Fair Value and Historical Cost: The BasicsAccounting standard-setters have defined fair value in divergence. All of them are essentially variations on current market value or an estimate, where a market value is unavailable or regarded as unreliable, of what the market valued be if there were a market. For this reason, fair value is also referred to as markto-market.There are various alternatives to fair value as a basis of measurement in accounts. The principal one, and in the context of the current debate the only one seriously considered as an alternative, is “historical cost”,or in the context of financial instruments, “amortized cost”. The amortised cost of financial instrumentsinvolves adjusting the original cost for subsequent cash flows (eg loan repayments) and reducing the valuefor any impairment provision (eg bad debt).
The accounting rules set out how impairment provisions must be estimated. They may be best illustrated using the example of a portfolio of mortgages, as follows:
— When there is a problem with an individual mortgage, it is reduced in value or written off entirely as a bad debt. This is sometimes called a specific provision.
— The bank may also know that there will be other problem mortgages, based on past experience, without knowing which mortgages. For example, redundancy or divorce might create problem mortgages before the bank finds out about the problems. The bank may make a provision for bad debts for these. This is sometimes called a collective impairment provision.
A bank may also expect that some of its loans will run into problems in the future, particularly in the current economic conditions. The accounting rules do not allow the bank to make a provision for future problems. This restriction on provisioning was introduced to prevent company management from manipulatingtheir profits. In the past,management was suspected of manipulating results to give smooth profits by increasing provisions in good times and releasing them in downturns. While it may be prudent to save in good times and use the savings to cushion the bad times, it was never clear why management expected more future losses in good times than they did when things turned bad.
The method for making impairment provisions is also relevant. They are made based upon the management estimate of the
cash flows they will receive on the problem loans (payments, recoveries fromcollateral, costs). The cash flows are discounted12 according to the time that they are expected to be received.The accounting rules require the interest rate from when the instrument was first acquired to be used as thediscount rate.
We have gone into these points in some detail because it is important to understand them for the purposesof the current debate.
Fair Value and Historical Cost:
The DifferencesThere are two major diVerences between fair value accounting and historical cost accounting:
— Fair value accounting recognises gains values above their historical cost. Another way of putting this is that fair valuerecognises unrealised gains, whereas historical cost only recognises realised gains—ie, gains that arise when assets are sold.
— When assets fall in value, this is recognised under both fair value and historical cost accounting.
But whereas fair value means the assets are written down to market value (or an estimate of whatthat might be in the absence of an active market), historical cost means that assets are subject toan impairment review where there is evidence that values have dropped. There are similarities in the process for making impairment valuations and estimating market values using models. Both would estimate future cash flows and discount the cash flows to reflect the timing of payments.
There are three basic reasons why fair value and the impairment model for historical cost will have divergent values at present. 12 Discounting reflects the fact that £1 today is worth more to someone than the promise of £1 in the \future. Discounting is a process to reduce the current value of future payments to reflect the time value of money (eg inflation) and the risk that the amount will not be paid.