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BAO3309 Research Assignment Historical Cost Versus Fair Value Accounting For Non-Financial Assets

BAO3309 Research Assignment

Historical Costs Versus Fair Value Accounting for Non-Financial Assets Abstract The purpose of this paper is to briefly explain the measurement concepts of non-financial assets in context to historical costs and fair value accounting by referring to the conceptual framework for international financial reporting (IASB Framework) and international financial reporting standards (IFRS) fair value measurements. We study the benefits and challenges when adopting fair value method and historical method to measure non-financial assets. From our research we find out that reliability is the main factor that dominates fair value. fair value seems far more of advantage in theoretical context, but in practicality historical cost seems to be more reliable and verifiable. fair value system is improbable of becoming the primary valuation method. Thus, our findings specify that there should be a free choice between the two-valuation system for the firms.

Introduction Although both measurement concepts are extensively used by various firms when figuring their financial position, there has always been a dispute regarding superiority. Historical costs measurement method measures the value of an asset in the original or nominal amount when the firm acquired the asset. However, Fair value accounting measures the asset on its existing or dominant price of an asset in the market. While both the measurement concepts are widely used and firms are given a free choice between fair value accounting and historical accounting. Australian valuations offer accurate and vigorous valuations in compliance with the International & Australian accounting standards (IAS, AASB) and International Financial Reporting Standards (IFRS).

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BAO3309 Research Assignment

This paper shows the valuation practices of non-monetary asset group: Property, Plant and equipment (PPE) and intangible assets using both historical and fair value cost method. We also analyse the benefits and challenges of either methods by looking in the accounting literature. Thirdly we observe the valuation practices in companies listed under New York stock exchange (NYSE), London Stock Exchange (LSX) and Australian Stock Exchange (ASX). The paper also reflects the facts that under IFRS has provide firms to choose either fair value or historical cost method for PPE and Intangibles.

1.Measurement Concept of Historical Cost and Fair Value Accounting The Conceptual framework of financial reporting defines historical costs accounting as a measurement tool that uses financial information about assets, liabilities, income and expenses derived from the transaction that created them. Historical cost measures fail to seek the changes in asset and liability values over the time. IFRS Framework also states that during the time of asset acquisition the historical cost of a non-monetary asset is the total amount of all the cost the took place when acquiring the asset, which includes the transaction costs and the amount of consideration given. However, this measurement system can be problematic to identify when there has been no observable transaction and it can be subjective to identifying impairment loss of the asset. Therefore, it is difficult to say that the historical cost is the current value. Similarly, it is hard to compare using historical cost when assets or liabilities that have been attained by a firm during two distinct periods are reported in the financial statement at different prices. The conceptual framework supports historical cost and does not discuss fair value, however IFRS allow its use. Fair Value is the agreed source of value and is measured in accordance with IFRS13 – Fair Value Measurement, in Australia it’s also known as AASB113 – Fair Value Measurement. AASB 113 defines fair value as the value that is received when an asset is sold or liability is transferred in and orderly transaction between two parties in the market at the measurement date. This form of measurement reflects the outlook of market participants. Assets and liabilities are valued by Page 2 of 11

BAO3309 Research Assignment

the market participants using the same assumption they would use when valuing their assets and liabilities in their economic best interest. Fair value reflects the approximations of the future cash flows, the time value of money as well as risk premium. This form of measurement also has a predictive value when measuring assets and liabilities as fair value shows the prospects about the sum, judgement and vagueness of the cash flows. It also has positive value by providing criticism about preceding estimates. reporting entities listed In Australia stock exchange (ASX) must comply with Australian Accounting Standards and Interpretations, as issued by the AASB and Corporations Act 2001.

2. Historical Cost Versus Fair Value Accounting for Property, Plant and Equipment (PPE) And Intangibles

Both Fair value and historical cost method have their differences on the valuation non-monetary assets. Some laws, allow revaluation of these assets while other jurisdictions stick to historical cost accounting. For instance, the US GAAP and German GAAP does not allow the assets to be revalued. Similarly, other developed countries like China, Japan and German do not allow revaluation either. Whereas countries like Australia, U.K, Belgium and New Zealand allows the fixed assets to be valued upwards. However, it is the decision of the management to implement fair value cost model over traditional cost. it is therefore it resting to understand the pros and cons of both the method of accounting. (Missonier-Piera, 2007)

Benefits and challenges using Historical cost method

One of the major benefit of using historical cost method for property, plant and equipment is that historical cost can be verified as the initial cost of the asset is recorded in invoices, contracts and so on. the sum of expense reported on the income statement is determined by the historical cost of plant and equipment. under this technique the amount of depreciation is also recognized and stated in the firm’s annual reports in addition to that on the balance sheet of the firm the Page 3 of 11

BAO3309 Research Assignment

accumulated depreciation is reported as a deduction from the assets historical costs. (MissonierPiera, 2007) Whereas in case impairment, there are chances that assets might be recorded at less amount on historical cost. This shows that the information provided through historical costs are reliable. historical cost method maintains the objectivity of the financial information since this measurement is not clouded with subjective increase and decrease in value. (Christensen and Nikolaev, 2002) When cost model is applied to PPE, the asset is valued at cost of acquisition less amortization deducted in case of depreciable assets, less impairment loss (IAS 16). IAS 36 provision ensures that the impairment losses are valued and accounted.

Even though historical cost is a well-established method of accounting, it also has some major challenges. Intangible Assets such as goodwill, trademarks and copyrights, have low development cost compared to their current value. This value is subjective and are open to any form of changes in the market. In today’s world companies are willing to pay large sum of money ti buy those intangibles. If an active market exist these intangibles should be measured in fair value, in terms of acquisition as historical cost of measurement is objective technique. Likewise, property market is liquid, historical cost is unlikely to present the current market values as valuation of assets can be difficult as it fails to reflect the effect of inflation. This cost method of measurement also possesses another major drawback as it is more likely for the figures to be outdated and cashflows can be inaccurate. (Christensen and Nikolaev, 2002)

Benefits and challenges using Fair value cost method

Fair Value method uses current market value as a method of recognizing as per the Financial Accounting standard board fair value accounting is more superior than historical cost of accounting. assets. (Christensen and Nikolaev, 2002) This method is more relevant way for users to make decisions using financial statements as it reveals the true economic and financial position of the firm. Non- monetary assets are often revalued due to the changes of price in the market. When accounting for property managers have high chances of adopting fair value method as it eases performance measurement. Likewise, the value changes in investment properties are informative of the operating performance. This method provides accurate asset Page 4 of 11

BAO3309 Research Assignment

valuation to the users of the company. This valuation method improves transparency, comparability, and the timeliness of accounting information (Schipper 2005).

As we know that the US GAAP does not support asset revaluation, however the Swiss GAAP forbids revaluation in separate accounts but approves them in the consolidated accounts. Under the Swiss GAAP and IFRS the company can choose revaluation model for PPE. (MissonierPiera, 2007) Upward revaluation of PPE is verified by measuring the difference in calculation done through historical cost method and fair value method. The difference is added to the firm’s equity as revaluation surplus. If these assets are depreciable, the declined amount is recorded in the firm’s income statement. Similarly, the revaluation surplus can be transferred to retained earning if the revalued assets are de recognized. Revaluation model lets us know the current value of fixed assets at the time, therefore investment property and intangible assets use fair value cost method. However, IFRS have stricter requirements for valuing intangibles at a fair value. (Missonier-Piera, 2007)

Firms that opt for the fair value method should revalue assets every time when the book value is different than the market value. Similarly, Fair value are unreliable than historical cost as a company may value similar assets differently than issues are likely to arise. (Christensen and Nikolaev, 2002) Under this method estimation of market value is important, it is bizarre to discover a market to refer to a reliable fair value, this involves broader choice in determining financial values. Management can easily manipulate the numbers and estimates. This makes fair value method difficult to verify. When revaluating PPE at this method fair value is primarily based on an estimate, in cases where there is no active market, the accounting standards offer various ways to estimate the fair value. According to IFRS 13 “when a price for an identical asset or liability is not observable, an entity measures fair value using another valuation technique that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs” (IFRS 13, para 3). There has been a controversy that revaluation model is a tool used lower debt cost, meet the overseas stake holder needs, manage firms leverage ratio and so on.

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BAO3309 Research Assignment

3.Valuation practices for non-financial assets of Companies listed under:

Australian Stock Exchange (ASX)

Australian and New Zealand Banking Group Ltd. Also known as ANZ, is the third largest banking corporation in Australia. ANZ is listed on Australian Stock Exchange. The financial statements of the company have been compliance to the Banking Act 1959, Australian Accounting Standards (AAS), Corporation Act 2001 and AASB. The financial information has used traditional cost method except for assets and liabilities such as derivative financial instrument, assets to be sold in near future, financial trading instruments and assets and liabilities chosen as fair value over profit or loss. (ANZ Ltd, 2016)

In the Annual reports of ANZ goodwill is not amortized, but it is impaired (when assessed). this leads to capitalization of earnings methodology to govern the projected recoverable value of goodwill. Recordable amount equals to fair value less the cost of disposal. The difference between the book value and the recoverable amount is recorded in the income statement. (ANZ Ltd, 2016) Whereas other intangible assets of ANZ such as management fees and aligned advisor relationships are amortized for seven and eight years respectively. At the end of the annual reporting period amortization of the assets are reviewed and changes are made if necessary. ANZ depreciates property, plant and equipment on a straight-line basis. At the end of the reporting period the historical cost of PPE is reviewed for impairment. Recoverable amount is estimated and compared against the book value if there are chances of impairment. if there is a difference in the carrying amount and recoverable amount, the difference is charged to the income statement. If there has been an increase in the estimated recoverable amount than the impairment loss is reversed. (ANZ Ltd, 2016)

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BAO3309 Research Assignment

London Stock Exchange (LSX) The British multinational banking and financial corporation Standard Chartered PLC is a universal bank with operations in corporate, consumer and treasury services. This bank was listed in the London Stock Exchange in 1970. Standard chartered PLC is compliance with the UK GAAP, Companies act 2006 and the IFRS. The 2016 annual report of Standard Chartered states that All the PPE is recorded at cost less accumulated depreciation and impairment loss. The cost includes expenditure that directly relates to the acquisition of assets. At the end of each reporting period the residual values and the life time of assets are revised and adjusted wherever necessary. Here, if the assets book value is greater than the recoverable amount then the property, plant or equipment is written down to its recoverable amount. The income statement of Standard Chartered also include gain or losses on disposals (Standard Chartered PLC, 2016). The PPE such as buildings, aircraft, ships, equipment and motorcycle are depreciated on straight line basis. Non-monetary Assets such as property held for sale are measured in their fair value. Intangible assets such as goodwill is assessed at the end of every reporting period for impairment and cost less any accumulated loss. Goodwill is recorded in the book value in the balance sheet, they ensure that goodwill has been impaired as well. In the books of Standard Chartered the intangible Assets are originally measured at their fair value, which shows that the firm will generate future economic benefits from the assets. These intangible assets are then amortized at the basis of their expected useful life. (Standard Chartered PLC, 2016). Intangible assets are written down immediately in cases where the book value is greater than the recoverable amount.

New York Stock Exchange (NYSE)

Honda Motor company Ltd is a multinational corporation known for manufacturing automobiles, aircraft, motorcycles, power equipment and so on. The company is listed both in New York Stock exchange and Tokyo Stock Exchange. Honda’s property, plant and equipment for six months ending at Sept 30, 2016 was $212,914 million. (Honda,2016). By observing the balance sheet of Honda Ltd, we can observe that non-monetary assets have been recorded in their book value or historical cost. According to the US GAAP, the value tangible assets such as property Page 7 of 11

BAO3309 Research Assignment

plant and equipment having a life over a year needs to be reported in its historical cost. Similarly, the intangible assets of Honda Ltd have also been recorded at historical cost. They are shown at value significantly less than their actual price, moreover the amortization has been deducted from cost of intangible assets.

The

Condensed

Consolidated

Interim

Financial

Statements

of

Honda

Ltd

dated

30/September/2016 also states that Honda uses fair value method to measure assets and liabilities such as Cash, Trade receivables, Trade payables, Debt securities and receivables from financial services. (Honda, 2016). Moreover, unless the value of the assets is impaired or to be traded in near future, historical cost remains dominant in the balance sheet of Honda Ltd. Besides, the going concern assumption of Honda supports historical cost, the company do not plan to sell its non-monetary assets but intend to rather use these assets. Thus, recording PPE in fair value would be providing limited information to the decision makers.

Conclusion There has been a long-standing debate regarding the free choice of using historical cost method or fair value method when accounting for PPE and intangible assets. As firms can freely choose either accounting methods to measure their assets, Both the valuation methods have their own pros and cons. No matter how, superior fair value measurement system is in the market, there is a very limited use of this system. Fair value practice is used when the market estimates are reliable and accessible at a less cost and they provide the knowledge about the performance of the firm. Moreover, when accounting plant, equipment and intangible assets at fair value, the balance sheet is likely to have significantly higher asset values. As we examined the use of the three companies, each listed in different stock exchange. We found out that companies generally use historical cost method when measuring intangible assets, investment property and property, plant and equipment. Historical cost was more dominant that fair value cost measurement. We notice

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BAO3309 Research Assignment

that fair Value was being used in case of properties going on sale as property have a liquid market. To sum up with I believe that there should be a free choice for the firms when measuring their non- monetary assets as this choice is useful from both academic and regulatory perspective. Under the hypothesis that market is well monitored, they should observe the benefits related with fair value over historical cost. This free choice under IFRS allows the management to disclose preferences with admiration to valuation practices. Thus, the firms should be compliance with the IFRS and IASB framework and have a pre- commitment to either practice.

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References

1. AASB Framework, AASB 116, AASB 138, AASB 13, retrieved from http://www.aasb.gov.au 2. Annual Report 2016. (2016). [ebook] London: Park Communications, pp.230-247. Available at: https://www.sc.com/en/resources/global-en/pdf/annual_reports/2016annual-report.pdf [Accessed 26 Jan. 2018]. 3. Annual Report 2016. (2016). [ebook] Melbourne: Australia and New Zealand Banking Group Limited (ANZ). Available at: http://ttp://shareholder.anz.com/sites/default/files/anz_-_annual_report_2016.pdf [Accessed 23 Jan. 2018]. 4. Barker, R. and Schulte, S. (2017). Representing the market perspective: Fair value measurement for non-financial assets. Accounting, Organizations and Society, 56, pp.5567. 5. Christensen, Hans B. & Nikolaev, Valeri V., (2013). Does fair value accounting for nonfinancial assets pass the market test? Review of Accounting Studies, 18(3), pp 734-775. 6. IASB Framework, IAS 16, IAS 38, IFRS 13, retrieved from http://www.ifrs.org 7. Missonier-Piera, Franck., (2007). Motives for fixed-asset revaluation: An empirical analysis with Swiss data, The International Journal of Accounting, 42(2), pp186–205. 8. Schipper, K. 2005. Fair values in financial reporting. http,//fars.org/2005AAAFairValue KSchipper.pdf. 9. World.honda.com. (2016). Annual report 2016. [online] Available at: http://world.honda.com/content/dam/si...