Fair value vs. Historical cost: Which of these methods better leads to high quality financial statements?

Fair value vs. Historical cost

High quality financial statements are statements that reflect every qualitative characteristic included in the IFRS taxonomy. Of those, the fundamentals are:

  • Relevance
  • Materiality
  • Faithful representation

When a financial report already possesses these basic traits, its efficiency is increased significantly by such enhancing qualitative characteristics as comparability, verifiability, timeliness, and understandability.

The basic difference between the historical cost and the fair value principles is that the former does not incorporate the current market value when tracking and documenting either financial or non-financial data.

When used for assessment purposes, the fair value measurement (i.e., the IFRS Standard 13) accentuates current market data, and not a single financial entity (i.e., the business valuation of a specific company). Within an active, organized market where assets and liabilities are traded commodities, using the fair value principle produces financial reports of much higher quality.

The issue arises when there’s no organized market and fair value has to be measured through valuation methods that prioritize the three levels of input. In such cases, one has to deal with such vulnerabilities like the subjectivity in estimations, and the underestimation of:

  • non-financial assets (mostly),
  • and the developmental prospects of any business entity with unique value-adding traits which are devalued by the unstable environment, a likely result of a financial crisis and its derivative conditions (i.e., the increase in interest rates that depreciates future cash flows, etc.).

Even then, a historical cost-based model cannot counter the vulnerabilities of the fair value principle; especially when the latter is applied consistently and without being affected by any fluctuations in the financial cycle or any attempts to manipulate financial statements during periods of economic growth.

The disclosures imposed by the IFRS Standard 13 also work as a safety valve, securing that users of financial statements receive high quality information as they are fully informed on how a business entity’s management performs its assessments.

What’s the case with the new Greek Accounting Standards?

Since the application of the Greek Accounting Standards in 2015 under Law 4308/2014, article 24 provides any subject entity’s management with the option to use the fair value principle as an alternative to the historical cost model. The Greek Accounting Standards borrow their definitions and conventions from the IFRS as described in Standard 13.

However, the fair value method has rarely been used ever since. The historical cost principle still holds as the most popular valuation method in Greece.