Historical Cost vs Fair Value

Valuation is a highly subjective matter. Nevertheless, valuation is the base for all the transactions, business analysis, and mergers and acquisitions deals. Valuation may be at historical cost, fair value, notional value, intrinsic value, etc. The primary purpose of doing valuation is to identify the correct value of the asset for which a deal or transaction is to be undertaken. It is not only helping sellers determine the right price for their commodity but also this aids in reaching the level to identify which class of market and the customer can be identified to settle the deal.

In this article, we will look at historical cost vs. fair value in detail –

Historical cost means the actual price at which the transaction was initiated. All the commodities or assets present in the balance sheet are needed to be disclosed at historical value. Historical cost is globally accepted as a measure to record the property plant and equipment. It will always show assets on a historical basis, considered for calculating depreciation and other statutory matters.

Fair value means the actual value of the asset in the market as on the day. It is highly dependent on the demand, availability, perishability, market, set of assumptions, etc. Professionals are required to determine the fair value of any asset, commodity, or intangibles. Fair value is also known as intrinsic value, actuarial value, market price, etc.

Let us understand the historical cost vs. fair value with an example:

ABC Ltd. acquired land at $100,000 in 2002

• The actual market price of that land in 2018 is around $1.75 million.
• Here, the cost of the land in the balance sheet will reflect $100,000, which is nothing but historical value.

The market value of $1.75 million is considered the asset's fair value.

Here, we provide you with the top 8 differences between historical cost vs. fair value.

The critical differences between historical cost vs. fair value are as follows: –

• Historical cost is the transaction price or the acquisition price at which the asset acquired, or transaction was done, while fair value is the market price that a property can fetch from the counterparty.
• As per Indian GAAP, we follow historical-based accounting. However, IFRS, at the global level, requires fair value based accounting.
• Depreciation on the fixed asset is calculated on historical cost, while impairment on the commodities is derived based on their fair value.
• Professionals are needed for deriving the fair value, while even non-specialists can derive the historical cost.
• In the Balance sheet, PP&E is disclosed at historical cost. In contrast, financial instruments are revealed at fair value.
• Historical cost derivation is majorly easy and readily available. However, on the contrary, fair value calculation is highly complex and requires technical and niche skills.
• Historical cost calculation does not require any assumptions; whereas, fair value calculation itself is dependent on the various beliefs and methods of analysis.
• One of the Financial statements utility is using the same for comparison. Historical cost-based accounting will not give a better comparison as there can be different methods of depreciation, inventory recording, etc. However, fair value-based accounting helps better comparability.

Valuation is at heart while discussing the business. The historical value will keep track of the value of the transaction at the time of the acquisition, while the fair value shows the attainable value of the same transaction as on date. Also, there are many approaches to calculating them and deriving different valuations based on various assumptions. Therefore, it is always challenging to choose the right method. Also, there will be a financial impact based on the mode selected.