Hans Hoogervorst, chairman of the International Accounting Standards Board (IASB), shares with The Accountant’s readers his take on the long-awaited proposals to update the standard-setter’s Conceptual Framework
Determining how to measure an asset or a liability is arguably one of the most controversial and sensitive issues in accounting. Should an asset be measured at the price you paid for it or is it the amount you can sell it for in today’s market? What if you are not planning on selling it?
Measurement techniques used by companies to report their financial performance can be split into two basic categories: historical cost and current value. Within the current value category, it is fair value (market value) accounting that generates the most controversy. Both historical cost and fair value have their fan clubs, and discussions about their relative merits tend to be heated and often ideological.
The fans of historic cost like it for its alleged objectivity and relative stability. They dislike fair value for the volatility resulting from changes in market prices and for the subjectivity needed when fair values must be estimated (for example, mark-to-model valuations). They also tend to believe fair value accounting is more prone to abuse because of its alleged subjectivity.
The fans of fair value like it for the very reason that it does require a full update of all inputs at each reporting date, even if that update is subjective. They believe this gives the most meaningful picture of the financial position and performance of a company. They recognise that fair value may lead to volatility in the income statement, but they believe that to be an accurate reflection of economic reality. They consider historic cost to be a very primitive measurement basis that provides information that very quickly becomes outdated.
Not miles apart
For many economic activities, using fair value would not lead to relevant information. For example, when an asset is used to produce goods, fluctuations in fair value could muddy the income statement. Fair value has its weaknesses but so has historical cost. I do not think that the dichotomy between historical cost and fair value is as stark as many think.
First of all, for many transactions, historical cost starts and ends with fair value (or values that come very close to it): the original purchase price and the selling price of an asset or a liability. The dates of purchase and sale are when historical cost is most objective.
Secondly, despite its name, historical cost gets updated too, albeit less so than fair value. The most common updating of historical cost is depreciation of property, plant and equipment. Estimating depreciation is certainly not free from subjectivity. Subjectivity in historical cost accounting is even more pronounced when an asset is deemed to be impaired and an estimate of its value-in-use needs to be made. That estimate is based on management’s estimates of future cash flows, which are no less subjective than mark-to-model valuations. With this subjectivity, there is also room for abuse. Practice has shown many instances of ‘big bath’ impairments by new CEOs to bolster earnings in future years.
Thirdly, the alleged stability resulting from historical cost accounting can be extremely misleading and the stability of historical cost can be interrupted by steep cliff effects. Because measurement updates are less frequent and comprehensive, a creeping erosion of the balance sheet may remain unseen for a long time. When problems finally erupt, they tend to do so with a vengeance. The stability of historical cost then turns into serious convulsions.
In conclusion, all the vulnerabilities that are often attributed to fair value accounting also apply to historical cost accounting.
Mixing the two
The IASB, which sets standards used by listed companies in more than 100 countries around the world, has recently published proposals to update its Conceptual Framework. This framework underpins the standard-setting process and also helps companies determine accounting policies. Within it, we have opted to use both historical cost and current value measurement, including fair value, methods.
I believe that current value measurements provide useful information if a company’s business activity is to trade assets or liabilities in an active market. However, historical cost may be more useful for assets that are used together with other assets in order to produce goods and services.
These are very broad strokes indeed, and in practice even more factors will need to be taken into consideration. Using mixed measurements — both historical cost and current value — does not provide easy answers. However, it gives us the best tools to set standards that provide the most useful information to investors.
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