Combining Historical Cost and Fair Value

Abstract

This study is to examine the economic consequences of asset measurement bases for illiquid, productive assets. We explicitly model both the entrepreneur (the seller) and the investor (the buyer) investment decision in a setting where the entrepreneur’s hidden action (investment decision) and hidden information (future prospects of the asset) are communicated through accounting reports. We derive three main …findings. (i) Historical cost rule dominates fair value rule (in terms of securing greater social surplus) if and only if the expected prospects of the asset are sufficiently good. (ii) The lower of cost or fair value rule is welfare improving relative to the two pure measurement bases. (iii) Under the lower of cost or fair value rule, a large amortization rate induces a lower level of investment. However, such interplay between accounting and real decisions varies with the prevailing asset measurement basis.

Keywords: asset measurement, historical cost, fair value, lower of cost or fair value

JEL Classification: D53, D60, D82