Comparative Analysis: Fair Value Vs. Historical Cost Accounting For Non-Financial Assets (Essay)

Refer to the current IASB Framework and IFRS 13 Fair Value measurements, briefly explain the measurement concepts in relation to historical cost and fair value accounting.

The recent study is about the heavily debated issue as to use of historical cost accounting or fair value accounting for the valuation of non-financial assets majorly property, plant and equipment. As the IFRS give the open choice to the companies’ regarding the use of fair value as their method of accounting or historical cost method. This has resulted in variation of the accounting practices followed by the companies in UK, Australia and USA. We focus on the UK, Australia and USA based companies’ and present a comparative practices that has been adopted by them regarding the use of fair value method of accounting or historical cost method of accounting as these three countries’ cover the major market of the world. We do examine the changes in accounting policy followed by the companies after the implementation of (IFRS) International Financial Reporting Standards in United Kingdom (London), Australia and United States of America (USA). Under these new standards, companies in these countries are free to make a choice between historical cost as method of accounting and fair value accounting for the property, plant and equipment as well as for intangible assets of the company that we examine. We can reasonably assume that companies select the valuation practices optimally. Hence, the valuation methods observed in practice provide reasonable evidence on when and where fair value accounting is contractually efficient method for valuation (Georgiou and Jack, 2011).

With the help of this study we provide direct evidence for the application of the fair value method of accounting and historical cost accounting under IFRS and generally evaluates on when and where fair value accounting is being preferred over historical cost accounting. As there are many positive reviews available for the usage of fair value accounting and its benefits. We will not only assess the benefits that are related with fair value method of accounting for the selected set of companies but also for the economy as a whole as which method of accounting prove to be more beneficial for the companies and which method companies use in practice.

The IFRS states that the company is free to make a choice either to use Historical cost or Fair value  accounting method to value its non-financial assets particularly (property, plant and equipment) but it is clearly stated in IFRS that the investments need to be stated at cost or fair value whichever is lower. The selection of historical cost method of accounting and Fair Value accounting is directed by the IASB that promotes the decision and emphasize usefulness of accounting decision (Christensen and Nikolaev, 2009). Fair Value accounting method is defined as predictable price on which an organised transaction to allocate the liability or to sell the asset will take place under present market circumstances between market participants on the due date. The assets measured at fair value might be a group of asset or a stand-alone asset. The fair value measurement is completely different from offsetting the risk associated with that articular asset (Whittington, 2008). There is debate as to adopt the fair value method of accounting or historical cost accounting to value the property, plant and equipment and investments of the company. We need to analyse the companies to know as if what they practice the most either fair value accounting method or the historical cost accounting method to record the property plant and machinery in their financial statements as there is no restrictions on part of companies or any prescribed guidelines implemented by the IFRS procedural code and the IASB framework regarding the method of accounting used for recording the property, plant and equipment (Kieso, Weygandt and Warfield, 2010).

Company Practices regarding Fair Value and Historical Cost Accounting

The choice that is made by the company between Fair Value accounting and Historical Cost method is to be stated in the notes to account under the disclosure column of accounting policy in the annual report of the company as per the IFRS requirements and need to be followed consistently, a company that uses fair value method of accounting will revalue its assets every single time the book value of the asset is substantially dissimilar from the market values of the asset. A company that chooses the method of accounting as historical cost method for the valuation of property, plant and equipment need not to perform revaluation of the assets on the upward side in the future (Christensen and Nikolaev, 2013). A shift between historical cost accounting and fair value method is considered to be a thoughtful change in the accounting principle and need to be disclosed in the notes to account section of the financial statements of the company as the investors and other stakeholders need a justification regarding the valuation practice of the company for property, plant and equipment and the intangibles of the company (Boyer, 2007). The companies usually use the Historical Cost as its method of accounting. We did analysed 3 companies one from UK, one from New York and one from Australia all the companies use Historical Cost method of accounting. Historical cost make available the stakeholders with the cost of investment while the fair value guesses the measure of what management think to get in return after investing in the company. Historical cost method is not based out of any assumption or any valuation it is just a simple method as the cost of acquisition of the asset or the amount paid for acquiring that asset with all the capital expenditure incurred on that asset which increased its efficiency. The Historical cost method takes into account the wear and tear of property plant and equipment as they are presented in financial statements at net cost that is cost less the amount of accumulated depreciation which makes it easy for the users/viewers of financial statements to understand the valuation.

 The benefits of using fair value method o accounting are all the information are adequate and precise for the time being and it tries to provide the most relevant estimates. This method prove to be more accurate in valuation of the property, plant and equipment and for the valuation of investments as the value of the asset on a particular date is estimated although it proves to be conflicting as estimates are made by some expects and the results may vary but still it is created on the current valuation. The Fair value measurement enhances the informative power of the financial statements of the company as opposite to historical cost method. Fair value method of accounting requires the firm to disclose all the wide-ranging information about the procedures and methods used for valuation and the assumptions being made by them in the valuation (Barth, Beaver and Landsman, 2001).

Evaluation of Fair Value Accounting

On one hand benefits of fair value method are more reasonable then the historical cost method although the users rely on the historical cost method because ultimately they want to know the actual flow of the money the fair value accounting estimates provide present value of investment made by the company in previous years but the historical cost method says about the actual spending of the company. In fact the IFRS and IASB itself remain silent about which method is more appropriate and they also given an open choice regarding the use of the fair value accounting method or Historical cost accounting method for valuing the property, plant and equipment (Cañibano, Garcia-Ayuso and Sanchez, 2000)

All the listed companies in United Kingdom (London), Australia and USA must prepare the consolidated statements in line with the International Financial Reporting Standards (IFRS) and their local GAAP (Soderstrom and Sun, 2007). These new standards provide the same set of the valuation alternatives regardless of the domicile of the company that means that the IFRS principles are applicable to all over the world equally. Yet these companies are relying on very different local GAAP regimes as well as institutional environment. Upward revaluation is not allowed for any of the assets group that is property, plant and equipment or the intangible assets under UK GAAP, while under US GAAP companies need to recognise the investment at the lower of fair value or historical cost. IFRS elaborates the valuation methods adopted by the companies in UK, Australia and USA (Ball, 2006). Companies which are domiciled under any of the three countries are allowed to adopt the IFRS method or to endure with the same valuation as stated in the local GAAP. . This means that the companies domiciled in the UK can shift to historical cost for the valuation of investment property and the US and the Australia companies can switch to fair value method of accounting for investment, property, plant and equipment once after the implementation of IFRS. Note that the implementation of IFRS offers chance to the companies to recognise investment property at Fair Value and for the UK companies to recognise the investment at the historical cost method.

Our study is based out of three companies one is EASYJET which is a British airline company based out of London. It operates on 820 routs for both domestic and international scheduled services in more than 30 countries. EASYJET is a public limited company whose shares are listed on the London Stock Exchange and this company is domiciled and incorporated in the United Kingdom. The accounts of EASYJET are prepared in harmony with the International Financial Reporting Standards (IFRS) as accepted by the European Union. The accounts of the company are prepared based on historical cost convention as its property plant and equipment are recorded at cost less depreciation although its derivative financial instruments are measured at fair values except this all assets are measured at cost. This is properly mentioned in the notes of accounts of the company that company follows historical cost method for valuation of its property plant and equipment (Easyjet, P. L. C. 2016).

Benefits of Fair Value Method

The next company selected is FMC Corporation which is diversified chemical company serving industrial markets, agricultural markets and consumer globally with market leading products and innovative solutions and applications. The shares of FMC Corporation are listed on New York Stock exchange this company is domiciled in New York and serves the diversified business line. As we have gone through the audited annual report of the company and analysed its consolidated financial statements we come to know that the company uses historical cost method to record the property, plant and equipment. The majority of the investments of the company are valued at cost basically but some are valued at fair value or cost whichever is the more appropriate for valuation (Corporation, FMC., 2016).  

The third company we selected is an Australian based company namely Iluka Resources Limited this is specialised in mineral sand exploration. Iluka is globally the largest producer of titanium and zircon dioxide- derived rutile and synthetic rutile. Iluka resource limited is listed on the Australian Stock exchange and domiciled in Australia only since its establishment. The company’s annual report and audit financial statements states that the company’s property plant and equipment are indicated at cost less the depreciation amount that means company uses historical cost accounting method to record the property plant and equipment. The investments of the company are stated at cost as all the valuation by the company is done by historical cost accounting method. It is clearly mentioned in the notes to account of the company that the valuation method used by the company is historical method (Iluka, Resource Ltd. 2016).

We did analysed the three companies method of valuation used for valuing property, plant and equipment is its books of accounts and all the company’s annual report and financial statements are audited by the auditors and no biases are there in the method of the valuation. We covered the three major market segments of the world economy that is Australia, United Kingdom and USA it is clearly stated in the IFRS as the companies are free to make a choice between fair value method of accounting and the Historical cost method of accounting (Power, 2010). As we have gone through with audited financial statements and the annual reports of the three companies which are different in their domicile as one is American company based in New York, another one is Australian company and the third one is listed on London stock exchange. We also did not preferred to choose the company out of the same segment as the segment of all the companies are totally different one is Airline Company, another one is Chemical Company and the third one is Mineral Exploration Company to make the study more relevant and elaborative.

Use of Historical Cost Method

As with this research we came to know that all the three companies use Historical method of accounting for the valuation of its property, plant and equipment although the method used for the valuation of investment is different in all the three companies but the major thing is that the investments are recorded at cost. We had covered a vast area under our preview for this research as we did cover all the major industry segments as well all the majorly privileged countries in the world economy.

Conclusion:

The research is based on the most debated issue as whether to practice fair value method of accounting or the Historical cost accounting method for the valuation of property, plant and equipment and the investments of the company. As the Users of Financial Statements has a significant interest in the Financial Statements of the company so we need to disclose as if which method we chose for the valuation of our property, plant and equipment and the investments. The IFRS and the IASB both have opened the choices for the countries and the companies as to which method they want to adopt for the valuation of their property plant and equipment (Barlev and Haddad, 2003).

We did analysed the three companies for the three big economies of the world namely EASYJET based out of London, FMC Corporation based out of New York and Iluka Resource Limited based our of Australia. After the research being made and the analysis of their annual reports and audited financial statements is done we came to know that they all uses Historical cost method of accounting for the valuation of their property, plant and equipment but the method for valuation of investments vary in between these three companies but at last we seen that the investments are valued at cost only. We did this research and chosen the three different companies from different domicile to make the research more effective as the company not only follows the IFRS and IASB framework but also they have their local GAAP on the basis of the domicile of the company (Muller, Riedl and Sellhorn, 2011). That is why only we had chosen three different company form different domicile to know as the methods they follow coincide with each other as in all the countries framework are somehow intersect with each other. The companies all over the follow IFRS regulations but the local GAAP for all the countries are not same. This research proves that the companies have a open choice as to make between the Fair Value method and Historical Cost method of accounting and most of the companies rely on the historical cost method as the fair value method have inherent some restrictions.

IFRS and Local GAAP

The companies should use Historical cost method as the Historical cost method presents more valuable information for users/ viewers of financial statements as well as shows the actual flow of funds and value after changing the depreciation. Although Fair Value method also provide relevant information but that is a contrasting thing as the fair value depicts the current market value of property, plant and equipment, that too on some estimated basis. The fair value of the property plant and equipment is required only at the time of their disposal to know about the sale value. The fair value valuation is somewhat assumption based and complicated too. This represents the estimated value of property plant and equipment which is against the concept of fair representation of financial statements. The investments on the other side are more appropriate if valued at fair values as the cost of investment has no use in the decision making. Investment is actually being for earning some return over it so it will be more appropriate for companies to value investments at fair value rather than valuing them on lower of cost or fair value. Hence, with this research we came to know that the better way to value property, plant and equipment is the historical cost method of accounting and for investment is fair value method. 

References:

Ball, R., 2006. International Financial Reporting Standards (IFRS): pros and cons for investors. Accounting and business research, 36(sup1), pp.5-27.

Barlev, B. and Haddad, J.R., 2003. Fair value accounting and the management of the firm. Critical Perspectives on Accounting, 14(4), pp.383-415.

Barth, M.E., Beaver, W.H. and Landsman, W.R., 2001. The relevance of the value relevance literature for financial accounting standard setting: another view. Journal of accounting and economics, 31(1), pp.77-104.

Boyer, R., 2007. Assessing the impact of fair value upon financial crises. Socio-economic review, 5(4), pp.779-807.

Cañibano, L., Garcia-Ayuso, M. and Sanchez, P., 2000. Accounting for intangibles: a literature review. Journal of Accounting Literature, 19, p.102.

Christensen, H. and Nikolaev, V., 2009. Who uses fair value accounting for non-financial assets after IFRS adoption. Paper posted at SSRN: https://papers. ssrn. com/abstract, 1269515.

Christensen, H.B. and Nikolaev, V.V., 2013. Does fair value accounting for non-financial assets pass the market test?. Review of Accounting Studies, 18(3), pp.734-775.

Corporation, FMC. 2016. Annual Report and Accounts, Viewed on 21-Jan-2018. Retrieved from <https://www.annualreports.com/HostedData/AnnualReports/PDF/NYSE_FMC_2016.pdf>.

Easyjet, P. L. C. 2016, Annual Report and Accounts, Viewed on 21-Jan-2018. Retrieved from < https://corporate.easyjet.com/~/media/Files/E/Easyjet/pdf/investors/result-center-investor/annual-report-2016.pdf>.

Georgiou, O. and Jack, L., 2011. In pursuit of legitimacy: A history behind fair value accounting. The British Accounting Review, 43(4), pp.311-323.

Hellström, K., 2006. The value relevance of financial accounting information in a transition economy: The case of the Czech Republic. European accounting review, 15(3), pp.325-349.

Iluka, Resource Ltd. 2016. Annual Reoport and Accounts, Viewed on 21-Jan-2018. Retrives from < https://www.iluka.com/docs/default-source/asx-releases/iluka-annual-report-2016-inc-appendix-4e>.

Kieso, D.E., Weygandt, J.J. and Warfield, T.D., 2010. Intermediate accounting: IFRS edition (Vol. 2). John Wiley & Sons.

Muller III, K.A., Riedl, E.J. and Sellhorn, T., 2011. Mandatory fair value accounting and information asymmetry: Evidence from the European real estate industry. Management Science, 57(6), pp.1138-1153.

Power, M., 2010. Fair value accounting, financial economics and the transformation of reliability. Accounting and Business Research, 40(3), pp.197-210.

Soderstrom, N.S. and Sun, K.J., 2007. IFRS adoption and accounting quality: a review. European Accounting Review, 16(4), pp.675-702.

Song, C.J., Thomas, W.B. and Yi, H., 2010. Value relevance of FAS No. 157 fair value hierarchy information and the impact of corporate governance mechanisms. The Accounting Review, 85(4), pp.1375-1410.

Whittington, G., 2008. Fair value and the IASB/FASB conceptual framework project: an alternative view. Abacus, 44(2), pp.139-168