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Transition to Fair Value in Financial Reporting: Impact & Implications, Lecture notes of Accounting

Wrexham Glyndŵr UniversityAccounting

This paper explores the significance of transitioning from historical cost to fair value assessment in financial reporting. the influence of fair value evaluation, changes in accounting and financial situations, and the impact on an entity's image. Keywords: historical cost, fair value, accounting principles, financial reporting.

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Annals of the University of Petroşani, Economics, 16(1), 2016, 233-244 233
THE TRANSITION FROM HISTORICAL COST
TO FAIR-VALUE, A CHOICE WITH MAJOR
IMPLICATIONS IN ACCOUNTING
ILIE RĂSCOLEAN,
ILEANA-SORINA RAKOS *
ABSTRACT: This paper treats the importance of the transition from valuation at
historical cost to valuation at fair value of the assets within an economic entity, and the
contents of the result obtained in financial reporting. The work deals with the influence that the
fair value assessment can have on the level of an entity’s economic performance. Starting from
a few statements such as: fair value option evaluation to influence significantly the fair value;
presentation of the elements on the balance sheet at fair value leads to significant changes in
the accounting of the economic entities, in data analysis was used a questionnaire based on the
four questions whose results were analysed and which have led to carrying out this study. The
research was supported by the information collected from individuals and companies within
certain economic entities. The paper ends with the conclusions of authors related to the fair
value assessment which, as if trying to address the shortcomings of historical cost, by aiming to
correct cost of customer acquisition assets with market value, achieved through constant re-
evaluation of the balance sheet items. On the other hand, a concurrent evaluation of both
historical cost and fair value, depending on the inherent characteristics of the elements of the
balance sheet, resulting in getting relevant, reliable financial statements, in accordance with
reality.
KEY WORDS: historical cost; creation of value; assessment; fair view; accounting
principles; accounting rules; financial situations; fair amount.
JEL CLASSIFICATION: M41.
1. INTRODUCTION
About value has been written and talked much and from different positions
towards defining it, versus its role in people’s lives. In accounting, the value is seen as
* Assoc. Prof., Ph.D., University of Petroşani, Romania, ilierascolean@yahoo.com
Assist. Prof., Ph.D., University of Petroşani, Romania, nihilsinedeo_68@yahoo.com
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Download Transition to Fair Value in Financial Reporting: Impact & Implications and more Lecture notes Accounting in PDF only on Docsity!

Annals of the University of Petroşani, Economics, 16(1), 2016, 233-244 233

THE TRANSITION FROM HISTORICAL COST

TO FAIR-VALUE, A CHOICE WITH MAJOR

IMPLICATIONS IN ACCOUNTING

ILIE RĂSCOLEAN,

ILEANA-SORINA RAKOS *

ABSTRACT: This paper treats the importance of the transition from valuation at historical cost to valuation at fair value of the assets within an economic entity, and the contents of the result obtained in financial reporting. The work deals with the influence that the fair value assessment can have on the level of an entity’s economic performance. Starting from a few statements such as: fair value option evaluation to influence significantly the fair value; presentation of the elements on the balance sheet at fair value leads to significant changes in the accounting of the economic entities, in data analysis was used a questionnaire based on the four questions whose results were analysed and which have led to carrying out this study. The research was supported by the information collected from individuals and companies within certain economic entities. The paper ends with the conclusions of authors related to the fair value assessment which, as if trying to address the shortcomings of historical cost, by aiming to correct cost of customer acquisition assets with market value, achieved through constant re- evaluation of the balance sheet items. On the other hand, a concurrent evaluation of both historical cost and fair value, depending on the inherent characteristics of the elements of the balance sheet, resulting in getting relevant, reliable financial statements, in accordance with reality.

KEY WORDS: historical cost; creation of value; assessment; fair view; accounting principles; accounting rules; financial situations; fair amount.

JEL CLASSIFICATION: M41.

1. INTRODUCTION

About value has been written and talked much and from different positions

towards defining it, versus its role in people’s lives. In accounting, the value is seen as

* (^) Assoc. Prof., Ph.D., University of Petroşani, Romania, ilierascolean@yahoo.com

Assist. Prof., Ph.D., University of Petroşani, Romania, nihilsinedeo_68@yahoo.com

234 Răscolean, I.; Rakos, I.S.

the result of the evaluation of assets, debts, and capital and reserves. Through value,

the accounting uniforms assets, otherwise quite heterogeneous, in order to quantify the

whole heritage. The method of calculating the value of own assets, debts, and capital

have differed in time and space, the accounting seeking the most appropriate

procedures for determining the value of the assets, aiming for “ playing fair ” and the

results of the work carried out.

The assessed original cost, measured and recorded to the entry of assets and

debts in the accounts is known as the historical cost. The historical cost is oriented

towards the past, but unlike other assessment bases, presents the major advantage of

being clearly defined and verifiable, and once established it remains fixed as long as

the property is in possession of the respective economic entity. The historical cost

accounting information is based on data relating to past events contained in supporting

documents without reference to data on current market prices. Historical cost leads to a

negative vision of the entity since, in accordance with the principle of prudence, this

does not allow the recognition of the potential losses for assets and earnings.

Therefore, the historical cost accounts do not anticipate all the profits of the

entity, but anticipates all losses. In the case of assets, the historical cost delimits the

amount in cash or by cash equivalent paid at the time of purchase or the fair value of

the amount paid at the time of purchase. Within the framework of normal business, if

debt, the historical cost is the amount of cash equivalents obtained in exchange for the

obligation or under certain circumstances (for example, in the case of corporation tax),

the value of what is expected to be paid in cash or cash equivalents to extinguish debts.

In order to be able to rely on the information provided by the producers of information,

internal and external users must ensure that the information is verifiable and objective.

Or, just the use of the historical cost as the basis of measurement, enables

manufacturers to provide verifiable information in financial statements and goals.

Producers and users of financial statements have noted that, in measuring and

presenting information, the historical cost would be most useful. Aristotle is that which

has given a new dimension to value. The term value descended from the Latin

etymological verb “valere”, whose original meaning was: “ can, be powerful, procure

satisfaction ”. Value designates the stable qualities, perennial, empirically ascertainable

of things. The philosophy is separating the two concepts relating to value: on the one

hand axia - value, on the other hand timo - price. Scholastics economists have defined

value by usefulness of the good, as well they are those who talk about the “exact

price”.

The exact price was the cost of production or current market price, the price

given by a person who is unable to influence it. It was probably the earliest occurrence

of the notion of fair value. The concept of fair value is broader and the more general

utility than that of market value: indeed, in the absence of a market price noted in an

active market, the evaluation shall be determined according to the value of the

exchange on which the two independent parts agree, by the market price of an item

with close features or by calculating the net present value of future flows. Attention on

the fair value was determined by the financial crisis since 2008 that led to a major

policy debate what involved both the United States Congress and the European

236 Răscolean, I.; Rakos, I.S.

fixed assets for which there is no direct effect on the entity cash-flow. At the same

time, they shall consider the matter from the perspective of a reassessment and its

influence on the price action of an economic entity. They believe that this link between

revaluation and value of an entity’s action can be explained by understanding the

purpose for which revaluation is done.

Basically, they believe that the incentive that motivates managers to make the

voluntary revaluation of assets is just the effect of the revaluation on the value of the

shares of the entity (value accounting math). At the same time, some English authors

are of the opinion that the reassessment affects the costs of the economic entity, it

representing the reason that managers are not indifferent to the manner and time of the

reassessment of its assets. Under their personal view, revaluation of assets could help

solve some problems caused by information asymmetry, i.e. managers could signal

important information which they hold relating to the revaluation of the assets they

control.

3. RESEARCH METHODOLOGY

Bearing in mind the targets, we achieved a questionnaire that has been applied

to some economic entities, testing the reaction of the two categories of participants

(shareholders and managers), in terms of:

 “ Is accounting information provided by the financial statements sufficient

and relevant to the analysis of the transition from historical cost to fair

value?”;

 “What is the impact of the evaluation at fair value on the image of the

entity’s accounting?”;

 “What are the factors that limit the use of fair value in the financial

reporting framework?”.

The importance of the transition from the historical cost, to the fair value, is

evidenced by the very concerns of IASC/IASB bodies as well as the concerns of

various national and international researchers in the field.

4. The qualitative characteristics of accounting information according to the

conceptual accounting framework

In the life of an economic entity the dominant relationship is the relationship

between its owners and managers. Internal users are represented by the managers. They

resort to accounting information that reflects mining operations, investment, financing

and treasury management for foundation and decisions. For this purpose, they use the

information generated by both current accounts and disclosures in the annual financial

statements or half-yearly/quarterly, as of the final accounting products.

Under the terms of the internationalization of Romanian accounting, managers

have a major role in the election, namely: policies options definition most appropriate

to accounting entities, in order to reflect the economic reality. Mandated by the owners

to manage the wealth and activity of the economic entity, the managers have data

supplied by financial accounting and management accounting (which are exclusively

The Transition from Historical Cost to Fair-Value, A Choice with ... 237

reserved for them). External users are represented by the economic entity funders, its

commercial partners, social partners, public power and other external users. The

funders are users, which potentially or actually, shall make available to an entity the

economic resources for its activities.

The role of financial reporting is to generate useful information to users of

financial statements. New version of conceptual accounting framework considers the

most important category of users includes investors and lenders, and the financial

statements must be addressed mainly to their needs. In the new version of the

framework it is considered that the information needs of investors and creditors and

other needs include user categories. Information provided by financial reporting must

be useful to users, both internal and external, in investment and lending decisions.

The usefulness of accounting information is obtained through the achievement

of qualitative characteristics. The general framework for the preparation and

presentation of the IASB financial statements stipulate four main features as shown in

Figure 1.

Figure 1. Qualitative characteristics of accounting information according to the Conceptual framework for accounting

Since 2002, the IASB and FASB have signed an agreement bearing the name

Norwalk Agreement whereby the rapid increase of its forces to solve the problems of

accounting treatments for searching solutions of the highest quality. General

accounting framework has undergone improvement in year 2005, eight stages in the

process of obtaining the final draft, a process whose final being established for the year

2010. In terms of the qualities that accounting information must meet to demonstrate

its usefulness to investors and creditors, two groups are suggested: fundamental and

amplifier characteristics, shown in Figure 2.

Qualitative characteristics of the Intelligibility accounting information Relevance (^) Credibility

Similarity

Economic prevalence on juridic

Fair Neutrality Circumspection Thoroughness representation

The Transition from Historical Cost to Fair-Value, A Choice with ... 239

Despite universal adoption of the fair value of the normalized accounting, the

positive role of accounting in fair values has generated intense debate among investors,

academics, normalizers. In order to assess the arguments for, and in favour of fair

value it is required to understand the objectives of financial reporting.

5. THE OBJECTIVE OF FINANCIAL STATEMENTS

The financial statements shall present the financial results of an economic

entity grouped by category of information in accordance with the economic

characteristics of the generically “structures of financial statements” that are directly

related to the evaluation of the financial position (assets, liabilities and equity) and

performance (revenue and expenditure). Financial statements provide information

concerning: the financial position of the company; its performance; the cash flows.

This information become useful for various users in decisions relating to the

justification to: the purchase or selling the participations in the company; the

appointment or replacement of people from the governing bodies. The financial

statements contain information on: active; passive; own funds; revenues, expenses,

gains and losses; cash flows.

In table 1 we present a summary of the requirements for the preparation of the

financial statements of an entity.

Table 1. The synthesis of requirements of financial statements by economic entities

Financial statements in accordance with the objectives of the EEC taking into account criteria of size Total assets: Eur 3650000 Net turnover: Eur 7.3 million Medium No. of employees: 50

Simplified Do not exceed the limits of two of the criteria of size

Balance sheet The profit and loss account The situation of the change on equity The cash-flow situation Explanatory notes

Abridged balance sheet The abbreviated profit and loss account Explanatory notes Optional: the situation of a change of equity and/or cash flow situation

Financial auditor report Checking is done according to law

The objective of financial statements is to provide general information about:

financial position; performance and cash flows of an economic entity, useful for a wide

range of users in making economic decisions. The financial statements shall also

forward the results of the management by the leadership of the enterprise resources

entrusted to it.

Application of fair value in accounting seems to permit preparation of financial

statements which make third parties better information regarding the performance of

the present and future of the undertaking and therefore the possibility of their

decisions. Such a statement forces us to ask ourselves the question on the relationship

240 Răscolean, I.; Rakos, I.S.

between the accounting results, in the broad sense of this term and the stock value of

the company. The exponential growth of the financial markets, some foreign experts

are asking the following question: during past results and recognition is likely to

generate information on the evolution of future results?

The authors examine the direct link between the outcome and the course of the

stock market and they enquire of the accounting assessments. Model Edwards-Bell-

Ohlson provides an adequate framework for reflection, to the extent that the value of a

company depends on its book value and abnormal results updated. Yet one question

remaining: why some firms negotiate prices higher (or lower) the accounting value?

Despite the criticisms formulated, informing the financial information as a

whole constitute the richest, made available to investors. The financial theory

developments have eased the proposal of a framework to enable analysis of the

importance of its contribution to the markets.

Annual accounts must give a true and fair view of the financial position,

performance, modification of equity and of cash flows of the enterprise for that fiscal

year. They must meet the needs of the users. However, experts in the field of

accounting have found that they do not provide all the information they need in relation

to decision-making, as “largely” the financial statements reveal the effects of past and

does not provide, as a rule, non-financial information. Also, on the basis of the

financial statements, the results of the evaluation of the management of the enterprise,

including the management of the resources entrusted to managers. Those users who

want to evaluate how management of the undertaking or to establish the responsibility

of the manager take economic decisions aimed at either the option “ keep or sell ” in that

undertaking, or reconfirming or replacing its leadership.

At the same time, financial statements constitute informational support

required to carry out financial analysis oriented towards formulating a diagnosis. The

different categories of users are using financial information and other information

provided by the accounting, statistical and operational organisation, to diagnose its

activities, and on that basis to substantiate economic and financial decisions. Each

economic entity has an obligation to draw up annual financial statements which must

include: balance sheet; the profit and loss account; the situation of equity changes; the

situation of cash flows; accounting policies and explanatory notes.

The multitude of consequences for providing information via summary

documents (the distribution of wealth among individuals, the aggregate level of risk

and its allocation among individuals, allocating resources between companies, the level

of the resources used for the production, certification, public disclosure, analysis and

interpretation of information, etc.) generates the necessity of choosing the pattern of

synthesis documents.

On the constituents of an optimal set of synthesis documents there is an

agreement, and it was accepted only in regard to the fact that the policy for disclosure

of synthesis documents is the result of the combined action of accounting

normalisation and factors such as: the size of enterprise, the number of shareholders,

the stock exchange listing, the performance of the undertaking, the costs associated

with the disclosure of information.

242 Răscolean, I.; Rakos, I.S.

Table 2. Characteristics of the historical cost versus the fair value

Characteristics of the historical cost Characteristics of the fair value is the cost of origin - recorded, measured and evaluated upon entry of assets and debts;

  • in the case of assets, the historical cost consists in the cash sum paid or payable at the time of purchase or production that makes possible the acquisition of an asset;
  • in the case of debts, the historical cost equivalents represent the value obtained in exchange for the obligation or, in certain circumstances (such as corporation tax), the value of which is expected to be paid in cash or cash equivalents in order to off debts;
  • somebody verifiability and objectivity of accounting documents attesting to (the use of historical cost as the basis of measurement, enables manufacturers to provide financial statements, objective and verifiable information).
  • is the consequence of the application of accounting principles used in the Western practice, namely nominalism and monetary prudence (in order to be able to rely on the information provided by the manufacturers, internal and external users must ensure that the information is accurate and it is based on facts);
  • once established, the historical cost remains fixed, so long as the property remains in the possession of economic entity;
  • can be defined as that “sacrifice which has been consented to bring the good in its entity at the date of entry”;
  • the historical cost used in measuring the fair value can be defined in terms of the undertaken sacrifices (engaged costs) plus the associated cost of wasted opportunities;
  • orients accounting of economic entity towards the past, whereas plays information about the value on the balance sheet structures at the date of

Through the notion of the fair value we follow “correcting the acquisition costs of assets with their market value (...) the work done by the permanent balance sheet items revaluation”. Accounting dictionaries define fair value as a rational and fair estimate of the market price of a good, service or financial asset by taking into account elements such as: production/distribution costs, the utility (in the case of goods and services), yield (for assets) or market availability. In the field of finance, there are two streams of opinion with regard to the relationship between market value and fair value:

  • efficient markets theory, according to which on a well-organized and informed market, the market price is equal or almost equal to fair value, investors having immediate and adequate response to any external information;
  • behavioural theory, according to which, on the contrary, the market price is often very different from the fair value as a result of the collective spirit and emotional state of investors. The controversy between the two models (historical cost and fair value) had as its starting point the relevance of information based on market prices, but the period of time (moment) which belong to the prices used in the accounting evaluation and this is because, while historical cost uses market prices from the moment of obtaining the asset or debt, the fair value recourses to the current one. The fair value is based, firstly, on the prices available on the market, because they reflect the market’s assessment regarding:
  • the present value of future cash flows statements embedded in a single element (calculated through the current rates of interest);
  • the risk that the amount or timeliness of these flows will differ compared to expectations. This results in increasing the objectivity of having the effect of improving the value of the financial statements prepared informative of the economic entity. We can thus affirm that, in practice, the fair value is materialized in the market value or in values derived from it. We

The Transition from Historical Cost to Fair-Value, A Choice with ... 243

their acquisition;

  • accounting professionals agree that the objective of the accounting should not be confined to play financial position and past performance of the economic entity, and for investors, a particular importance is presenting its prospects.

consider that the assessment at the fair value which deals with a large number of non- financial assets and liabilities can be the foundation of a new model of representation of economic entity by means of which it seeks better manifestation of uncertain financial states affecting financial forecasts of financial flows and investment opportunities.

7. CONCLUSIONS

The current model of financial reporting represents a mix between historical

cost and fair values. Historical cost with all the inherent advantages set forth

limitations, we can say that it has aged. Historical cost reflects fair value items at the

time of their initial recognition as fair value at that date. But as time passed, he takes a

very historic dash if the item still appears in the balance sheet.

Economic parameters, both general (purchasing power, interest rate) and

specific (profitability) that surrounds it, never ceases to evolve.

Thus, in the case of a perennial in existence, historical cost accounts of an item

may no longer play after a certain period, the exact value it should reflect. Of course,

there are a number of corrections of amounts, as well as the revaluation of accounts,

indexed to inflation, but these are insufficient for rendering an image closely. And the

reason is that historical cost is less and less used in the valuation of the balance sheet in

accordance with IFRS. That does not mean it will be abandoned, but only that it should

be substituted where it does not work, with a different value. Valuation at fair value

has many opponents in whose opinion the historical cost is still the most logical basis

of measurement the financial statements presentation.

At the heart of the debate on historical cost in relation to fair value lies

between compromising the credibility and relevance of the two associated forms of

evaluation. At the level of individual societies, the historical cost will subsist and due

to the fact that it is and will be required for the purpose of determining the taxable base

by tax regulations.

Although the fair value is used in the assessment of the majority of items on

the balance sheet, however, historical cost retains a well-defined status. The argument

lies in the fact that, on the one hand, stocks and fixed assets held for sale cannot be

assessed at a higher value than their cost, and on the other hand, for intangible asset

headings, the tangible assets and asset headings exploration, for which there are

accounts option on the assessment at historical cost or fair value, the basic treatment

recommended by the IASB is the valuation at cost. Only in the case of real estate

investment, IASB recommends as basic treatment: the evaluation at fair value.

REFERENCES:

[1]. Bunea, Ş. (2011) Standarde internaţionale de Raportare financiară (IFRS) 2011- Implicaţii pentru entităţile din România , Curierul Naţional, nr. 5938