Is cost accounting more appropriate than fair value accounting for Intangible assets?

HISTORICAL COST VS. FAIR VALUE

Is cost accounting more appropriate than fair value accounting for Intangible assets?

Introduction....................................................3

Discussion.....................................................4

What are historical cost and fair value accounting?......................4

Intangible Assets and Valuation....................................5

Historical Cost Accounting – Pros and Cons...........................6

Fair Value Accounting – Pros and Cons..............................7

The application of historical cost and fair value accounting to intangible assets.10

Conclusion.....................................................11

Reference

Introduction

In recent years, there has been continuous discussion done globally about the accounting methods that should be used for financial reporting. Traditionally, historical cost accounting method has been applied to financial statements widely. However, an increasing number of international standards are allowing or requiring the use of alternative accounting method, such as fair value accounting, for financial reporting these days. That is to say, the trend for the choice of accounting method is changing from “traditional” historical cost accounting to “newly introduced” fair value accounting. Jaijairam (2013) emphasizes that it is very important to understand the advantages and disadvantages of traditional and alternative accounting method – historical cost and fair value accounting – and decide which one would be the appropriate accounting method to be applied to financial statements. Because a firm’s choice of accounting treatment for various assets can have a significant impact on its financial reporting, management decision, and firm’s future performance.

Either to choose historical cost or fair value accounting for financial reporting can influence how companies value their assets, including intangible assets. Intangible assets have become increasingly important elements of success in corporate activities. Talha (2004) emphasizes that for most companies, intangible assets represent both essential factors in their progress and a considerable part of their corporate value. Also, the valuation of intangible assets is a matter of great interest to managers, investors and companies. Therefore, it is important for many parties to understand how historical cost and fair value accounting are applied to financial statement and how to estimate the value of intangible assets in different ways.

Since historical cost vs. fair value has been debated globally, CICA Handbook Part 1 is suitable to describe this topic in regards of CICA Handbook. According to the handbook, "International finance reporting standard 1 that has been adopted by the accounting standards board. Newly issued, amended or revised international financial reporting standards are part of Canadian GAAP only after they are approved by the accounting standards board in accordance with its due process". That is to say, historical cost accounting had been mainly used worldwide, but fair value accounting has been adopted and recognized as newly and useful accounting standard (CICA Handbook, 2014).

This paper will discuss the definition of historical cost and fair value accounting, pros and cons of both accounting methods, and the conclusion whether historical cost is more appropriate accounting method for intangible assets in financial statements.

Discussion

What are historical cost and fair value accounting?

Before discussing pros and cons of both accounting methods, it is important to understand how these two methods are defined. First, historical cost accounting–often considered as one of the most basic principles of financial accounting - is the accounting method that requires most assets and liabilities of a business be accounted for on the basis of their original acquisition cost (Powers, 1991). According to Jaijairam (2013), under historical accounting, the initial price paid by the company during the purchase of the asset or incurrence of the liability is the one that matters. Thus, historical cost accounting reflects the real value of items at the date of their entering the company (Diana, 2009). Second, fair value accounting, also called “mark-to-market” accounting, refers to the accounting standard of assigning a value to a position held in a financial instrument based on the current fair market price for the instrument or similar instruments. This accounting method is defined as the act of recording the price or value of assets or liabilities to reflect its current market value rather than its book value (Wagner & Garner, 2010). Jaijairam (2013) also defines fair value accounting as the practice of declaring the value of the assets or liabilities and helps companies to reset the prices of certain assets on its balance sheet every quarter to reflect changes in the market price.

Intangible Assets and Valuation

Since this paper is specific to intangible assets, it is necessary to understand the definition of intangible assets and how the value of these assets is calculated. According to IFRS, an intangible asset is defined as an identifiable non-monetary asset without physical substance and must arise from contractual or other legal rights or be separable. Goodwill, copyrights, trademarks, brand names, franchises, patent and Intellectual capitals are good examples of intangible assets (Quilligan, 2006).

There are the few valuation methods of intangible assets such as market-based, cost-based, use value, investment value, owner value, insurable value, and collateral value methods (Reilly, 2011). Among these methods, market-based method and cost-based methods are commonly used. First, market-based method values intangible assets by reference to transactions or benchmarks of comparable assets that occurred in a similar market recently. This method provides the best evidence of fair values that relies on actual market transactions. However, it is important to consider that it may be difficult to ensure that the asset under consideration and the market transaction are sufficiently comparable (Quilligan, 2006). Talha (2004) also states that this method is difficult enough because it is never possible to find a transaction that is exactly comparable. Talha emphasizes that the search for a comparable market transaction is almost futile because of different negotiating skills with different purchasers in the market and the distorting effects of the peaks of economic cycles. Second, cost-based method values intangible assets by assessing the development or replacement cost of the asset. This method is often used for valuating internally developed assets such as software (Quilligan, 2006). This method takes for granted some relationship between cost and value. However, cost-based method has major issue that is associated with historic earning capacity, and this method has difficulty in adjusting to alternative uses of the assets (Talha, 2004).

Historical Cost Accounting – Pros and Cons

According to Krumwiede (2008), historical cost accounting is the one that produces reliable, verifiable information. Krumwiede emphasizes that financial information must contain varying degrees of relevance and reliability to be useful but fair value accounting, in comparison, does not provide reliable information. Krumwiede also believes that historical accounting minimizes the use of estimates and judgments whereas fair value accounting that often requires significant time for decision process. Diana (2009) states that historical cost accounting is the most utilized accounting method, and the information can be verifiable as the cost is recorded in the document that proves the property right over a certain asset. One of the most important advantages of historical cost is objectivity because this accounting method is supported by transactions that have already been completed, and thus it is evident and easily understandable. Diana learns from other studies that historical cost accounting should be used for financial statement rather than fair value accounting because the information provided based on fair value is not dependable as they are not based on verifiable transactions. She also argues that fair value accounting should not be allowed to constitute grounds for making decisions in any cases. Jaijairam (2013) also believes that historical cost accounting is easy to understand as it is based on a fixed price that is always completely known, specifically the actual price that a company paid.

However, Jaijairam also argues that historical cost accounting possibly underestimates the value of assets depicted on the balance sheet due to depreciation, depletion, and obsolescence. Another issue of historical cost accounting is that a firm using this accounting method may be tempted to manipulate its figures on depreciation to overestimate the useful life of an asset or its residual value. It eventually could result in overestimated income. According to Diana (2009), historical cost accounting reflects the real value of assets at the date of acquisition, but any significant subsequent change tends to make the historical cost inaccurate and out of date. This also possibly leads to a regular under-valuation of the assets. Inflation could be an issue as well. Historical cost accounting is an inaccurate reflection of the actual situation. The assets are under-valuated, and the performance of the company cannot be assessed correctly because of over-valuated profit. Especially for the firms that invest in intangible assets, historical cost accounting fails to reflect the actual capacity of generating future profits that expresses the actual value of the firm.

Fair Value Accounting – Pros and Cons

Despite her argument on the use of historical cost accounting, Diana (2009) also finds that fair value accounting is relevant for financial reporting. According to Diana, fair value accounting ensures a connection between the value created by the company and its stock market evolution, allows all executive managers to become aware of the costs incurred by all the capital used, and outlines the performances broken down in profit-generating units. Fair value accounting also improves comparability by valuating similar elements in a similar way. She also introduces few advantages of fair value accounting; investors are interested in value, rather than costs, therefore financial information must be reported using fair value in order to provide accurate information for investors; historical cost becomes irrelevant for establishing the company’s financial situation as the price provides an updating of the information regarding the value of the assets. In other words, cost does not mean much but price does. Price tells how the company is doing with assets and funds; fair value reflects an economic situation. The fair value determined based on market prices is not affected by factors that are specific to certain companies.

However, fair value is often considered as too unstable and that means it would be too easy to manipulate, which makes it unsuitable to be used as an estimate for the value of an asset. Fair value accounting could not be certain to make an estimate as the value is often based on the flows expected in the future from the use of that asset (Diana, 2009). Krumwiede (2008) finds that fair value accounting seems to compromise the relevance and comparability of financial reporting. According to Krumwiede, fair value accounting often requires significant judgment thus the valuation could be too subjective. Also, the uncertainty in measuring risk clearly illustrates the difficulty in making accurate predictions for determining fair value. He specifically states that estimating fair value could be even more difficult when goodwill or other indefinite-life intangible assets exist because management must exercise judgment in estimating the life of the goodwill or other indefinite-life intangible assets. The question that must be asked is “How could we possibly measure fair value that is not always practical or possible?” Krumwiede also questions the reliability in fair value accounting. Sacrificing a certain degree of reliability in return for more relevant information could be considered as an appropriate trade-off but at least a sufficient level of reliability should be presented in financial reporting and Krumwiede does not believe that in fair value accounting. To the extent different entities use different assumptions and procedures in estimating fair value, the comparability would be decreased.

Therefore, if the company chooses historical cost accounting for financial purpose, that means the company must give up the real market value and only depend on the acquisition cost when the company purchased the assets. The company would not be able to reflect the economic cycle, and that would generate overestimated or underestimated income for the company. Historical cost does not tell the company the accurate value of assets at the current point, thus it would be important to have asset management experts. On the other hand, the company that chooses fair market value accounting for financial purpose must give up objectivity and the relevance because of lack of previous history, transactions, and subjective judgments. The value of assets would be valued by experts, but it would be solely subjective judgments. The company also may have to take a risk for manipulation by management because fair value is not stable and too subjective, thus it would not be too difficult to manipulate the value and get compensation by overestimated income from the company. Therefore, it is very important for companies to understand the advantages and disadvantages of both accounting methods and, trade-off, thus the company minimizes the risk of over or underestimated income for financial reporting.

The application of historical cost and fair value accounting to intangible assets

As previously stated, intangible assets are an identifiable non-monetary asset without physical substance, thus it is not likely possible to determine exact and accurate value. The value of certain intangible asset may be differently valuated by various sources. Therefore, the company should carefully decide which approach the company will use as the value of the intangible asset is hard to accurately measure.

Based on my study, the most important factor that the companies should consider in order to valuate intangible assets for financial statement is the objectivity. It is nearly impossible to measure exact value of intangible assets. That is to say, historical cost accounting is a more objective method than fair value accounting because accountants easily find historical accounting more objective based on previous transactions and dependable data. On the other hand, fair value accounting is considered too subjective and unstable because most of time the values are decided by judgment at the current position, but not reflect how the previous process is done. Accountants and companies also would be able to predict how their assets could be valued based on how other companies’ assets were estimated in the past.

Intangible assets are also fairly vulnerable to manipulation because this kind of asset is hard to measure, as stated above. For instance, brand name is an intangible asset and it is impossible to tell exact value as it does not even exist. Therefore, without previous data, the value of this brand name could be estimated quite differently by different financial experts. This tells that intangible assets are easily told as any price by anyone. Of course, financial experts would do some research for income and estimate how much this brand name helps companies to generate this certain income, but there is no exact value to be certain. Thus, when historical cost is used for measuring intangible assets, accountants or companies should be able to find how similar assets have been recognized in a similar market and use this data as references and evidences before making a decision for the value of intangible assets.

Henry, my boss and chartered accountant, also supports historical cost as the more appropriate accounting method for intangible assets. He also emphasizes that fair value is too unstable and hard to measure exact value. According to him, most of clients prefer historical cost for any assets and liabilities including intangible assets because if fair value accounting is applied to financial statement, it could often cause two different perspectives regarding the value of certain assets to accountant and business owner because accountant and client might view the current market condition and economic cycle differently. It means each individual could view same intangible asset differently and it possible lead the parties to argue about “the real value”. To avoid this kind of hassle, Henry agrees that it would be more appropriate to use historical cost accounting which is objective and evident with previous transactions.

Conclusion

This paper discussed how different historical cost and fair value accountings are, advantages and disadvantages of both accounting methods, and which one would be more appropriate for intangible assets in financial statements. Therefore, based on this research and few studies, is historical cost accounting more appropriate than fair value accounting for intangible assets? My conclusion is yes - because historical cost is more objective, easy to trace, relevant, evident with previous transactions and data, possible to compare with other companies’ histories and these factors are especially important for intangible assets as intangible asset is an identifiable non-monetary asset without physical substance. In conclusion, historical cost accounting is more appropriate than fair value accounting for intangible assets.

Reference

Diana, C.I. (2009). Historical cost versus fair value. Annuals of Faculty of Economics, 3 (1), 860-865.

Jaijairam, P. (2013). Fair Value Accounting vs. Historical Cost Accounting.The Clute Institue for Aacademic Research, 17, (1).

Krumwiede, T. (2008). Why Historical Cost Accounting make sense. Strategic Finance.Institute of Management Accountants. 9, (2), 33,35-39.

Powers, O. (1991). Historical Cost Accounting – Are changes needed? Business Credit. 93, (5), 23.

Quilligan, L. (2006). Intangible assets identification and valuation under IFRS 3. Accountancy Ireland. 38, (3), 10-12.

Reilly, R. (2011). Defining the intangible asset valuation assignment. Construction Accounting & Taxation. 21, (3), 32-41.

Suntharee, L. (2010). Fair value accounting and intangible assets: goodwill impairment and managerial choice. Journal of Financial Regulation and Compliance. 18, (2), 120-130.

Talha, M. (2004). Valuation of intangible assets in accounting. Construction Accounting & Taxation. 14, (1), 25-31.

Wagner, A., & Garner, D. (2010). Fair Value Accounting – Fact Or Fancy. Journal of Business & Economics Research, 8, (11), 35.