Accounting Forum 30 (2006) 43–59
The quality of fair value measures for property,
plant, and equipment
Don Herrmann a,∗ , Shahrokh M. Saudagaran b,1 , Wayne B. Thomas c,2
a William S. Spears School of Business, Oklahoma State University,
401 Business Building, Stillwater, OK 74078, USA
b School of Business, University of Washington, Tacoma, Tacoma, WA 98402-3100, USA
c Price College of Business, University of Oklahoma, 307 West Brooks,
Room 200D, Norman, OK 73019, USA
Abstract
Based on Statement of Financial Accounting Concepts (SFAC) No. 2, this paper argues for fair value
measures of property, plant, and equipment and challenges the primary arguments in support of maintaining
the current status quo in the United States—strict historical costs for all property, plant, and equipment
unless the asset is impaired. We first provide a summary of the valuation of property, plant, and equipment
internationally noting that revaluations to fair value are an acceptable practice under international and many
national accounting standards. We also provide a brief historical perspective of accounting in the United States
where prior to 1940 the upward valuation of property, plant, and equipment was an acceptable accounting
alternative. We then evaluate fair value versus historical cost measures for property, plant, and equipment
based on the qualitative characteristics of accounting information in SFAC No. 2. We argue that fair value
measures for property, plant, and equipment are superior to historical cost based on the characteristics
of predictive value, feedback value, timeliness, neutrality, representational faithfulness, comparability, and
consistency. Verifiability appears to be the sole qualitative characteristic favoring historical cost over fair
value. Finally, we address key measurement concepts for property, plant, and equipment. The United States
could learn from the practices already established in other countries and in International Financial Reporting
Standards by reconsidering fair value measures for property, plant, and equipment.
© 2005 Elsevier Ltd. All rights reserved.
Keywords: Fair value measures; Conceptual framework; Fixed assets
∗ Corresponding author. Tel.: +1 405 744 8602.
E-mail addresses: don@okstate.edu (D. Herrmann), shahrokh@u.washington.edu (S.M. Saudagaran),
wthomas@ou.edu (W.B. Thomas).
1 Tel.: +1 253 692 4580.
2 Tel.: +1 405 325 5789.
0155-9982/$ – see front matter © 2005 Elsevier Ltd. All rights reserved.
doi:10.1016/j.accfor.2005.09.001
44
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
1. Introduction
The International Accounting Standards Board (IASB) recently set up a Working Group to
propose a convergence model for the revaluation of property, plant, and equipment. This proposal
will be submitted to the IASB in the development of an Exposure Draft of a revised IAS 16
Property, Plant, and Equipment and a revised IAS 36 Impairment of Assets. On a much broader
level, the IASB has engaged national standard setters, with Canada taking the lead role, in the
development of a discussion paper on measurement issues. In May 2005, the IASB approved
for publication the discussion paper entitled “Measurement Bases for Financial Reporting: Measurement on Initial Recognition.” The document will be issued in the third quarter of 2005 for
a nine-month comment period. The work of the IASB has important implications to standard
setting by the Financial Accounting Standards Board (FASB) in the United States and standard
setting in many other countries as well.1
At a joint meeting in September 2002, the FASB and the IASB entered into a Memorandum of
Understanding formalizing the FASB’s and IASB’s commitment to convergence. The FASB and
IASB pledged to use their best efforts to make their existing financial reporting standards fully
compatible and coordinate their future work programs to ensure that compatibility is maintained.
The two boards agreed to undertake a short-term convergence project directed at removing a variety
of individual differences between U.S. and international standards. Furthermore, the Boards are
committed to removing remaining differences through continued progress on joint projects and
the coordination of future work programs. The U.S. Securities and Exchange Commission (SEC),
responsible for the enforcement of U.S. accounting standards, strongly supports the agreement
between the FASB and IASB to work together toward greater convergence between U.S. standards
and International Financial Reporting Standards (IFRS). The Chairman of the SEC said, “This is
a positive step for investors in the United States and around the world. It means that reducing the
differences in two widely used sets of accounting standards will receive consideration by both
boards, as they work to improve accounting principles and address issues in financial reporting
(SEC Press Release, October 29, 2002).”
In response to concerns about the quality and transparency of U.S. financial accounting and
reporting, the FASB issued a proposal for a Principles-Based Approach to U.S. Standard Setting
(FASB October, 2002). A primary concern is that U.S. accounting standards have become increasingly detailed and complex. Because much of the detail and complexity results from rule-driven
implementation guidance, the standards may allow companies to structure transactions around
the rules, circumventing the intent and spirit of the standards. In response to these concerns,
the FASB is considering the feasibility of adopting a principles-based approach to U.S. standard
setting similar to the approach already in place for IFRS. The SEC will also carefully consider
comments to the FASB proposal as Section 108(d) of the Sarbanes-Oxley Act requires the SEC to
conduct a study on the adoption of a principles-based accounting system in the United States and
to submit a report to Congress. As indicated in the proposal, a principles-based approach could
facilitate convergence between the FASB, IASB, and other national standard setters in developing
common high-quality accounting standards.
The purpose of this paper is to provide guidance to the IASB, FASB, and other national
accounting standard setters as they propose a convergence model addressing the revaluation of
1 Listed companies in the European Union and all reporting entities in Australia will follow International Financial
Reporting Standards (IFRS) beginning in 2005. In 2007, New Zealand companies will also adopt IFRS.
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
45
property, plant, and equipment. We first provide an overview of the valuation of property, plant,
and equipment internationally including a historical perspective on the valuation of property, plant,
and equipment in the United States. We then evaluate fair value versus historical cost measures
for property, plant, and equipment based on SFAC No. 2. The conflict between fair value and
historical cost measures can be linked to the qualitative characteristics of relevance, reliability,
comparability, and consistency described in SFAC No. 2 and provides a natural framework in
which to evaluate fair value versus historical cost measures for property, plant, and equipment.
Finally, we address key measurement concepts for property, plant, and equipment. Recently, the
issue has taken on even greater importance due to the current changes taking place internationally
in the valuation of property, plant, and equipment.2
The paper proceeds as follows. Section 2 provides an overview of the valuation practices for
property, plant, and equipment across five countries and allowable practices under current IFRS.
Section 3 examines the use of fair value versus historical cost measures in the valuation of property,
plant, and equipment based on the qualitative characteristics of accounting information outlined
in SFAC No. 2. Section 4 addresses measurement concepts for property, plant, and equipment.
Section 5 concludes the paper, briefly summarizing the major points.
2. The valuation of property, plant, and equipment across countries
2.1. International Financial Reporting Standards
The current rules for the measurement of property, plant, and equipment are provided in
IAS 16 (IASC, 2003). Separate rules for the accounting of investment property and agriculture
are outlined in IAS 40 and IAS 41, respectively. IAS 16 permits two accounting models for
the measurement of property, plant, and equipment subsequent to initial recognition. Under the
cost model, property, plant, and equipment are carried at historical cost less accumulated depreciation and any accumulated impairment losses. Under the revaluation model, property, plant,
and equipment are carried at fair value at the date of revaluation less subsequent depreciation.
Revaluations are to be made often enough so that the carrying amount does not significantly
differ from fair value at the balance sheet date. The practice of upward asset revaluations for
firms reporting in accordance with international standards appears to be common. Ashbaugh and
Olsson (2002, p. 122) indicate that 13 of the 19 IAS firms in their sample reported upward asset
revaluations.
Under the revaluation model, fair value is normally determined by appraisal. When property,
plant, and equipment are revalued, the entire class to which that asset belongs should be revalued
(IAS 16, para. 34). This is to avoid the selective revaluation of certain property, plant, and equipment and to avoid reporting a mixture of historical costs and fair values for the same asset class
in the financial statements. Initial upward revaluations are credited to a revaluation surplus in
stockholders’ equity and initial downward revaluations are recognized as an expense. The revaluation surplus in stockholders’ equity may be transferred to retained earnings when the surplus
is realized (i.e., through sale, disposal, or as the asset is used). Upward revalued amounts do not
affect income except for the subsequent increase in depreciation expense as depreciation is based
on the revalued amount.
2 An analysis similar to the one used in this paper may also be useful in the debate on the use of fair values for financial
instruments.
46
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
Requirements for measuring impaired assets are outlined in IAS 36 (IASC, 1998b). Like the
United States, an impairment loss should be recognized whenever the recoverable amount of an
asset is less than its carrying amount. Unlike the United States, the recoverable amount of an asset
is the higher of its net selling price and its value in use, both based on present value calculations.
Net selling price is the amount obtainable from the sale of the asset in an arm’s length transaction.
Value in use is calculated as the present value of estimated pre-tax future cash flows over the asset’s
useful life and subsequent disposal. An impairment loss should be recognized as an expense in
the income statement for assets carried at cost and treated as a revaluation decrease for assets
carried at revalued amounts. An impairment loss should be reversed (and income recognized)
when there has been an increase in the estimates used to determine an asset’s recoverable amount
since the last impairment loss was recognized. For assets carried at revalued amounts, a reversal of
an impairment loss should be recognized as a revaluation increase up to what the current carrying
value would have been had the asset never been impaired.
2.2. United States
Revaluations have not always been a violation of U.S. GAAP. Prior to about 1940, upward
valuations of property, plant, and equipment were an acceptable accounting alternative in the
United States. Montgomery’s 1940 edition of Auditing makes reference to write-ups or footnote
disclosures of appraisal values for property, plant, and equipment as though, from an auditing
perspective, these practices were clearly acceptable accounting alternatives (Montgomery, 1940,
pp. 238–241). After 1940, accounting academics in the United States continued to express support
for either the upward valuation of property, plant, and equipment or the footnote disclosure of
current market values (Graham & Dodd, 1951, p. 180; Paton & Dixon, 1958, p. 457; Weston,
1953, p. 489).
The demise of fair value measures for property, plant, and equipment in the United States can be
linked to the early years of the SEC. Neither the SEC nor the earliest private accounting standard
setting body in the United States (i.e., the Committee on Accounting Procedures) produced explicit
rules addressing the issue of upward asset valuations. Rather, the removal of fair value measures
and/or fair value disclosures of property, plant, and equipment in financial reporting was imposed
through progressively more stringent informal administrative procedures by the SEC (Walker,
1992). The SEC began discouraging fair value accounting for property, plant, and equipment
in response to unsubstantiated asset revaluations by corporations made in the 1920s prior to
the establishment of the SEC (Zeff, 1995, p. 59). According to Walter Schuetze, former chief
accountant to the SEC, the SEC considered fair value numbers to be too soft (Schuetze, 2001, p.
10).
Initially in the mid to late 1930s, the SEC discouraged, but did not restrict, asset write-ups to
fair value in the filing of financial information leading to the registration of securities for public
offering. By the 1940s, the SEC had essentially removed the option of upward revaluation of
property, plant, and equipment through the enforcement of financial statement information filed
with SEC registration statements. By the 1950s, this ban had been extended to the disclosure of
fair values in the footnotes to the financial statements. All of this was accomplished indirectly
through internal enforcement procedures within the SEC without ever issuing a formal statement
disallowing the practice of fair value accounting for property, plant, and equipment. It was many
years later that APB Opinion No. 6 (AICPA, 1965) formally stated that “. . . property, plant, and
equipment should not be written up by an entity to reflect appraisal, market or current values
which are above cost to the entity” (para. 17).
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
47
Table 1
Valuation of property, plant, and equipment across five countries and under International Financial Reporting Standards
(IFRS)
Valuation basis
Australia
United
Kingdom
New
Zealand
Japan
United
States
IFRS
Cost or fair
value
No
Cost or fair
value
No
Cost or fair
value
Yes
Costa
Cost
N/A
N/A
Cost or fair
value
No
Equity
Expense
Equity
Expense
Equity
Equity
N/A
N/A
Equity
Expense
Yes
Yes
Nob
Yes
Yes
Independent appraisal required
for revaluations
Treatment of initial revaluation gain/loss
Upward
Equity
Downward
Expense
Impairment if recoverable
amount < carrying amount?
Yes
a Under a special law regarding the revaluation of land, Japanese firms were permitted to revalue land from March 31,
1998 to March 31, 2002 (Article 7 of the Commercial Code, 1999). Other than this one time exception, Japan requires
the valuation of property at cost.
b Impairment is currently not recorded in Japan. New impairment rules in Japan are effective for fiscal years beginning
April 1, 2005.
An exception to reporting property, plant, and equipment at historical cost is made for impairments under the guidelines of SFAS 144 (FASB, 2001). SFAS 144 states that an impairment
exists when the sum of the undiscounted expected future net cash flows of an asset is less than its
carrying amount. When this occurs, the asset is written down from its current carrying amount to
either fair value, or present value of expected future net cash flows if no active market exists for
the asset, and a loss is recognized in the income statement. The reporting of asset impairments can
have a significant impact on a company’s financial statements (Nurnberg & Dittmar, 1997) and
empirical research documents evidence of their usefulness to decision makers (Alciatore, Easton,
& Spear, 2000).
2.3. Overview of country standards and IFRS
The IASB has indicated that items on its convergence agenda will be based on selecting the
“best of breed” standard from existing national standards and IFRS. Along these lines, Table 1
provides an overview of the valuation of property, plant, and equipment in Australia (AASB
1041; AASB 1010), the United Kingdom (FRS 15; SSAP 19; SAS 520), New Zealand (FRS-3),
Japan (Article 7 of the Commercial Code, 1999), the United States (APB Opinion No. 6; SFAS
144), and IFRS (IAS 16; IAS 36).3 While Australia, the United Kingdom, New Zealand, and
International Standards allow for revaluations to fair value, the United States and Japan do not
generally allow revaluations. However, Japan, with a strong reputation for strict adherence to
historical cost, recently made a one-time exception. Under a special law regarding the revaluation
of land, Japanese firms were permitted to revalue land from March 31, 1998 to March 31, 2002
3 The table is intended to provide only a brief overview. Interested readers may obtain a more detailed comparison in
the revised International/U.S. GAAP comparison of standards published by the IASB. The Big Four accounting firms
also publish detailed comparisons of individual country GAAP with International Standards.
48
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
Fig. 1. A hierarchy of accounting qualities.
(Article 7 of the Commercial Code, 1999). This law permitted a one-time option during the
four-year period to report land held for their own use at fair value on their balance sheet.4
Accounting standards in countries that allow for revaluations encourage the use of independent
appraisals in assessing fair value; however, only New Zealand requires a separate independent
appraisal in recording a revaluation adjustment. Upward revaluation adjustments are taken directly
to equity, unless it represents the reversal of a revaluation decrease previously recognized as an
expense, in which case it should be recognized as income. Downward revaluation adjustments
are used initially to reverse any previous upward revaluations in equity and then recorded as an
expense in Australia, the United Kingdom, New Zealand, and International Standards.5 However,
initial downward revaluations adjustments bypass the income statement and are taken directly to
equity in Japan. Finally, with the exception of Japan, an impairment is recognized if the recoverable
amount is less than the carrying amount of the asset. Similar impairment rules have been adopted
in Japan, but are not effective until fiscal years beginning April 1, 2005.
3. Evaluation of fair value and historical cost measures for PPE based on SFAC No. 2
The FASB’s Conceptual Framework was developed to “describe concepts and relations that
will underlie future financial accounting standards and practices and serve as a basis for evaluating
existing standards and practices (FASB, 1978, Par. 3).” In this spirit, we base our analysis on the
use of fair value measures versus historical cost measures for property, plant, and equipment on the
qualitative characteristics of accounting information in SFAC No. 2. The qualitative characteristics
of accounting information are summarized in Fig. 1. Definitions of the qualitative characteristics
in this section are taken from the glossary of terms in SFAC No. 2.
An important user-specific factor in both the FASB’s and the IASB’s Conceptual Framework
is the quality of understandability. Understandability is defined in SFAC No. 2 as “the quality of
information that enables users to perceive its significance.” Similarly, the IASB framework defines
understandability as “information should be presented in a way that is readily understandable by
users who have a reasonable knowledge of business and economic activities and accounting and
4 If the revaluation alternative is selected by a company using International Financial Reporting Standards, property,
plant, and equipment must be appraised periodically. Hence, the one-time option to revalue land in Japan would be a
violation of International Financial Reporting Standards.
5 The reversal of a previous revaluation adjustment is measured for a class of assets under Australian and New Zealand
GAAP, but for individual assets under International standards.
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
49
who are willing to study the information diligently.” However, while understandability is one of
four principal qualitative characteristics in the IASB’ Framework it is not given the same status in
SFAC No. 2. SFAC No. 2 contends that as a user-specific quality, understandability represents a link
between the characteristics of decision makers and the decision-specific qualities of information
used in evaluating fair value measures versus historical cost measures, as discussed in more detail
below. The role of understandability in a revised joint IASB/FASB conceptual framework is
discussed in FASB Action Alert No. 05-26.
3.1. Relevance
Relevance is defined as “the capacity of information to make a difference in a decision by
helping users to form predictions about the outcomes of past, present, and future events or to
confirm or correct prior expectations (SFAC No. 2).” The three primary characteristics of relevant information are predictive value, feedback value, and timeliness. All three characteristics of
relevance favor fair value measures over historical costs in the valuation of property, plant, and
equipment.
3.1.1. Predictive value
Predictive value is defined as “the quality of information that helps users to increase the likelihood of correctly forecasting the outcome of past or present events (SFAC No. 2).” Although
fair values are generally assumed to provide greater predictive value than historical cost measures, until recently, no empirical evidence on the issue was available. Several important papers
examine the relation between stock prices, returns, earnings forecasts, and/or future earnings and
the revaluation of property, plant, and equipment in Australia (Barth & Clinch, 1998; Easton,
Eddey, & Harris, 1993) and in the United Kingdom (Aboody, Barth, & Kasznik, 1999). These
studies generally find that asset revaluations are incrementally value-relevant beyond historical
cost amounts for purposes of explaining current returns and prices. These studies also find that
the revaluation of property, plant, and equipment improves forecasts of future earnings (out of
which dividends may be paid). Furthermore, the predictive value of fair values over historical
cost extends to situations in which the entity is no longer a going concern. Fair values are clearly
preferable to historical costs in estimating an acquisition price or in liquidating the assets of the
firm.Fair values of assets may also provide relevant information in the prediction of dividend
restrictions in the United States. The maximum allowable dividend distribution in the United
States is based on state incorporation law. Many states have adopted the 1984 Revised Model
Business Corporation Act as a guide to the legality of distributions. Under this act, as long as
the fair value of assets exceeds the fair value of liabilities after the distribution, the company
is considered to be solvent and can pay dividends even in cases where stockholders’ equity is
negative (Roberts, Samson, & Dugan, 1990, p. 42). Therefore, in many states, dividend restrictions are unrelated to the equity numbers reported on the statement of financial position. Rather,
dividend restrictions are dependent on the fair value of assets and liabilities. Roberts et al. (1990)
provide an illustration based on Holiday Inns of America, a hotel chain with property values that
on average greatly exceed the depreciated historical cost used in financial reporting under U.S.
GAAP. In 1987, Holiday Inns of America distributed a US$ 1.55 billion dollar dividend to prevent
a hostile takeover, thereby reducing stockholders equity from US$ 639 million at the beginning
of 1987 to a US$ 770 million deficit at the end of 1987. The US$ 1.55 billion dividend, financed
with borrowed funds, was made possible due to the undervaluation of assets (i.e., hotels) on the
balance sheet. Without information on the fair value of assets, predictive estimates of dividend
50
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
restrictions in states that have adopted the 1984 Revised Model Business Corporation Act are not
possible.6
3.1.2. Feedback value
Feedback value is defined as “the quality of information that enables users to confirm or
correct prior expectations (SFAC No. 2).” At the point of initial acquisition, historical cost is
equivalent to fair value for most property, plant, and equipment. However, over time the two
measures diverge. Fair value changes over time and thus, if changes in the fair value of property,
plant, and equipment are recognized in financial reporting, this information has the potential to
provide valuable feedback to users. It can confirm or correct prior expectations formed by users
based on current economic conditions and the most recent revaluation. For example, subsequent
changes in the fair value of a firm’s substantial investments in real estate could provide important
feedback to investors and creditors. On the other hand, historical cost by definition, does not
change over time, providing limited feedback to users subsequent to acquisition.7 Book values,
measured as historical cost less accumulated depreciation, may even provide feedback in the
wrong direction. Book values systematically decrease over time even when the underlying asset is
appreciating.
Under the current historical cost model for property, plant, and equipment in the United States,
one situation in which historical cost measures provide feedback value subsequent to acquisition is
when historical cost measures exceed expected future cash flows (i.e., an impairment). Assuming
impairment, property, plant, and equipment are written down to fair value potentially providing
users with important feedback (Alciatore et al., 2000; Nurnberg & Dittmar, 1997). Yet, impairment
adjustments for property, plant, and equipment are based on fair value measures not historical
costs.
3.1.3. Timeliness
Timeliness is defined as “having information available to a decision maker before it loses its
capacity to influence decisions (SFAC No. 2).” The reporting of changes in the fair value of property, plant, and equipment has the potential to provide timely information to investors, creditors,
and other interested users of financial information. Investors benefit from current information as to
the value of assets and liabilities provided such information is considered reliable (Aboody et al.,
1999; Barth & Clinch 1998). Creditors, when using property, plant, and equipment as security for
a loan, generally require a current appraisal to determine the fair value of the assets to be used as
collateral. Other interested users of financial information might also benefit from information on
current changes in the value of property, plant, and equipment. Government regulators in capitalintensive industries such as utilities, oil and gas, or airlines, are likely to consider recent changes
in the fair value of property, plant, and equipment, if available, in negotiations between industry
and government representatives. Historical cost also has the capacity to influence decisions as
6 Dividend distributions in the United Kingdom are based on the concept of distributable profit. Distributable profit
is computed as accounting profit based on generally accepted accounting principles adjusted for certain items deemed
non-distributable, including those related to the revaluation of marketable securities, capitalization of development costs,
and foreign currency translation. A detailed summary of the dividend distribution law in the United Kingdom is provided
in Leuz, Deller, and Stubenrath (1998).
7 Calculating return on investment (ROI) based on historical costs is a potential example of feedback value as to whether
management’s decision to invest in property, plant, and equipment was a wise decision.
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
51
long as book values reasonably approximate fair values. As book values under historical cost
deviate from fair values, the capacity to influence decisions under historical cost weakens.
3.2. Reliability
Reliability is defined as “the quality of information that assures information is reasonably
free from error and bias and faithfully represents what it purports to represent (SFAC No. 2).”
The three primary characteristics of reliability are verifiability, neutrality, and representational
faithfulness.
3.2.1. Verifiability
Verifiability is “the ability through consensus among measurers to ensure that information
represents what it purports to represent (SFAC No. 2).” Arguments for the measurement of
property, plant, and equipment at historical cost are based primarily on the characteristic of
verifiability (Nichols & Buerger, 2002). Historical cost, defined as the costs incurred upon acquisition, is assumed almost without question to be highly verifiable. Yet, this is not always the
case. The historical cost of some types of property, plant, and equipment, as discussed below,
is not easily verified. This section on verifiability concludes with a discussion of numerous
departures from historical cost accounting for property, plant, and equipment currently allowed
under U.S. GAAP whereby fair value measures are used effectively in place of historical cost
measures.
Self-constructed assets challenge the verifiability of historical costs. Commonly, only a portion of a self-constructed asset is made up of materials supported by actual costs incurred. The
remaining portion of the asset’s cost may include a variety of more subjective items such as direct
and indirect labor costs, overhead allocations, and capitalized interest. The degree of subjectivity
in arriving at historical cost for self-constructed assets raises the question whether historical cost
in these specific circumstances is more verifiable than fair value based on an independent external
appraisal.
The frequency of business acquisitions has grown extensively in recent years. Many firms
have acquired ten, twenty, even hundreds of other businesses. In an acquisition, the property,
plant, and equipment of the acquired firm are reported on the consolidated financial statements
at fair value. While this is consistent with the historical cost concept of cost representing the
fair value at the time of acquisition, it raises an interesting issue regarding the verifiability
of fair values for property, plant, and equipment. The fair value of the individual assets in a
business acquisition are not subject to separate verifiable transactions, but rather are based on
appraisals of fair value. Why then, is the verifiability of fair values for property, plant, and
equipment such an impediment when it is already common practice in business acquisitions?
It seems that a greater concern in business acquisitions relates to the valuation of acquired
intangible assets and goodwill than to the valuation of property, plant, and equipment at fair
value.
Fair values are used rather extensively under certain exceptions to historical cost in the valuation of property, plant, and equipment under current U.S. GAAP. As mentioned previously, assets
subject to impairment are written down to fair value. Similarly, fair values are used to record property, plant, and equipment subject to discontinued operations. Another departure from historical
cost is made for donations whereby donated property, plant, and equipment are measured at fair
value as there is no historical cost alternative. Fair value estimates for real property are used in
the financial reporting of defined benefit pension plan assets. Fair values of property, plant, and
52
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
equipment are also sometimes reported in connection with going concern engagements. Assets
acquired in a bundled purchase (e.g., land with an existing building) are allocated based on relative
fair values. Supplemental disclosures of fair values of oil and gas reserves are required in the oil
and gas industry. The inclusion of fair value estimates is normally required in loan applications
when property, plant, and equipment are used as security. Finally, investors and creditors already
interpret financial statements of foreign firms listed in the United States prepared using fair value
estimates for property, plant, and equipment under foreign GAAP or IFRS. The number of fair
value exceptions already existing under U.S. GAAP provides many examples whereby fair value
measures are currently used in place of historical cost measures.
3.2.2. Neutrality
Neutrality is defined in SFAC No. 2 as “absence in reported information of bias intended
to attain a predetermined result or to induce a particular mode of behavior.” Bias is defined in
SFAC No. 2 as “the tendency of a measure to fall more often on one side than the other of what it
represents instead of being equally likely to fall on either side. Bias in accounting measures means
a tendency to be consistently too high or too low.” Historical cost measures for property, plant,
and equipment introduces a distinct conservative bias documented in Dietrich, Harris, and Muller
(2000). This conservative bias can become especially large for property, plant, and equipment over
time due to inflation. Impairment adjustments further increase this bias. Historical cost allows
for the write-down of assets to fair value assuming the undiscounted value of its estimated future
cash flows is less than book value, but does not allow for the write-up of assets to fair value.
Historical cost should not be defended on the basis of conservatism. Conservatism is not
included as a qualitative characteristic under SFAC No. 2, but it is discussed in SFAC No. 2
as a reaction to uncertainty that conflicts with the qualitative characteristics (Foran & Foran,
1987, p. 47). “Conservatism in financial reporting should no longer connote deliberate, consistent
understatement of net assets and profits. The Board emphasizes this point because conservatism
has long been identified with the idea that deliberate understatement is a virtue (SFAC No. 2,
para. 93).” SFAC No. 2 further explains that “Any attempt to understate results consistently is
likely to raise questions about the reliability and integrity of information about those results and
will probably be self-defeating in the long run. That kind of reporting, however well-intentioned,
is not consistent with the desirable characteristics described in this Statement (SFAC No. 2, para.
96).” Thus, based on the FASB’s own conceptual framework, conservatism is not a valid basis
to support the continued use of strict historical costs for the valuation of property, plant, and
equipment.
3.2.3. Representational faithfulness
Representational faithfulness is a “correspondence or agreement between a measure or description and the phenomenon that it purports to represent (SFAC No. 2).” The following quote, by
William Paton in March 1946, was reprinted in the FASB’s “Understanding the Issues” Series
with the May 2001 Status Report (Foster & Upton, 2001):
Cost and value are not opposing and mutually exclusive terms. At the date of acquisition,
cost and value are substantially the same – at least in most transactions. In cases where the
medium of payment is property other than cash, the cost of assets acquired is measured by
the fair market value of such other property. In fact cost is significant primarily because it
approximates fair value at the date of acquisition. Cost is not of basic importance because
it represents an amount paid; it is important as a measure of the value of what is acquired.
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
53
These conclusions were further embodied by the Accounting Principles Board “presumably,
because the members of the respective Accounting Principles Boards believed that fair value is
the most faithful representation of a transaction (Foster & Upton, 2001).”
Faithful representation relates not only to when a transaction occurs, but also to changes in
financial information between transactions. This is the primary purpose behind adjusting entries
recorded at the end of each accounting period. Adjusting entries are often necessitated not by
a transaction occurring, but by the passage of time. Failure to record adjusting entries on a
timely basis inevitably leads to misrepresentation of assets, liabilities, and income in the financial
statements. Similarly, failure to adjust the original fair value of property, plant, and equipment (i.e.,
historical cost) for changes in fair value leads to information that does not faithfully represent
the underlying fair value. Of course, if the objective of accounting is to accurately record the
events that have occurred in the past, then historical cost accounting is representationally faithful.
Given this, Chambers (1989, p. 14) still questions the representational faithfulness in historical
cost based financial statements in the following quote:
The balance sheet, widely described as a statement of financial position at a stated date,
commonly contains assets stated at or based on prices at other, often distant, dates. The
practice implies that every dollar, however recently or distantly spent, is equal in some
financial sense to every other dollar at the balance sheet date. That is patently false. If the
purchase dates were shown for every asset ‘at cost’, it could be said that each component
statement was historically true. But when the only date given is the balance sheet date, ‘at
cost’ implies at that date; and that is historically false.
The charge for depreciation and the consequential revision of residual value is a compound consequence of the use of a past-dated price (the cost of the asset), a future selling
price (the expected scrap or resale value), and an assumed mode of diminution of value
over the conjectured intervening interval. That consequence purports to be a representation of a presently dated event—yet the present date enters into its derivation in no way
whatever!
From an income perspective, historical cost accounting is often considered a more faithful
representation for property, plant, and equipment than annual asset revaluations because historical
cost earnings are less subject to manipulation. Gains and losses on asset revaluations are based on
appraisals or other valuation techniques. These techniques are subject to estimation and therefore
provide managers with a tool for managing earnings (Dietrich et al., 2000). As a result, some
believe that historical cost accounting produces a more representationally faithful amount for
earnings. However, there is also evidence that income is managed under strict historical cost
accounting through the timing of asset sales (Herrmann, Inoue, & Thomas, 2003). Assets recorded
under historical cost can accumulate large holding gains and losses. Firms can time the sale of
assets to strategically realize these large holding gains or losses in reported income. If firms engage
in such behavior, then earnings management arguments in support of historical cost accounting
are less convincing.
3.3. Comparability
Comparability is defined as “the quality of information that enables users to identify similarities
in and differences between two sets of economic phenomena (SFAC No. 2).” Fair values, when they
can be reliably measured, enhance the comparability of information. Historical cost measures can
54
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
hinder comparability both by failing to identify similarities between similar items and by failing
to distinguish differences between different items. For example, assume a firm purchases a piece
of land for US$ 5 million in 1980. Another company purchases a piece of land in 2000, virtually
identical in every respect to the first including location, for US$ 15 million; the higher price being
attributable to increasing real estate values in the region. This represents the classical example
given in microeconomics whereby historical cost distorts the comparability of two identical assets.
Each company has a piece of land equal in value, but the assets will be reported at substantially
different amounts, making the financial statements less comparable as historical cost fails to
identify similarities between similar items.
Extending the example, assume the second company rather than purchasing a similar piece of
land for US$ 15 million, purchases a much smaller piece of land in 2000, clearly inferior to the first,
for US$ 5 million. This also distorts comparability under historical cost as the companies report
equal dollar amounts of land, even though the first company owns land at three times the value.
This extended example illustrates the inability of historical cost to clearly distinguish differences
between different items. Note that the use of historical cost for property, plant, and equipment
also affects the comparability of income as historical costs do not distinguish differences in the
asset appreciation earned by the two companies.
Foreign currency further weakens comparability under historical cost. The current rate method
under U.S. GAAP appears incompatible with historical cost. Assuming a foreign functional currency, historical cost assets are translated into U.S. dollars using the current exchange rate. This
produces different historical cost amounts for identical assets due to the change in exchange rates
between original acquisition and the current balance sheet date. Schuetze (2001, pp. 9–10) provides an example whereby three identical assets, bought at the same time, for the same price, and
located in three different countries, would be shown at three different historical cost amounts at
the current balance sheet date.
The issue of allowing versus requiring revaluations of property, plant, and equipment also
has important implications regarding comparability. It is likely that revaluations will continue
to be allowed under the IASB’s convergence model for property, plant, and equipment due its
widespread use internationally. By allowing, rather than requiring revaluations, comparability
may be reduced. Many companies will continue to report under historical cost, while others
will periodically revalue assets to fair value. It is more difficult to identify similarities in and
differences between firm’s property, plant, and equipment when such assets are reported using
different valuation methods.
3.4. Consistency
Consistency is defined as “conformity from period to period with unchanging policies and
procedures (SFAC No. 2).” This qualitative characteristic again favors fair value measures for
property, plant, and equipment. The use of fair value consistently applies one valuation approach
over time. Historical cost with impairment results in a mixture of valuation methods. If expected
future cash flows exceed the book value of an asset, the asset is reported at historical cost. If the
book value of an asset exceeds expected future cash flows, the impaired asset is reported at the
lower fair value.
Fair value accounting reports all transactions (past and present) at fair values. Historical cost
accounting reports past transactions at historical amounts whereas current transactions are reported
at fair value. Therefore, reported amounts under historical cost represent a basket of valuations
ranging from recent to old transaction prices, while all property, plant, and equipment under fair
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
55
value accounting are reported at current fair values. Numerous departures from historical cost
for property, plant, and equipment, discussed previously under the characteristic of verifiability,
further add to a lack of consistency under historical cost.
4. Measurement concepts for property, plant, and equipment
Although the primary emphasis of this paper is on the evaluation of historical cost and fair
values based on the qualitative characteristics of accounting information, the discussion would
not be complete without also addressing the broader measurement concepts, particularly as they
relate to property, plant, and equipment. While the concepts statements on objectives (SFAC Nos.
1 and 4), qualitative characteristics (SFAC No. 2), and elements of financial statements (SFAC
Nos. 3 and 6) have over time represented highly useful contributions to the field of accounting,
the concepts statement on recognition and measurement (SFAC No. 5) has been a relative disappointment especially in the area of accounting measurement. The FASB and IASB concepts
statements describe measurement attributes, but are silent on the important issue as to when a
particular measurement attribute should be implemented. The need for additional guidance in
the area of accounting measurement is readily acknowledged by the IASB as well as national
standard setters. With the assistance of the Accounting Standards Board (AcSB) in Canada, the
IASB approved for publication the discussion paper entitled “Measurement Bases for Financial Reporting: Measurement on Initial Recognition.” The document will be issued in the third
quarter of 2005 for a nine-month comment period. The FASB also issued an exposure draft
on fair value measurement in June 2004 with the intent to increase the consistency and comparability of fair value measures (FASB, 2004). The FASB plans to issue a final statement on
fair value measurement in the fourth quarter of 2005. The following discussion is intended to
aid in the choice of measurement attributes particularly as they relate to property, plant, and
equipment.
SFAC No. 5 defines five different measurement attributes used in current practice: historical
cost, current cost, current market value, net realizable value, and present value of future cash
flows. Historical cost is defined as the amount of cash, or its equivalent, paid to acquire an asset,
commonly adjusted after acquisition for amortization or other allocations (SFAC No. 5, para.
67a). The other four measurement attributes represent different measures of fair value. Current
(replacement) cost is the amount of cash, or its equivalent, that would have to be paid if the same
or an equivalent asset were acquired currently. Current market value is the amount that could
be obtained by selling an asset in orderly liquidation. Net realizable value is the non-discounted
amount of cash, or its equivalent, into which an asset is expected to be converted less any direct
costs to make that conversion. The present value of future cash flows is defined as the discounted
value of future cash inflows into which an asset is expected to be converted less present value
of cash outflows necessary to obtain those inflows. Current replacement cost represents an entry
measure of fair value, current market value and net realizable value represent exit measures of
fair value, while the present value of future cash flows is neither an entry or exit measure, but
rather a measure of value in use. Unfortunately, SFAC No. 5 does not go beyond the definitions
to prescribe what measurement approach should be used in specific situations and what type of
principles based standards might flow from these revised concepts.
The U.K.’s Statement of Principles (1999) provides some guidance in this area as it takes a
more prescriptive approach to measurement in comparison to the purely descriptive nature of the
IASB/FASB frameworks. In cases where the measures of fair value materially differ, the U.K.
framework recommends the selection of the fair value measure that maximizes relevance. Under
56
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
Fig. 2. A hierarchy of measurement approaches to fair value based on deprival value.
a deprival value or value to the business view, fair value is most relevant when it reflects the
loss the entity would suffer if it were deprived of the asset involved. The process is illustrated in
Fig. 2. Assuming the asset is put to profitable use, the recoverable amount will exceed replacement
cost. Fair value will then be measured at the lower replacement cost as this best represents the
loss that the entity would suffer if deprived of the asset involved. However, if replacement cost
exceeds the recoverable amount, the asset would not be replaced and fair value should reflect the
lower recoverable amount. Recoverable amount can be measured as the greater of value in use
or net realizable value. When the most profitable use of an asset is to sell it, fair value is best
represented by the net realizable value. If it is more profitable to continue using the asset, fair value
is estimated as the present value of future cash flows (i.e., value in use). One additional benefit to
this framework in determining fair value is its consistency with the impairment standards provided
in IAS 36 (IASC, 1998b).
The above discussion is based solely on the relevance of the fair value measures. The reliability
of the fair value measures must be considered as well. In many cases, reliable estimates of fair
value can be obtained for property, plant, and equipment from active used asset markets. The
lack of an active market for an asset does not necessarily prohibit reliable estimates of fair value.
There is an increasing use of fair value estimates in financial reports when there are no observable
prices. Examples for property, plant, and equipment include asset retirement obligations, acquired
assets in a purchase combination, and asset impairments. At a minimum, some type of reliability
constraint needs to be implemented to insure that the fair value estimate is measured with sufficient
reliability.
The reliability of fair value measures for property, plant, and equipment varies greatly. The fair
value of at least some asset categories is highly verifiable while the fair value of others is likely
to be far more subjective. A process might be followed similar to that made for investments in
debt and equity securities leading to the issuance of SFAS No. 115. Investments whereby the fair
value is highly verifiable, such as for marketable debt and equity securities, are reported at fair
value. Investments whereby the fair value is more subjective, such as privately held securities, are
measured at cost. Similarly, if the fair value of property, plant, and equipment clearly provides
relevant information to users and the fair value is reasonably verifiable, why not encourage the
reporting of this information in the financial markets? Real estate investment property comes
to mind. The fair value of investment property clearly provides relevant information to users in
evaluating companies with assets containing a significant real estate component. The fair value
of most investment property is also reasonably verifiable. The fair value of investment property
determined through independent appraisals is relied upon heavily in the mortgage loan industry.
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
57
Other tangible assets whereby fair values may be independently verified at a reasonable cost
include transportation equipment, pipelines, office buildings, mineral reserves, and timberlands.
5. Summary and conclusions
We overview the valuation of property, plant, and equipment internationally and argue in favor
of using fair value measures for property, plant, and equipment based on the framework developed
in SFAC No. 2. In doing so, we challenge the primary arguments in support of maintaining the
status quo in the United States—strict historical costs for valuing property, plant, and equipment
unless the asset is impaired. If in the final analysis, financial statements are to be evaluated based
on their usefulness for economic decision-making, we believe that there are viable alternatives to
the strict historical cost basis for valuing property, plant, and equipment.
Recording property, plant, and equipment at fair value is not a new idea. IAS No. 16 includes the
option to revalue property, plant, and equipment to fair value. Many countries including Australia,
the United Kingdom, and New Zealand allow for the reporting of property, plant, and equipment at
fair value. Upward valuations of property, plant, and equipment were even an acceptable practice
in the United States prior to 1940. We contend that the strict adherence to historical cost in the
United States does not have a strong conceptual basis.
We argue that fair values for property, plant, and equipment are more relevant to decision
makers. Academic research has shown that upward revaluations of property, plant, and equipment
are correlated with stock prices and are helpful in predicting future earnings. Fair values also
provide relevant information regarding dividend restrictions. In addition to improved predictive
value, fair values provide greater feedback value and more timely financial information than
historical cost measures of property, plant, and equipment.
Reliability consists of verifiability, neutrality, and representational faithfulness. Verifiability
favors historical cost, although in cases such as self-constructed assets the superiority of historical
cost over fair value is not always clear. Neutrality and representational faithfulness support fair
value measures over historical cost for property, plant, and equipment. Historical cost measures
for property, plant, and equipment violates neutrality as it introduces a distinct conservative bias.
Historical costs do not provide representationally faithful measures of asset values when the
market rate of depreciation (or appreciation) differs materially over time from the book rate of
depreciation. With respect to reported earnings, academic research has shown that gains and
losses on the sale of historical cost assets can be used to manage earnings. Thus, the traditional
arguments of greater reliability of assets and earnings under historical cost can be challenged.
Fair values are also superior from the standpoint of comparability and consistency. Fair value
accounting allows property, plant, and equipment reported in different periods to be valued on
a comparable basis. Historical cost hinders comparability for property, plant, and equipment by
failing to identify similarities between similar items and failing to distinguish differences between
different items. Historical cost also weakens the consistency of reported amounts. Historical cost
accounting aggregates purchase prices (or their unamortized residuals) from different time periods
with different purchasing power. Historical costs without purchase dates lack usefulness because
they do not allow financial statement users to determine the monetary equivalent or the current
value of property, plant, and equipment listed on the balance sheet. As Chambers (1987, p.
105) points out: “When an asset is stated to be ‘at cost’ without a purchase date, ‘cost’ is not
interpretable.” The utility of financial statements ultimately remains in their ability to provide
information useful to decision makers. In this light, we argue that the measurement of property,
plant, and equipment in the United States needs to be reconsidered.
58
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
Acknowledgements
We are grateful to Dennis Beresford, Lanny Chasteen, Stephen Courtenay, Gary Meek, Alan
Roberts, Chris Skousen, Tony Van Zijl, R.S. Olusegun Wallace and participants at the 2002 AsianPacific Conference on International Accounting Issues for helpful comments and suggestions.
References
Aboody, D., Barth, M. E., & Kasznik, R. (1999). Revaluations of fixed assets and future firm performance: Evidence from
the U.K. Journal of Accounting and Economics, 26(1–3).
Alciatore, M., Easton, P., & Spear, N. (2000). Accounting for the impairment of long-lived assets: Evidence from the
petroleum industry. Journal of Accounting and Economics, 29(2), 151–172.
American Institute of Certified Public Accountants (AICPA) (1965). Accounting Principles Board Opinion No. 6. Status
of accounting research bulletins. AICPA.
Ashbaugh, H., & Olsson, P. (2002). An exploratory study of the valuation properties of cross-listed firms’ IAS and U.S.
GAAP earnings and book values. The Accounting Review, 77(1), 107–126.
Barth, M. E., & Clinch, G. (1998). Revalued financial, tangible, and intangible assets: Associations with share prices and
non-market-based value estimates. Journal of Accounting Research, 36(Suppl.), 199–233.
Bartov, E. (1993). The timing of asset sales and earnings manipulation. The Accounting Review, 68(4), 840–855.
Chambers, R. J. (1987). Accounting education for the twenty-first century. Abacus, 23(2), 97–106.
Chambers, R. J. (1989). Time in accounting. Abacus, 25(1), 7–21.
Dietrich, J. R., Harris, M. S., & Muller, K. A. (2000). The reliability of investment property fair value estimates. Journal
of Accounting and Economics, 30(2), 125–158.
Easton, P. D., Eddey, P. H., & Harris, T. S. (1993). An investigation of revaluations of tangible long-lived assets. Journal
of Accounting Research, 31(Suppl.), 1–38.
Financial Accounting Standards Board (FASB) (2001). Statement of Financial Accounting Standards No. 144: Accounting
for the impairment or disposal of long-lived assets. Norwalk, Conn.: FASB.
Financial Accounting Standards Board (FASB) (2004). Fair value measurement. Exposure draft (June 23, 2004). Norwalk,
Conn.: FASB.
Foran, N., & Foran, M. (1987). SFAS No. 12 and the conceptual framework. Accounting Horizons, 1(4), 43–50.
Foster, J. N., & Upton W. Financial Accounting Standards Board. (May 2001). Understanding the issues. The case for
initially measuring liabilities at fair value. Vol. 2, Series 1. Norwalk, Conn.: FASB.
Graham, B., & Dodd, D. L. (1951). Security analysis (3rd ed.). McGraw-Hill.
Herrmann, D., Inoue, T., & Thomas, W. (2003). The sale of assets to manage earnings in Japan. Journal of Accounting
Research, 41(1), 89–108.
International Accounting Standards Committee (IASC) (2003). International Accounting Standard No. 16. Property,
plant, and equipment. IASC.
International Accounting Standards Committee (IASC) (1998). International Accounting Standard No. 36. Impairment
of assets. IASC.
Leuz, C., Deller, D., & Stubenrath, M. (1998). An international comparison of accounting-based payout restrictions in
the United States, United Kingdom and Germany. Accounting and Business Research, 28(2), 111–129.
Montgomery. (1940). Auditing (6th ed.). Ronald Press.
Nichols, L., & Buerger, K. (2002). An investigation of the effect of valuation alternatives for fixed assets on the decisions
of statement users in the United States and Germany. Journal of International Accounting Auditing and Taxation,
11(2), 155–163.
Nurnberg, H., & Dittmar, N. (1997). Reporting impairments of long-lived assets: New rules and disclosures. Journal of
Financial Statement Analysis, 2(2), 37–50.
Paton, W. A., & Dixon, R. L. (1958). Essentials of accounting. MacMillan.
Roberts, M. L., Samson, W. D., & Dugan, M. T. (1990). The stockholders equity section: Form without substance?
Accounting Horizons, 4(December), 35–46.
Schuetze, W. P. (2001). What are assets and liabilities? Where is true North? Abacus, 37(1), 1–25.
Walker, R. G. (1992). The SEC’s ban on upward asset revaluations and the disclosure of current values. Abacus, 28(1),
3–35.
Weston, J. F. (1953). Revaluations of fixed assets. The Accounting Review, 18(October), 489–490.
D. Herrmann et al. / Accounting Forum 30 (2006) 43–59
59
Zeff, S. A. (1995). A perspective on the U.S. public/private-sector approach to the regulation of financial reporting.
Accounting Horizons, 9(1), 52–70.
Further reading
Accounting Practices Board (APB) (1995). Statement of Auditing Standards 520: Using the work of an expert. London:
Institute of Chartered Accountants in England and Wales.
Accounting Standards Board (ASB) (1999a). Statement of Principles for Financial Reporting. London: Institute of Chartered Accountants in England and Wales.
Accounting Standards Board (ASB) (1999b). Financial Reporting Standard 15: Tangible fixed assets. London: Institute
of Chartered Accountants in England and Wales.
Accounting Standards Committee (ASC) (1981). Statement of Accounting Standard Practice No. 19: Accounting for
investment properties. London: Institute of Chartered Accountants in England and Wales.
Australian Accounting Standards Board (AASB) (1999). AASB 1010: Recoverable amount of non-current assets. Melbourne: AASB.
Australian Accounting Standards Board (AASB) (2001). AASB 1041: Revaluation of non-current assets. Melbourne:
AASB.
Financial Accounting Standards Board (FASB) (1980). Qualitative characteristics of accounting information. Statement
of Financial Accounting Concepts No. 2. Norwalk, Conn.: FASB.
Financial Accounting Standards Board (FASB) (1984). Recognition and measurement in financial statements of business
enterprises. Statement of Financial Accounting Concepts No. 5. Norwalk, Conn.: FASB.
Financial Accounting Standards Board (FASB) (2005). FASB Action Alert No. 05-26 (June 30, 2005). Norwalk, Conn.:
FASB.
Japanese Commercial Code (JCC) (1999). Law regarding revaluation of land. Article 7, c. 24.