohd. "Historical Cost Accounting Versus Current Cost
Accounting." Accountants Today, January 2007: 20-23.