Amortised Cost vs Fair Value: Two Ways to Carry an Asset

Amortised cost carries an asset at what was paid for it, adjusted for what has since been earned and collected, so the balance sheet shows a history and nothing reaches profit until it is genuinely earned. Fair value carries the same asset at what it would fetch on the measurement date, so the balance sheet shows a price and a movement reaches profit before anything is sold. The choice between them is not free.

Here is what sits underneath that. A balance sheet has to put one number against every asset, and there are only two honest ways to arrive at that number. One is to report what the asset has actually done, a record of money paid out and money since brought in. The other is to report what somebody would give for it today, a price nobody has received and may never receive. Both are defensible. The two are answers to different questions, and the accounting standard decides which question each asset has to answer rather than leaving it to whoever is preparing the statements.

Each basis stands on its own first, then the same asset runs through both for two years, then the two tests that decide which basis applies, and last the question costing raises, which is where inventory sits. The short answer is that inventory sits on neither basis, and the reason is worth the walk.

What does carrying something at amortised cost actually mean?

Most people have already used the mechanism in an ordinary household form. Rs 1,00,000 goes into a five-year deposit at the post office. A year later somebody asks what that deposit is worth. The answer is not found by ringing around to see what a stranger might pay for it. The deposit has earned interest and nothing else, and the holder will get exactly that, so the answer is the Rs 1,00,000 put in plus the interest that has piled up on it since. Amortised cost is exactly that habit written into an accounting standard: the number on the balance sheet is a running record of the asset's own cash flows, not a price anybody has quoted.

The record is built in a fixed order. The record opens with what was paid, including the costs of buying the asset. Each period it is increased by the income earned, decreased by any cash actually received, and decreased again by any allowance for amounts that now look unlikely to be collected. The number that comes out is the carrying amountThe single number an asset is shown at on the balance sheet, after every adjustment the accounting basis requires. The carrying amount is what the statement says the asset is, not necessarily what anyone would pay for it.. Nothing in that list is a market price, and no step in it asks what anybody else thinks the asset is worth.

The income figure is where the word amortised earns its place. Under the effective interest methodA way of spreading income across the life of an asset using one single rate, fixed when the asset is first recorded, applied each period to the carrying amount at that moment rather than to the original sum., the income recognised in a period is the carrying amount at the start of that period multiplied by one rate that was fixed when the asset was first recorded and never touched again. Because the carrying amount grows, the income grows with it. Where an asset was bought for less than it will eventually repay, the same mechanism pulls the carrying amount up towards the repayment amount a slice at a time. On the last day the two meet, and the pulling is the amortising.

Work one through. Anjani Stationers, an invented notebook maker, puts Rs 10,00,000 of surplus into a two-year deposit certificate on which interest is not paid out but accumulates until the end. The rate is seven per cent a year. The mechanism runs the same way at any rate, and the rate a deposit actually pays moves with the market and the date. Year one: Rs 10,00,000 times seven per cent is Rs 70,000 of income, and the carrying amount closes at Rs 10,70,000. Year two: Rs 10,70,000 times seven per cent is Rs 74,900, and the carrying amount closes at Rs 11,44,900, exactly what the certificate repays. Across the two years the certificate produced Rs 1,44,900 of income, and at no point did the carrying amount consult a market.

What does fair value mean, and fair value as of when?

Fair value is not a variation on amortised cost, so put the amortised cost idea completely to one side. Fair value is a different question asked of the same asset. Fair value is the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. Fair value is therefore an exit price on a stated day, not a record of anything that happened. Three words in that sentence do all the work, and each of them is a trap if it is skipped.

The first is exit. Fair value is what would be received for handing the asset over, not what was paid for it, not what it cost to build, and not what it is hoped it will fetch when the market improves. A household knows this instinctively about a second-hand scooter: the price on the invoice from four years ago is not the number, and neither is the number the seller has in mind. The number is what a buyer would actually pay this week.

The second is orderly. An orderly transactionA sale with normal exposure to the market beforehand and a willing seller who is not being forced. A distress sale, a fire sale or a court-ordered auction is the opposite of one, and its price is not fair value. assumes a willing seller who has had normal time to find a buyer. A forced sale at three days' notice is not orderly, and the price it produces is not fair value. The orderly condition is why fair value does not automatically collapse in a panic: the measure asks what an unhurried sale would fetch, not what a desperate one did.

The third is the measurement dateThe single day the price is struck for, normally the last day of the reporting period. Fair value is always as of a date, and a fair value with no date attached is not a measurement at all., and it is the one readers skip. Fair value is always as of a day, normally the last day of the reporting period. On the last day of March the certificate is worth what somebody would pay on the last day of March. On the first day of April that number is already history, and the balance sheet will carry it, unchanged and increasingly stale, for the whole of the following year until the next measurement date arrives. A reader who treats a fair value as current is reading a photograph as though it were a window.

One more thing has to be said before the contrast, and it is the part most explanations leave out. Most assets have no quoted price at all. A listed government bond has one. A deposit certificate that trades thinly might have an indicative one. A stake in an unlisted business has none whatever, and its fair value has to be estimated with a model, from inputs somebody chose. So fair value ranges from a number that can be looked up to a number somebody built, and the reliability of the two is nowhere near the same. How that range is graded, and what the grades are called, is set out under valuation and measurement.

What happens when the same asset is put on both bases?

Both definitions are now standing on their own feet, so the contrast can be drawn without either one leaning on the other. Take the identical certificate, the identical two years and the identical cash flows, and change nothing except the basis it is carried on. Anjani Stationers paid Rs 10,00,000. Rates have moved against a fixed-rate instrument, so at the end of year one the market price is Rs 9,80,000. At the end of year two the certificate repays Rs 11,44,900 in cash.

Under amortised cost, year one reports Rs 70,000 of income and the carrying amount is Rs 10,70,000. Under fair value, year one carries the certificate at Rs 9,80,000 and reports the movement from Rs 10,00,000, a loss of Rs 20,000. The same asset, in the same year, held by the same business, reports Rs 70,000 of income on one basis and a Rs 20,000 loss on the other, a difference of Rs 90,000 with not one rupee of cash moving in either direction.

Now run year two and watch the difference undo itself. Amortised cost reports Rs 74,900, taking the carrying amount from Rs 10,70,000 to the Rs 11,44,900 that is repaid. Fair value reports the movement from Rs 9,80,000 up to that same Rs 11,44,900, a gain of Rs 1,64,900. Add each pair. Amortised cost: Rs 70,000 plus Rs 74,900 is Rs 1,44,900. Fair value: minus Rs 20,000 plus Rs 1,64,900 is Rs 1,44,900. The two bases report exactly the same total across the life of the asset and disagree only about which year the money is reported in. No other fact about the pair is as useful. Timing is the whole argument. Nothing is created and nothing is destroyed by the choice.

A reader who misses one fork inside fair value itself will misread half the statements they open. A fair value movement does not always land in profit. Where the asset is one the business holds both to collect its cash flows and to sell when it suits, the interest still runs through profit on the effective interest method, and the rest of the fair value movement is parked in other comprehensive incomeA separate section of the performance statement, sitting below profit, that collects certain gains and losses which the standard keeps out of profit for the time being. Other comprehensive income is part of the year's total result but not part of the profit figure most readers quote. instead. Run year one that way and the arithmetic is exact: Rs 70,000 of interest into profit, minus Rs 90,000 into other comprehensive income, and the two together give the minus Rs 20,000 total change in the carrying amount. Same balance sheet number as full fair value, same profit number as amortised cost, and the difference sits in a section many readers never scroll to.

What decides which basis an asset is carried on?

The most common misunderstanding on this whole subject is that a business picks. It does not. The classification is decided by two tests applied when the asset is first recorded, and both tests are about facts rather than preferences: how the business manages the asset, and whether the asset's cash flows are only principal and interest. Fail either test and amortised cost is not available, whatever anyone would prefer.

The first test asks what kind of cash flows the asset produces. Are they only payments of principal and interest on the principal still outstanding, or is something else going on? A plain loan passes. A deposit certificate passes. A share does not pass. A dividend is not interest, and there is no principal to repay. An instrument whose return is linked to the price of paper does not pass either. Its cash flows are riding on something other than the passage of time and the credit of the borrower. Anything that fails this test goes to fair value through profit or loss, and the second test is never reached.

The second test is the business model testAn assessment of how a business actually manages a whole group of similar assets, judged from how it has behaved rather than from what it says it intends. The test is applied to the group of assets, not to one asset at a time., and it asks how the business manages a whole group of similar assets. Holding them to collect the contractual cash flows and nothing else points to amortised cost. Holding them both to collect and to sell when it suits points to fair value with the movement below profit. Holding them to trade, or managing them on a fair value basis, points to fair value straight through profit. Notice that the test is about observed behaviour across a group, not about a stated intention for one asset. A business that says it holds to collect and sells half the book every year has failed the test regardless of what the minutes say.

And the classification is sticky on purpose. The classification is fixed when the asset is first recorded. It can only be changed where the business genuinely changes how it manages that entire group of assets, and such a change is rare and highly visible when it happens. A movement that went the wrong way is never a reason to move an asset from one basis to the other, and that abuse is precisely the one the rule exists to prevent. A household version makes the point: the scooter cannot be a long-term keepsake in the year its resale price falls and a tradeable asset in the year it rises.

Why can two businesses holding the same asset report different profits?

Here the subject turns from mechanics into something a reader can be caught by. Two notebook makers are of exactly the same size, called here the first business and the second business. Each has operating profit of Rs 43,00,000 for the year. Each has bought Rs 1,00,00,000 of the same instrument on the same day. The instrument paid Rs 7,00,000 of interest in cash to both of them, and its market price rose Rs 6,00,000 over the year to Rs 1,06,00,000. Every fact about the two is identical. Only the classification differs.

The first business holds to collect, so the instrument sits at amortised cost. Its balance sheet carries Rs 1,00,00,000 and its profit before tax is Rs 43,00,000 plus Rs 7,00,000, a total of Rs 50,00,000. The second business manages the same instrument on a price basis, so it sits at fair value through profit or loss. Its balance sheet carries Rs 1,06,00,000 and its profit before tax is Rs 43,00,000 plus Rs 7,00,000 plus the Rs 6,00,000 unrealisedDescribes a gain or loss that has been recognised in the accounts while the asset is still held, so no sale has happened and no cash has changed hands because of it. gain, a total of Rs 56,00,000. Rs 56,00,000 against Rs 50,00,000 is exactly twelve per cent more profit on identical trading, identical assets and identical cash, and neither set of statements is wrong.

Sit with what that means for anyone comparing the two. The gap of Rs 6,00,000 is not performance. Not one rupee more came in. Both businesses received the same Rs 7,00,000 of interest and no more. If the price falls back next year, the second business will report a Rs 6,00,000 loss it never suffered in cash, and a reader watching only the profit line will see a business that deteriorated. And there is a third possibility that muddies it further: had the second business classified the instrument as held both to collect and to sell, its balance sheet would still show Rs 1,06,00,000 while its profit matched the first business at Rs 50,00,000, with the Rs 6,00,000 sitting quietly below the profit line.

Comparing two reported profits without first reading the classification note is comparing the answers to two different questions. The comparison is so easy to get wrong, and so rarely checked, for one reason: the classification is disclosed in the note, not on the face of the statements. Nothing on the face of either statement announces that these two businesses answered different questions.

Which basis does inventory use, and why is it neither of these?

The two bases matter to costing for one reason. A reader who has just learned two measurement bases will reach for one of them the next time an asset appears, and the asset closest to hand in costing is a godown full of paper. Inventory is on neither basis: it is carried at the lower of cost and net realisable value, a cost basis with a ceiling nailed on top of it.

Take the two halves separately. Cost is where inventory starts, and for Anjani Stationers at the end of year two that is Rs 28,00,000, being 14,000 reams at Rs 200 a ream. Cost is a history in exactly the same sense as amortised cost: money paid, plus the costs of getting the paper into the godown and into a usable state. Then net realisable valueThe amount the stock is expected to fetch in the ordinary course of business, less whatever still has to be spent to finish it and to sell it. Net realisable value is an estimate about one business, not a market quotation. (NRV) is the ceiling: the expected selling price of the stock, less the spending still needed to finish and sell it. The carrying amount is whichever of the two is lower, tested at every reporting date.

Now watch what the ceiling produces. It is not symmetric, and the asymmetry is the point. Suppose paper prices rise eight per cent during the year, so the 14,000 reams that cost Rs 28,00,000 could be replaced only at Rs 30,24,000 and would fetch more in the market than Anjani Stationers paid. What does the balance sheet show? Rs 28,00,000, unchanged. What does profit show? Nothing at all. The Rs 2,24,000 of value the business has picked up is simply not in the accounts, and it will only appear when the paper becomes notebooks and the notebooks are sold, at which point it arrives disguised as a fatter gross margin.

Turn it the other way and the behaviour changes completely. Suppose instead the ruled format has gone out of fashion and the same stock would now fetch only Rs 26,00,000 after the costs of selling it. Now the ceiling bites. The balance sheet drops to Rs 26,00,000 and a charge of Rs 2,00,000 lands in this year's profit, before anything has been sold and before any customer has refused to buy. Losses land the moment they are expected and gains wait for a sale. Fair value does the exact opposite, so inventory can never be described as being on a fair value basis. Nothing was actually written down in Anjani Stationers' year two, and the published closing inventory is the clean Rs 28,00,000.

One complication belongs here, and its full treatment sits under inventory write-downs. Raw materials are not written down simply because their own market price has fallen. If the notebooks made from that paper will still sell for at least what they cost to make, the paper stays at cost. The ceiling is judged by what the finished product will fetch, not by what a ream would fetch on its own, and forgetting that is how a perfectly healthy stock balance gets written down for no reason.

What do Anjani Stationers' own holdings look like under each treatment?

The whole subject fits on one table. Anjani Stationers ends year two holding two things that matter here: the Rs 10,00,000 deposit certificate and the Rs 28,00,000 of paper that is its published closing inventory. Over the year the market moved against the certificate and paper prices rose eight per cent. Every treatment sits side by side, with the actual basis in the first row of each pair and the counterfactuals shown for comparison only.

Two notes on that table matter more than the numbers in it. The first is that the certificate and its interest sit outside Anjani Stationers' published statement of profit and loss. That statement runs from revenue of Rs 2,70,00,000 down through operating profit of Rs 41,50,000, finance cost of Rs 3,50,000 and profit before tax of Rs 38,00,000. None of those figures move. The second is that only the paper row is real in the sense that it appears in the published accounts, and the Rs 28,00,000 there is the same Rs 28,00,000 published in the balance sheet.

Three readings from the slider matter. Drag the slider to plus eight per cent, the same rise the paper had. Fair value carries Rs 10,80,000 and reports Rs 80,000. The lower of cost and net realisable value still carries Rs 10,00,000 and reports nothing. Amortised cost still carries Rs 10,00,000 and still reports only its Rs 70,000 of interest. Now drag to minus eight. Fair value carries Rs 9,20,000 and reports minus Rs 80,000, and this time the lower of cost and net realisable value carries Rs 9,20,000 and reports minus Rs 80,000 too. On the way down the lower of cost and net realisable value behaves exactly like fair value, and on the way up it behaves exactly like amortised cost. The bend at zero means exactly that and nothing more. At minus twenty per cent the two lines sit on top of each other at minus Rs 2,00,000, and at plus twenty they are as far apart as the chart allows, because fair value reports Rs 2,00,000 of gain and the inventory basis reports nothing at all.

Who reads the classification note, and what do they do with it?

Three different people open these statements in the same week, and none of them is admiring the arithmetic.

A lender reads the classification to work out how much of the reported profit can pay interest, an analyst reads it to make two businesses comparable before comparing them, and Vaidehi Rao reads it because she has to justify to her board why profit moved when nothing about the trading did. Watch each of them work. The lender's question is blunt: of the Rs 56,00,000 the second business reported, how much arrived as money? Rs 7,00,000 of interest did. The Rs 6,00,000 gain did not, and it can go backwards next year without anybody doing anything wrong. A lender sizing a facility on cash flow strips it out and works from Rs 50,00,000, and does the same thing to the previous year before comparing the two.

The analyst's job is a step earlier. Before any comparison at all, find the classification note and check whether the two businesses answered the same question. Where they did not, the fix is to compare the line above the investment result rather than the profit figure, or to restate one of them, and to say in the note which was done. The check costs a few minutes and it is the difference between a comparison and a coincidence.

Vaidehi Rao's use is the most practical of the three, and it is the one a student can picture. She cannot control the price of an instrument. She can know, before the board meeting, exactly how much of the movement in reported profit came from trading and how much came from a measurement basis. Then the question does not arrive as a surprise. Knowing the split is not a defensive move. It is the only way to answer the board's real question: did anything about the business change?

Anjani Stationers Private Limited, Vaidehi Rao and the two comparison businesses are invented.
Educational material. Not advice on any investment, tax, budget or market position.