Difference Between 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 –
Table of contents
- Difference Between Historical Cost vs. Fair Value
What is Historical Cost?
Historical cost means the actual price at which the transaction was initiated. All the commoditiesCommoditiesA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units. or assets present in the balance sheet are needed to be disclosed at historical value. Historical costHistorical CostThe historical cost of an asset refers to the price at which it was first purchased or acquired. 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.
What is Fair Value?
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.
Example of Historical Cost and Fair Value
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.
Historical Cost vs. Fair Value Infographics
Here, we provide you with the top 8 differences between historical cost vs. fair value.
Historical Cost vs. Fair Value – Key Differences
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 counterpartyCounterpartyA counterparty in a financial transaction is the person or entity on the other side of the agreement. Any trade must have at least two parties who serve as counterparties for each other. For every buyer in a purchasing deal, there must be a seller. And for every seller, there must be a buyer willing to purchase..
- As per Indian GAAPGAAPGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting., we follow historical-based accounting. However, IFRSIFRSIFRS or International Financial Reporting Standards refers to a globally-accepted set of accounting and financial reporting guidelines for preparing and presenting financial statements. It ensures uniformity in accounting practice that makes financial records comparable across different reporting entities worldwide. Over the years, it has emerged as the new world standard in accounting., at the global level, requires fair value based accountingFair Value Based AccountingFair value accounting is the process of maintaining items in financial statements at their fair value and current valuation. Mark to market mechanism is applied at specified periods to change the value of items and show them as per their fair value in the market..
- Depreciation on the fixed assetFixed AssetFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples. 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 sheetIn The Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company., 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 statementsThe Financial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. utility is using the same for comparison. Historical cost-based accounting will not give a better comparison as there can be different methods of depreciationMethods Of DepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. , inventory recording, etc. However, fair value-based accounting helps better comparability.
Historical Cost vs. Fair Value Head to Head Difference
Let us now look at the head-to-head difference between historical cost vs. fair value:
|Basis – Historical Cost vs. Fair Value
|Fair ValueFair Value
|Historical cost is when a transaction is done or an asset is acquired.
|Fair value means the current market price that the investment can fetch.
|Depreciation is always getting calculated on the historical cost.
|Impairment is always calculated on a fair value basis.
|The layman can easily identify the historical cost as it is nothing but the transaction price.
|Professionals/actuaries are needed to calculate fair value.
|Items in the balance sheet
|As per Indian GAAP, property, plant, and equipment must be disclosed at historical cost in the balance sheet.
|As per Indian GAAP, financial instruments must be declared at fair value in the balance sheet.
|AS 16 requires historical cost-based valuation.
|AS 30, 31, 32, and IFRS 9 requires fair value-based valuation.
|The historical cost calculation is easy.
|The fair value calculation is highly complex.
|Historical cost does not require any assumptions.
|Fair value calculation requires various assumptions based on which fair value can be derived.
|A comparison is not possible under historical-based valuation as various methods can be adopted for depreciation, inventory valuationInventory Valuation Inventory Valuation Methods refers to the methodology (LIFO, FIFO, or a weighted average) used to value the company's inventories, which has an impact on the cost of goods sold as well as ending inventory, and thus has a financial impact on the company's bottom-line numbers and cash flow situation., etc.
|A comparison is possible between two entities under the said method of valuationMethod Of ValuationDiscounted cash flow, comparable company analysis, comparable transaction comps, asset valuation, and sum of parts are the five methods for valuing a company. that will disclose all the assets at fair value.
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.
This article is a guide to Historical Cost vs. Fair Value. We discuss the top differences between historical cost and fair value using infographics and a comparison table. You may also have a look at the following articles: –