A Comparison of Historical Cost and Fair Value Accounting Systems: General and Some Regulatory Concerns

A simple and parsimonious example compares the accounting results of two accounting systems in terms purely of aiding investor decision making (buying/holding and selling securities). This article summarises the ideas in Bromwich et al. (2011) though with a slight regulatory emphasis using a different example. A major aim of this chapter is to show that practical accounting models can help the understanding of their utility in predicting the future. A variety of regulators often have recourse to modelling the possible future outcomes of organisations involving accounting simulations and simulated comparisons of the results of different accounting systems. Reconciling the reported results with those derived from benchmark models reveals the deficiencies of accounting systems in supplying information for decision making. Historical cost (HC) accounting is found to perform poorly. Fair value (FV) systems without estimated FVs may perform even worse and may mislead investors but allowing FV estimates increases the subjectivity of financial reports.

Parts of this article use similar words and phrases to those used in Bromwich et al. (2011) without direct quotation to simplify the presentation. I am very grateful to my co-authors: Frank Clarke and Graeme Dean.

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Notes

This simplifies the analysis by avoiding the use of utility functions and the determination of market equilibrium (See Wagenhofer and Ewart 2011). It is not suggested that such refinements are unnecessary for a complete analysis, only that assuming certainty allows sharp focus on the results of the two systems.

Historical cost accounting records can only be based on market transactions because of the use of accruals.

Such markets are complete—all items are traded and perfect—prices are the same for all. Accounting entries are based on changes in market prices and on market transactions.

Similar examples appear in the Richardson [(NZ) Report issued in 1977] and the similar government sponsored Canadian Report shortly after.

Abnormal profits and their discounted sum, often called internal or subjective goodwill, can be generated by a large number of factors including positive net present value opportunities, synergy between activities, special skills and locational advantages, product differentiation and monopoly power (Edwards and Bell 1961, 36–37).

Generally, this relation will be equal to the equity value of the firm on the securities market where all markets are well organised and participants share common beliefs and objectives and have the same information and creative (neither aggressive nor conservative) accounting is not being practiced. This is the general case in our example.

See Bromwich et al. (2011). Thus, periodic residual incomes can be seen as measuring the distortions generated by the accounting system being utilised relative to the outcomes of the economic income approach.

This is, of course, true of all other accounting for ‘cash for cash’ projects but we are exploring the different timing of the release of this information by the accounting systems examined. Total profit—accumulated interest on opening value of assets in each period equals NPV₀ = (795−199.6−199.6) = 396.

The declared RI figures are more complex than it might seem. The RI figures for periods 1 and 2 of 190 and 270 respectively, each comprise of two elements. An interest amount equal to the undercharging of interest by the HC accounting system relative to economic income caused by interest on the project’s NPV of 39.6 not being charged in the RI calculations in period one; (199.6-160) and 24.5 in period 2 (199.5-175). The second element is the RI net of this interest. Theses RIs net of interest add to the project’s NPV (150.4 + 245.4 = 396).

In the case of our example, the only adjustment required to net asset values is for omitted abnormal profits as the change in the price of the operational asset is assumed not to affect cash flows. We do not wish to correct for the distortion caused by the use of accrual accounting as this is what we wish to appraise. The “bridge” required between equity and accounting values may be negative where net asset book value exceeds equity value where companies have not taken the abandonment option. Asset impairments represent one way of reducing the size of a negative bridge. In the practical world with uncertainty, the existence of bridges may serve to remind investors that equity market prices are estimates and depend for their validity upon the efficiency of the stock market. These estimates could be checked against the investor’s private information set, especially where bubbles are likely.

The difference between the RI of the first period of 190 and the abnormal profits impounded in that period’s net assets of 150 arises as residual income calculations do not incorporate the interest on abnormal profits which are included in dividends.

Decreased asset prices of this type indicate that the bridge to equate net asset carrying value and equity worth needs to be increased assuming that these changes do not indicate diminished cash flows.

It is unlikely in the contemporary environment that the gain accruing from the price increase in the operational asset will be taken to profit as it is with PFV accounting, rather it will be treated as an element of comprehensive income, that is, as capital reserves. This does not affect the value of information provided by capital gains providing that these gains are regarded as of equal quality to gains flowing from marking to market.

This is found by deducting from the project’s PV of 396 the net gain from the operational asset of 250 (500-250 extra depreciation in period one) which gives the value of the bridge required to give the PV of the project at time T₁ of 1,996.

Period one’s FV RI can be written as: HC abnormal profits realised in trading plus the gain on the operational asset unrecognised by HC accounting less the additional depreciation relative to HC depreciation on the operational asset less the additional write off above HC accounting on the development asset. This gives 190 + 250 − 300 = 140, the FV RI.

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Authors and Affiliations

1. Department of Accounting, London School of Economics, London, UK Michael Bromwich

1. Michael Bromwich