The Potential Trade-Off: Reliability of Historical Cost vs. Relevance of Fair Value Flashcards
How do Laux (2009) and Power (2010) define reliability in accounting?
Reliability is traditionally tied to verifiability and freedom from material error—historical cost is often viewed as reliable because it’s based on an actual transaction price.
How do Laux (2009) and Power (2010) define relevance in accounting?
Relevance is information that is timely and decision-useful for investors—fair value is viewed as more relevant because it reflects current market conditions.
What is the classic argument for historical cost being more reliable than fair value (Power, 2010)?
Historical cost is objective and verifiable at the time of purchase. There’s less potential for management bias or estimation error compared to using subjective valuation models or market quotes (especially in illiquid markets).
Why do proponents argue fair value is more relevant (Laux, 2009; IFRS, 2018)?
Fair value reflects current economic conditions, aiding decision-making about future performance. Market-based measurements can provide timely signals about asset/liability values, which is crucial for fast-paced financial markets.
Provide an example illustrating the potential trade-off between reliability and relevance.
Mortgage-Backed Securities (MBS) pre-crisis: Historical cost might show stable carrying amounts, ignoring current declines in value. Fair value reflects falling market prices, possibly leading to large write-downs—more relevant for risk assessment but raises concerns over valuation subjectivity in illiquid or distressed markets.
How does IFRS 13 attempt to balance reliability and relevance (IFRS, 2018)?
IFRS 13 introduces a Fair Value Hierarchy: Level 1 (observable market), Level 2 (observable inputs), Level 3 (unobservable, model-based). It also includes Disclosure Requirements to provide transparency about assumptions and inputs, aiming to bolster user confidence in fair value measurements.
Is the reliability vs. relevance trade-off resolvable (Laux, 2009; Power, 2010)?
They argue the tension persists; no single method is perfect. Fair value gains relevance but risks reliability under uncertain or illiquid market conditions, whereas historical cost is reliable but can lose relevance as market conditions shift.
