What is the difference between fair value and historical cost collateral valuation methods?

When you need to value an asset that you use as collateral for a loan, you have two main options: fair value or historical cost. These are two different methods of measuring the value of an asset based on different assumptions and principles. In this article, you will learn what each method means, how they differ, and what are the advantages and disadvantages of using them.

1 Fair value method

Fair value is the amount that you could sell an asset for in the current market conditions. It reflects the current supply and demand, as well as the risks and uncertainties of the asset. To determine the fair value of an asset, you need to use market prices, observable inputs, or valuation techniques. For example, if you want to value a stock that you use as collateral, you can use the market price of the stock on the date of valuation.

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Clint Engler

CEO/Principal: CERAC Inc. FL USA..... 🎯 🌐🧿🚩🌎Consortium for Empowered Research, Analysis & Communication
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Imagine you inherited a dusty old painting from your eccentric Aunt Agatha. With historical cost, you'd value it as a cobweb-caked canvas – same price she paid in 1973, even if nobody wants to buy it now. Fair value? Picture an art expert gasping, "That's a lost Da Vinci!" and investors tossing diamonds at you. Basically, one remembers Aunt Agatha's garage sale price, the other sees your ticket to a yacht in Monaco. So, next time you haggle over collateral, choose your valuation method like you choose your shoes: historical for comfy slippers, fair value for those dazzling stilettos that might break your ankle, but hey, you'll rule the dance floor!

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2 Historical cost method

Historical cost is the amount that you paid for an asset when you acquired it. It does not change over time, unless you make adjustments for depreciation, impairment, or amortization. To determine the historical cost of an asset, you need to use the original invoice, receipt, or contract. For example, if you want to value a machine that you use as collateral, you can use the purchase price of the machine minus the accumulated depreciation.

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Sophia Keshavarz

Broker of Record, President, Founder, CIPS at Homes With Sophia Realty Inc., Brokerage
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Key differences between historical cost and fair value lies in their timing and representation of an asset's worth. Historical cost reflects the original cost at the time of acquisition and remains static on the balance sheet unless specific events trigger adjustments. In contrast, fair value, representing the current market value, fluctuates based on market conditions. Fair value is particularly relevant for assessing an asset's true economic worth, especially in rapidly changing markets, making it preferable in collateral valuation for its real-time assessment capabilities. While historical cost may find use in specific contexts, it might not accurately capture the economic reality of the asset as effectively as fair value does.

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3 Differences between fair value and historical cost

The main difference between fair value and historical cost is that fair value reflects the current market value of an asset, while historical cost reflects the past acquisition value of an asset. This means that fair value can change over time, depending on the market conditions, while historical cost remains constant, unless there are adjustments. Another difference is that fair value requires more judgment and estimation, while historical cost requires more verification and documentation.

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Umar Y.

Chairman Medcorp OÜ |, Securities Backed Financing
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In a more simplified way, Historical cost is when a transaction is done or an asset is acquired. Fair value is the current market price that the investment can fetch. Depreciation is always calculated on the historical cost. Depreciation is always calculated on a fair value basis.

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4 Advantages of fair value

One advantage of using fair value as a collateral valuation method is that it provides more relevant and timely information for decision making. It shows the current economic value of an asset and how it affects the borrower's and lender's positions. It also allows for better risk management and alignment of interests. For example, if the fair value of an asset increases, the borrower can benefit from lower interest rates or higher borrowing capacity, while the lender can reduce the collateral requirements or increase the loan exposure.

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5 Disadvantages of fair value

One disadvantage of using fair value as a collateral valuation method is that it introduces more volatility and uncertainty in the financial statements. It can cause fluctuations in the income and equity of the borrower and lender, depending on the changes in the market value of the asset. It also requires more resources and expertise to measure and audit. For example, if the fair value of an asset decreases, the borrower may face margin calls or default risk, while the lender may face credit risk or impairment losses.

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6 Advantages of historical cost

One advantage of using historical cost as a collateral valuation method is that it provides more stable and reliable information for accounting purposes. It shows the original investment value of an asset and how it is recovered over time. It also reduces the risk of manipulation and bias in the valuation process. For example, if the historical cost of an asset is higher than its fair value, the borrower can avoid recognizing losses or impairments, while the lender can maintain a higher collateral coverage ratio.

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7 Disadvantages of historical cost

One disadvantage of using historical cost as a collateral valuation method is that it provides less relevant and timely information for decision making. It does not reflect the current economic value of an asset and how it affects the borrower's and lender's positions. It also ignores the opportunity cost and the risk-adjusted return of the asset. For example, if the historical cost of an asset is lower than its fair value, the borrower can miss out on potential gains or refinancing opportunities, while the lender can understate the value of the collateral or the loan.

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8 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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What is the difference between fair value and historical cost collateral valuation methods?

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1 Fair value method

2 Historical cost method

3 Differences between fair value and historical cost

4 Advantages of fair value

5 Disadvantages of fair value

6 Advantages of historical cost

7 Disadvantages of historical cost

8 Here’s what else to consider

Financial Management

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