Difference Between Historical Value vs Fair Value
Assets and liabilities are an integral part of any business, which tells the financial analyst the strength of the business and how strong the business is to repay its obligations. Assets and liabilities are valued under the IFRS and US GAAP valuation policies. IFRS uses the cost or revaluation model, but US GAAP solely uses the cost model. Under the revaluation model, there are a few kinds of values in which one can value the asset. One such parameter is Historical Value and Fair Value. In this article, we will try and understand the key differences and working between Historical Value vs Fair Value.
Table of Contents
- Difference between Historical Cost vs. Fair Value
- Historical Value Vs Fair Value Infographics
- Historical Value Vs Fair Value- Key Differences
- Historical Value Vs Fair Value- Comparison Table
- Advantages and Disadvantages of Historical Value
- Advantages and Disadvantages of Fair Value
- Conclusion
- FAQs
- Recommended Articles
Key Takeaways
- As stated on the balance sheet, the historical Cost is the Cost at which one initially acquires an asset, liability, or equity.
- The fair value represents a company’s assets at their current market worth, which differs from the original price. The former is distinct from the latter since it remains constant even if the asset increases in Value.
- As it helps minimize asset overvaluation in a fluctuating market, the historical cost principle is one of the leading accounting methods for fixed assets under the US Generally Accepted Accounting Principles (GAAP).
- Because one reports profit/loss after every quarter, fair value accounting adds volatility to accounting statements like balance sheets and profit and loss. Fair Value is commonly used, and both the standards, i.e., International Financial Reporting Standards (IFRS) and the US General Accepted Accounting Principles (GAAP), permit it.
Head-to-Head Comparison Between Historical Value vs Fair Value (Infographics)
Below is the top 6 difference between Historical Value vs Fair Value.
Key Differences Between Historical Value vs Fair Value
Let us discuss some of the major differences between Historical Value vs. Fair Value:
- Fair Value is frequently adopted when any asset on the balance sheet is valued. One can explain Fair Value as the true worth of an asset and the Value at which it should be recorded. Historical Cost, on the contrary, refers to the asset’s original Value at the time of acquisition by the company.
- Fair Value is not affected by external sources, and it is independent in itself as it is the basic intrinsic Value of the asset. After holding an asset for several years, the Historical Cost typically has little to no bearing on the market value.
- Under the fair value method, the asset is tested for impairment annually. Thus a loss from the impairment is booked in the income statement of that year. On the other hand, the historical Value does not account for an impairment loss.
- The land is an example of an asset generally kept at the historical Value of purchase until one sells the land and profit is recorded in the books of accounts. Marketable Securities are another example of an asset.
- The model of fair Value is commonly used, and it is permitted in both the standards, i.e., International Financial Reporting Standards (IFRS) and the US General Accepted Accounting Principles (GAAP). Historical Value is less used, and only US GAAP permits it.
- The Fair Value accounting method needs constant updating and review as the asset value keeps changing and assets are tested for impairment annually on the company balance sheet. On the other hand, an asset’s Historical Value does not change and is recorded in the balance sheet at the same amount every year and does not need constant updating and review.
Historical Value vs Fair Value Comparison Table
Let’s look at the top 6 Comparisons between Historical Value and Fair Value.
Historical Value | Fair Value |
Definition |
|
Historical Value refers to the original purchase price of the asset. | Fair value refers to the intrinsic value of the asset and works on the principle of fundamentals. |
Applicability |
|
The Historical Cost method is not used for all assets as it does not reflect their true worth. | Fair value is a more commonly adopted and tested method than any other valuation methodology. |
Valuation |
|
Historical Value remains stagnant throughout an asset’s lifetime as it is the original cost of the asset. | The fair value of an asset fluctuates when compared to any other valuation methodology as it is tested for impairment annually. |
Accounting Standard | |
The Historical Cost method is only permitted under US GAAP, not IFRS. | Fair value is a globally accepted measure used more often as it is more user-friendly than any other valuation methodologies, such as historical or market value. |
Application/Derivation | |
Historical Value is often used for intangible and Fixed assets. It does not apply to assets such as marketable securities. | Fair value is the true worth of assets, which is derived fundamentally and not determined by the market forces. |
Impairment | |
Historical Value is not tested for impairment loss on the balance sheet. | Fair Value is tested for Impairment loss annually. |
Advantages and Disadvantages of Historical Value
Advantages:
- Because the historical Cost is not susceptible to future changes, users do not need to conduct market research to determine the financial products’ current price or market value.
- Users can easily read and interpret financial reports even if they lack financial knowledge.
- The historical cost accounting concept is unbiased, affirmed, and reliable.
Disadvantages:
- The historical cost accounting notion is fixed, meaning it is documented based on the initial Cost in the invoice or receipt. As a result, it does not account for inflation or shifting pricing.
- It does not reflect the company’s assets at their genuine Value. All assets are recorded at their Value on the date of acquisition.
- Financial reporting, such as income statements, does not accurately reflect a company’s genuine profit since the company’s sales are reported at current prices. Still, Its expenses are recorded at historical costs resulting in an overestimation of profits.
Advantages and Disadvantages of Fair Value
Advantages:
- Valuations are more precise with fair value accounting, allowing them to track changes in pricing.
- Since a company’s total asset value reflects its actual revenue, it does not depend on a report of profits and losses but only considers the assets’ worth.
- Fair value accounting permits asset reduction, which aids businesses in surviving financially challenging times.
Disadvantages:
- In particular, volatile assets that might report changes in income that are inaccurate to the long-term financial picture and result in deceptive profits or losses in the short-term picture can cause significant swings in Value that occur several times during the year.
- As the loss of Value in the net income also constitutes an income loss for the investors, it may lower investor satisfaction.
- It is more challenging to establish a fair value estimate, which is meant to provide the most accurate data if a market for a specific item is not present in the active market.
Conclusion
A good financial analyst should take care of the valuation methods that different companies use and make necessary adjustments in the financial statements to make an apple-to-apple comparison among companies. One should analyze valuation methodologies should critically in order to do better analysis and cross-sectional analysis also. However, an analyst should dive deep into the reason for the adoption of valuation methods for a particular asset.
FAQs
1. What is the definition of fair Value?
The projected price at which an asset is purchased or sold when the buyer and seller voluntarily agree on a price is known as fair Value. By comparing the item’s present market worth, growth potential, and replacement cost, one can calculate the Fair value of an asset.
2. What is Historical Value?
The asset’s original purchase price is known as the asset’s historical Value. Since it is the asset’s original price, it does not fluctuate over the course of the asset’s lifetime.
3. Why is Historical Value important?
Historical Value makes it simpler for businesses to easily discover the original price of items when needed. It reduces overvaluation in a volatile market and is a helpful tool for evaluating capital expenditures.
4. How is Fair Value different from Market Value?
The main distinction between fair Value and market value is that market value is not a suitable metric for assessing an asset’s actual or intrinsic Value because market factors such as supply and demand will heavily influence it, which are again very inconsistent and dynamic in nature. On the other hand, Fair Value will only be determined by the asset’s genuine or intrinsic Value. Market forces like supply and demand do not influence it.
5. What approaches are used to assess fair Value?
The prices connected with actual market transactions for comparable assets are used in a market method to calculate fair Value. To calculate the fair value of the present, an income approach employs projected future cash flows or earnings. To determine an asset’s fair Value, a cost approach considers the expected Cost of replacing it.
Recommended Articles
This has been a guide to the top differences between Historical Value vs. Fair Value. Here we also discuss the key differences with infographics and a comparison table. You may also check out the following articles to learn more –
- Present Value vs Future Value
- Current Assets vs Non-Current Assets
- Nominal vs Real Interest Rates
- Issued Shares vs Outstanding Shares
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