Why Historical Cost Accounting makes Sence

                                                                                               By  Tim Krumwiede , CPA

As the Financial Accounting Standards Board (FASB) continues to march toward fair value accounting and away from historical cost accounting , it’s a good time to consider the flaws of fair value accounting .Enron’s demise , after all , has been partially blamed on fair value accounting . In addition , it has been suggested that the use of fair value accounting for securities backed by subprime loans has exacerbated the current credit crises. The difference between historical cost accounting produces reliable , verifiable information.

At the crux of the raging debate are reliability and relevance---the two cornerstones of financial reporting . Those opposed to fair value accounting believe it provides unreliable information. Proponents of fair value reporting , however , believe it provides more timely and relevant information despite its increased use of estimates and judgements.

Undoubtedly , financial information must contain varying degrees of relevance and reliability to be useful. These two attributes are the primary focus of this article , which will tackle the potential expanded application of fair value measurements to long-lived and intangible assets. Although the focus will be on long-lived and intangible assets, we can easily extend the points made to analyze other applications of fair value accounting . Rounding out the article will be a look at the direction of the FASB, a comprehensive fair value modle, fair value measurements and allocation, the criticisms, and how investment analysts use financial statements.

TOWARD FAIR VALUE ACCOUNTING

Generally , long-term and intangible assets are reported on a balance sheet at historical cost or historical cost adjusted for depreciation or amortization. Exceptions, however, exist under Statement of Financial Accounting Standards (SFAS) No.144, “Accounting for the Impairment or Disposal of Long –Lived Assets,” for impaired assets. These Standards require impaired assets to be measured at and written down to fair value . More recent guidance issued by the FASB suggests fair value accounting could be further extended to long—lived and intangible assets.

 To establish clear , consistent guidelines for fair value measurements and provide for fair value disclosures , the FASB issued SFAS No.157, “Fair Value Measurements,” in September 2006. On the heels of this Statement was SFAS No.159, “The Fair Value Option for Financial Assets and Financial Liabilities .” Although this Standard didn’t extend to nonfinancial assets and liabilities, the Board suggests in the background information for Statement No.159 that it will continue to consider additional fair value elections.

 This progression toward fair value is also evident in the Exposure Draft on the conceptual framework that the FASB issued on May 29,2008 (“Conceptual Framework for Financial Reporting : The Objective of Financial Reporting and Qualitative Characteristics and Constrains of Decision—Useful Financial Reporting Information”). In general , the exposure draft appears to emphasize the balance sheet instead of the income statement ,which ultimately implies the extended use of  fair value measurements . This emphasis differs from a more traditional view the FASB expressed in Statement of Financial Accounting Concepts (SFAC) No.1, “Objectives of Financial Reporting by Business Enterprises,” issued in 1978: The primary focus of financial reporting is information about earnings and its components. Financial accounting is not designed to measure directly the value of a business enterprise, but the information it provides may be helpful to those who wish to estimate its value .

 This view from SFAC No.1 is consistent with the view that the traditional income—statement approach should be emphasized. The income—statement approach uses historical cost accounting and a transaction approach that minimizes the use of estimates and judgments . This traditional approach, which companies have used for several hundred yesrs , provides information that has a sufficient level of reliability and is verifiable. On the other hand, a balance—sheet approach, which potentially would incorporate an extended use of fair value measurements that often aren’t grounded in market observations, can result in information that is potentially unreliable and not easily verified. Think Enron here.

 A COMPREHENSIVE FAIR VALUE MODLE

 The most unyielding proponents of fair value accounting would be in favor of extending it to all assets and liabilities during a period to the extent the changes aren’t attributable to transactions with owners (for example, payment of dividends and capital contributions).

 Consider Company A with ＄500 in operating assets and ＄400 in long—term debt originally borrowed to finance the operating assets. Assume that poor economic conditions result in a reduction in the future utility and fair value of the operating assets. At year—end , the fair value of the assets is estimated to be ＄200. Now assume the same conditions decrease the creditworthiness of the company and thus the fair value of its long—term debt. Assume the long-term debt has a market value of ＄300 year-end. In summary, the assets have decreased in value by ＄300, and the liabilities have decreased in value by ＄100. The decrease to equity from the fair value measurements is the net of the two, or ＄200.

 For comparison purposes, Company B is identical in assets and operations (＄500 in assets at the start of the period and a ＄200 value for the assets at the end of the period). But Company B isn’t leveraged and has no related long-term debt. For it, the decrease to equity is ＄300. Company B, the entity without the leverage, has the poorest performance as measured by the reduction in equity.Whether or not Company A ultimately turns around its performance and repays its debt, this use of fair value accounting would seem to compromise the relevance and comparability of financial reporting. Reporting liabilities at fair value has already provided some results that could be considered counterintuitive. For the quarter ended March 31,2008, some financial institutions that adopted SFAS No.159 reported significant amounts of revenue because of the write-downs of their liabilities.

 MEASURING FAIR VALUE

 The reliability of fair value depends on the inputs in the measurement process. SFAS No.157 provides an input hierarchy to measure fair value: Level 1, Level 2, and Level 3. The highest level of inputs, Level 1, are observations from active markets, such as the stock exchanges, for identical assets or liabilities. To the extent that fair value measurements are grounded in Level 1 market observations, most individuals would agree the measurements are reliable.

  Level 2 inputs, which the FASB prefers over Level 3 inputs, include all other observable inputs that aren’t Level 1 inputs. An example of a Level 2 input for an asset would be an observed sales price for a similar asset. Level 3 inputs are unobservable inputs. In most cases, Level 2 and Level 3 inputs will be used for long-term and intangible assets because Level 1 inputs won’t be available. When Level 2 and Level 3 inputs are necessary, the reliability of fair value measurements is questionable.

  A present value (PV) technique, such as discounted cash flow (DCF), is a common method of valuation for long-term and intangible assets. Because PV computations use forecasting, the reliability of this valuation technique is open to criticism. Stndies have found that DCF is the most commonly used valuation technique for goodwill. In addition, in SFAS No.144, the FASB acknowledges that a PV technique is commonly used to measure the fair value of long-lived assets. Let’s now focus on DCF because of its widespread use in measuring fair value for intangible and long-lived assets.

 In Appendix B of SFAS No.144, the FASB expresses the following thoughts regarding fair value measurement: The Board acknowledges that in many instances, quoted market prices in active markets will not be available for the long-lived assets covered by this Statement…a present value technique is often the best available valuation technique with which to estimate fair value…During its deliberations leading to the Exposure Draft, the Board concluded that an expected present value technique, especially in situations in which the timing or amount of estimated future cash flows is uncertain.

 ALLOCATION OF FAIR VALUE

 As a practical matter, it would seem unusual for cash flows to be measured on an asset-by-asset basis. It’s more common that cash flows are measured for a group of assets related to the production of one or more products. Furthermore, given the externalities from joint and common production, separation of the cash flows isn’t  conceptually possible. Accordingly, a DCF approach in the measurement of fair value requires grouping assets together. Once the fair value for an assets group is determined, an allocation of the asset group could prove challenging.

 To illustrate practical considerations, let’s look at a manufacturing operation that includes property, plant, equipment, and intangible assets. Measurement of the fair value for each individual asset or asset category isn’t always practical or possible. For example, a company may tailor and modify equipment and machinery to meet specific manufacturing needs. In addition, robots used in the manufacturing process are typically programmed for specific purposes. Once a company has modified these assets and used them for several years, it’s probable that no market observations exist for identical or similar assets. Furthermore, market values for intangible assets are generally not available. Even if market values are available foe some assets in a group, a DCF approach may be necessary to measure the fair value of the asset group because market values aren’t available for other assets in the group. Consequently, DCF will often become a necessary valuation technique for a group of assets, and allocation of estimated fair values among asset categories will be necessary.