Fair Value vs Historic Cost Depreciation

When producing balance sheets for financial statements, companies are required to place a value on their assets. Doing so accurately is important, as under or overstating financial position can have costly consequences by leading to ill informed decision making.

It stands to reason that only when directors have accurate knowledge about their company’s finances, can they make informed and considered decisions.

In the main, there are two methods for valuing assets for financial statement purposes. These are the traditional Historic Cost Depreciation, and Fair Value approaches. The former takes the original purchase price and reduces it each year in either a straight line or by a reducing balance in order to calculate net book value (NBV). A Fair Value valuation on the other hand, seeks to identify the price at which the asset would be expected to realise, if it were actually sold. The definition of Fair Value given by the International Financial Reporting Standards is “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

Marriott & Co have been providing Fair Value valuations for financial statement purposes for clients over many years. It is sometimes argued that Historic Cost Depreciation leads to a more ‘conservative’ valuation, but we don’t believe that this should be the objective. The clients who opt for a Fair Value approach feel the same way we do; that this is the path to choose if accuracy is the priority.

Whilst using Historic Cost Depreciation to calculate a net book value may be simpler, less time consuming and therefore potentially cheaper to ascertain, Fair Value accounts for a myriad of economic factors, each of which can have a significant impact on value, which Historic Cost Depreciation ignores. This is why the Fair Value process is able to produce a valuation that mirrors reality.

Condition of the asset, market trends, inflation, foreign-exchange rate factors, obsolescence, and technological advancement can each affect value significantly. Historic Cost Depreciation does not take account of all these factors, to say nothing of the fact that sometimes assets will increase in value over time.

Another facet of the Fair Value approach which our clients benefit from, is the potential for extra value on the balance sheet. This is achieved my establishing the fair value of each asset at the balance sheet date and reporting any surplus as a fair value reserve within shareholder funds. For businesses with a significant investment in plant and machinery, adopting the Fair Value approach will enhance the business’ financial reporting and overall value. Often, using Fair Value can reveal that the true value of an asset is far higher than the ‘book value’ generated by depreciating its historic cost. Added value on the balance sheet can make it easier for companies to raise investment or loan funds.

Providing an opinion on Fair Value requires an expert to give the matter careful consideration, as it is the more sophisticated approach. However, once this procedure has been established, revaluation is often less time consuming than the initial valuation, particularly if a desktop valuation is provided. This means that in subsequent years, the cost of producing a Fair Value valuation may be lower than on the first occasion.

We, and many of our clients, believe that Fair Value is the best approach for financial reporting.

Rich Cheeseman, Valuation Research Analyst, Marriott & Co.