Historical Cost vs. Fair Value

Robert E. Healy’s Lasting Mark on Our Profession

John D Rossi III, CPA

John D Rossi III, CPA

-By Guest blogger, John D Rossi III, CPA

Accounting standards in the United States have traditionally been based on historical cost. Not so well known, however, is that the use of historical cost accounting can be traced to the Securities and Exchange Commission (SEC), and that it has not always been advocated by the accounting profession.

In the early 20th century, accountants had significant latitude in selecting accounting practices and policies. The use of “current values” or “appraised values” for assets was common. During this period, balance sheets often included upward revaluations of long-term assets, such as property, plant, equipment, and intangible assets.

As a result of abuses, President Franklin Roosevelt signed into law the Securities Act of 1933, which regulated the public offering of securities; the Securities Exchange Act of 1934, which regulated stock markets; and the Public Utility Holding Company Act of 1935 (PUHCA), which regulated the utility industry. The reform effort was spearheaded by the newly created SEC as part a congressionally mandated investigation into market manipulations by public utility holding companies, with an emphasis on questionable accounting practices.

The person who advocated the SEC’s adoption of historical accounting standards nearly 70 years ago was Robert E. Healy. Prior to becoming one of the five founding SEC commissioners in 1934, Healy had been chief counsel of the Federal Trade Commission (FTC) from 1928 to 1934 and directed the FTC’s six-year, congressionally mandated investigation into the market manipulations by public utility holding companies, which centered on the use of “current values” and “appraised values” during the 1920s.

In the aftermath of the Great Depression, there was a general move toward more “conservative” accounting. This included a move away from the use of “current values” and “appraised values.” The use of historic cost accounting was strongly supported by Healy. Healy participated in the business practices investigations that uncovered widespread use of asset write-ups, which the FTC viewed as arbitrary.

Healy identified the problem to be an existing mentality that one could “capitalize practically everything except the furnace ashes in the basement,” and he became an uncompromising advocate of historical cost accounting and public utility reform. He was livid at the asset value write-ups that companies had been booking. In testimony to a Congressional committee in April 1934, he said, “The purpose of bookkeeping and accounting was to make a historical record of events.”

In a speech before the American Accounting Association on Dec. 27, 1937, Healy put forward his belief on the purpose of accounting: “The purpose of accounting is to account – not to present opinions of value.” This is not to say that current assets should not be carried at the lower of cost or market, or that the setting up of proper reserves does not require professional judgments. It’s that cost is usually certain.

The capital entrusted to management can usually be ascertained. Finding what has been done with that capital can be ascertained through accounting. The steward must account for the talents entrusted to management. “Accounting means the making of a historical record of financial events. Valuation is a very different matter,” he said. Healy did not imply that there are no circumstances under which unrealized losses or gains should be recognized on books of account. Unrealized gains should not be entered upon accounts until the probability or certainty of the permanence of the gain can be well established. “I believe that good accounting should observe this principle,” he stated.

In 1936, the SEC received academic support for its historical cost position when the American Accounting Association’s executive committee, led by association president Eric L. Kohler, published A Tentative Statement of Accounting Principles Affecting Corporate Reports, which strongly endorsed original cost for physical assets. The SEC’s chief accountant said in 1937 that he agreed with the statement, and four years later the Association published a monograph written by two members of its 1936 executive committee, William A. Paton and A. C. Littleton. The monograph contained a conceptual rationale for the use of historical cost accounting.

During Healy’s tenure, the SEC strongly endorsed historic cost accounting and moved to curtail the use of “appraised values.” By 1940, the practice of the upward revaluation of fixed assets, a practice that had been commonplace in the late 1920s, was virtually extinct from financial reporting in the United States. Healy’s views would guide a generation of leaders at the SEC through the early 1970s. Healy, who served longer than anyone as an SEC commissioner (12 years), died in office in 1946.

“Those who cannot remember the past are condemned to repeat it.” This saying appears in many different forms, but the earliest version is probably that of the poet and philosopher George Santayana. So, will the accounting profession learn from Healy and his efforts or are we condemned to repeat our past mistakes?

4 responses to “Historical Cost vs. Fair Value

  1. The failure of the capitalist system in the early 30’s was a direct result of the failure to record the transactions on a standard basis that was clearly understood by the investors. The measures used were called by many names, appraised value, economic value, current value. All were easily abused, and when the investors rely upon the accountants to derive these values, they fail to measure the risks themselves. Fair value continues this capitalist defeating system, establishing a value on the books that is generally misunderstood to be the realizable value, while accounting standards clearly define it as something else. How many times have you heard someone mistakenly refer to fair value as market value? Yet, fair value does not reflect any type of block value adjustment, or transaction specific adjustments. Capitalism is threatened by the very profession that should defend it. If investors wish to estimate an economic or current value, they should do so, in that way, they will fully understand the value they are assigning, and the risk adjustments that are involved in deriving that value. I am in agreement with Healy, “Accounting means the making of a historical record of financial events”.

  2. Pingback: Accounting Leaders Advice on Becoming a Partner | CPA Now

  3. I am a student doing a Senior thesis at UNIB having trouble correlating fair value verse historical cost accounting controversy to my accounting major is there a direction that you would recommend for me to visually explain the problem. Do you have journals, books or articles that I can use.

  4. Could you post some of your references related to Healy? I’m having trouble finding sources (of the quotes) that convey his opinion on historical cost accounting. Thanks.

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