Strategic Consequences of Historical Cost and Fair Value Measurements*

Abstract

The Financial Accounting Standards Board (FASB) recently released an exposure draft on fair value measurements to improve the consistency, reliability, and comparability with which financial and nonfinancial assets and liabilities are reported.1 It defined fair value as “the price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated willing parties” (FASB 2004, para. 4). Because the objective of fair value measurement is to estimate an exchange price in the absence of an actual transaction, the FASB grappled with the reliability of fair value measures, the reliability of these measures compared with the reliability of other measures based on judgements and estimates, and the causes of unreliable measures. In light of these concerns, it called for feedback on whether firms can consistently apply the fair value measurements outlined in the exposure draft. This paper examines the measurement of nonfinancial assets in imperfectly competitive markets. It also considers the effect of alternative measurements on firms’ investing and operating activities. Implementing fair value measurement requires a preparer of financial statements to estimate an exchange price. This estimate “is determined by reference to a current hypothetical transaction between willing parties” (FASB 2004, para. 5). In the absence of an actual transaction, the exposure draft proposes a hierarchy of information inputs that should be used to estimate fair value. The hierarchy assigns the highest priority to market inputs that reflect quoted prices in active markets and