186 Accounting: Business Reporting for Decision Making
discusses advantages and disadvantages associated with each of the measurement bases, noting that the
measurement basis selection is context specific and should be determined with reference to the desirable
qualitative characteristics of financial information — relevance, faithful representation, comparability,
verifiability and understandability.
Consider the following. At acquisition date, the historical cost and fair value should be fairly equiv-
alent. However, the fair value and cost value of an item can diverge as time passes. Take the example
of a property purchase. An entity pays $1 000 000 for a property. At acquisition date, the $1 000 000
represents the property’s historical cost and its fair value. Three years later, the property’s cost price
remains at $1 000 000. However, due to a property boom, its fair value based on the estimated selling
price is $1 500 000. For financial reporting purposes, this presents a problem: subsequent to initial recog-
nition, should the property be reflected on the balance sheet at its original cost, its cost adjusted for
changing prices associated with the inflation rate, or its fair value?
In terms of accounting rules and regulations (the standards), some accounting standards do prescribe
a particular measurement for items post-acquisition and other accounting standards provide account pre-
parers with a choice of measurements that could be applied post-acquisition. From a conceptual view-
point, the selected measurement basis should be one that is most useful to financial statement users’
decision making. In order to achieve this objective, financial information should be relevant (that is,
assist users in their decision making) and a faithful representation of the economic phenomena it
purports to represent (that is, be complete, neutral and free from error). Sometimes there is a tradeoff
between relevance and faithful representation. Take the case of the property purchased for $1 000 000.
The cost price is objective and a faithful representation, but would users find the fair value — the esti-
mated selling price of the property — more relevant for decision-making purposes?
Unless the accounting rules require otherwise, it is common to leave physical assets and liabilities at
their historical cost, or historical cost adjusted for depreciation in the case of assets, in the balance sheet.
However, where a measurement choice exists, some entities elect to use fair value. This means that not
all items on a balance sheet are recorded using the same measurement basis. However, the reality check,
‘Why fair value is the rule’, highlights the growing application of fair value.
We will use the 2015 JB Hi-Fi Ltd balance sheet to illustrate how items, particularly assets, can be meas-
ured for financial reporting purposes. Recall from earlier in the chapter that preparation of financial statements
involves choices, estimates and assumptions. Measurement is an area where these are particularly evident.
REALITY CHECKWhy fair value is the rule
Fair value accounting, the practice of market-based measurement of assets and liabilities, has been on
the increase. This increase is a large step away from the tradition of keeping books at historical cost.
Subsequently, this has implications across the business world as the accounting basis (fair value or his-
torical cost) affects investment choices and management decisions, with consequences for aggregate
economic activity.
Fair value accounting is supported on the basis that it makes accounting information more relevant,
while historical cost accounting is considered more conservative and reliable. The rise of fair value
accounting could be the result of financial theory, notably the idea that financial markets are efficient and
their prevailing prices are reliable measures of value, becoming more prevalent in academic accounting
research (from the 1980s onwards) — with the shift seeming to change opinions on the relative advan-
tages of historical cost and fair value.
The International Financial Reporting Standards use fair value extensively — such as in goodwill
impairment testing and financial asset and employee stock option assessment — despite claims that
fair value accounting led to suspicious practices before the 1929 Wall Street crash and the Global
Financial Crisis in 2008.
Sources: Ramanna, K 2013, ‘Why “Fair Value” is the rule’, Harvard Business Review, March; Australian Government
Australian Accounting Standards Board 2011, Fair Value Measurement, AASB Standard, September.