Difference Between Historical Cost vs. Fair Value
Valuation is a highly subjective matter. Valuation is the base for all the transactions, business analysis, and all 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 deal or transaction is to be undertaken. It is not only helping sellers to determine the correct price for their commodity, but also this aids in reaching the level to identify that in which class of market the customer can be identified, and the deal can be settled.
In this article, we look at Historical Cost vs. Fair Value in detail –
What is Historical Cost?
Historical Cost means the actual price at which the transaction was done. All the commodity or assets present in the balance 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, which will be considered for calculating depreciation and for other statutory matters.
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What is Fair Value?
Fair value means the actual value of the asset in the market as on the day. Fair value 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’s understand the historical cost vs. fair value with an example
ABC Ltd acquires land at $100,000 in 2002.
- The actual market price of that land in 2018 is around $1.75 million.
- Here land will be reflected in the balance sheet at $100,000, which is nothing but historical value.
The market value of $1.75 million is considered the fair value of the asset.
Historical Cost vs. Fair Value Infographics
Here we provide you with the top 8 difference between Historical Cost vs. Fair Value.
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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 was acquired, or transaction was done, while Fair value is the market price that an asset can fetch from the counterparty.
- As per Indian GAAP, in India, we are following historical based accounting. However, IFRS, 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.read more.
- Depreciation on the fixed asset is getting calculated on historical cost while Impairment on the assets is getting derived based on their fair value.
- Professionals are needed for the fair value derivation while even Layman 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.read more, PP&E are to be disclosed at Historical cost while Financial Instruments are to be disclosed at fair value.
- Historical cost derivation is easy and majorly readily available, while fair value calculation is highly complex and requires technical and niche skills.
- Historical Cost calculation does not require any assumptions; however, Fair value calculation itself is dependent on the various assumptions and various methods of calculation.
- 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.read more 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.
Historical Cost vs. Fair Value Head to Head Difference
Let’s now look at the head to head difference between Historical Cost vs. Fair Value.
| Basis – Historical Cost vs. Fair Value | Historical Cost | Fair Value |
|---|---|---|
| Definition | Historical Cost is the cost at which a transaction was done, or the asset was acquired. | Fair value means the present market price that the asset can fetch. |
| Depreciation/ Impairment | Depreciation is always getting calculated on the historical cost. | Impairment is always calculated on a fair value basis. |
| Layman/Professional | 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 are needed to be disclosed at historical cost in the balance sheet. | As per Indian GAAP, Financial Instruments are needed to be disclosed at Fair value in the balance sheet. |
| Accounting Standard | AS 16 requires historical cost based valuation | AS 30,31 and 32, as well as IFRS 9, requires Fair Value based valuation. |
| Calculation | The historical cost calculation is easy and can be easily derived. | Fair value calculation is highly complex. |
| Assumptions | Historical Cost does not require any assumptions. | Fair Value calculation requires various assumptions based on which fair value can be derived. |
| Comparability | The comparison is not possible under historical based valuation as various methods can have 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.read more, etc. | The comparison is possible between 2 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.read more as all the assets will be disclosed at fair value. |
Final Thoughts
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 fair value shows the obtainable value of the same transaction as on date. Also, there are many approaches in calculating them and derive different valuation based on various assumptions. It is always challenging to choose the right method. Also, there will be a financial impact based on the method chosen.
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