Historical Cost and Fair Value Essay

Abstract This paper is written for the accounting theory course as a course project. This paper discusses the differences between the historical cost accounting approach and the fair value accounting approach. The discussion will focus on the debate on using which accounting approach.

We begin by stating the definitions of both concepts and discussing them thoroughly, then we state the main advantages of the two approaches followed by comparison between them.The last section of this paper discusses the disadvantages of each approach, including the main criticism points against them. In the end, we draw a conclusion on the best approach to be used in the Accounting profession based on the previous discussion. Introduction Recognizing assets and liabilities in financial reports is an issue that accounting bodies try to find the best approach for.

The accounting regulators look for a method that takes into account the characteristics of the financial reporting such us reliability and relevance. Historical cost method has been used since long ago. Although this method has been criticized by many, it is still seen as a working method due to its simplicity and reduced costs.

Nowadays, there are many accounting professionals argue that other methods should be employed as the historical method is no more useful. Fair value method is a strong alternative.The supporters of this method argue that Fair value method provides information about financial assets and liabilities that is more relevant than amounts based on their historical cost. In this paper we will make a comparison between the two methods.

Historical cost Definition Historical cost is a term used instead of the term cost. Cost and historical cost usually mean the original cost at the time of a transaction. The term historical cost helps to distinguish an asset’s original cost from its replacement cost, current cost, or inflation-adjusted cost.For example, land purchased in 1992 at cost of $80,000 and still owned by the buyer will be reported on the buyer’s balance sheet at its cost or historical cost of $80,000 even though its current cost, replacement cost, and inflation-adjusted cost is much higher today. The cost principle or historical cost principle states that an asset should be reported at its cost (cash or cash equivalent amount) at the time of the exchange transaction and should include all costs necessary to get the asset in place and ready for use Fair Value AccountingFair value accounting is a financial reporting approach in which companies are required or permitted to measure and report on an ongoing basis certain assets and liabilities at estimates of the prices they would receive if they were to sell the assets or would pay if they were to be relieved of the liabilities, it is noted that under fair value accounting, companies report losses when the fair values of their assets decrease or liabilities increase. Those losses reduce companies’ reported equity and may also reduce companies’ reported net income.The previous definition is consistent with the FAS 157 definition which defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

” The goal of fair value measurement is for firms to estimate as best as possible the prices at which the positions they currently hold would change in transactions based on current information and conditions. To meet this goal, firms must fully incorporate current information about future cash flows and current risk-adjusted discount rates into their fair value measurements.When market prices for the same or similar positions are available, FAS 157 generally requires firms to use these prices in estimating fair values. The rationale for this requirement is market prices should reflect all publicly available information about future cash flows, including investors’ private information that is revealed through their trading, as well as current risk-adjusted discount rates. When fair values are estimated using unadjusted or adjusted market prices, they are referred to as mark-to-market values. If market prices for the same or similar positions are not available, then firms must estimate fair values using aluation models. FAS 157 generally requires these models to be applied using observable market inputs (such as interest rates and yield curves that are observable at commonly quoted intervals) when they are available and unobservable firm-supplied inputs (such as expected cash flows developed using the firm’s own data) otherwise. When fair values are estimated using valuation models, they are referred to as mark-to-model values.

Advantages of Historical Cost Supporters of Historical Cost Accounting argue that this method has several advantages that make it popular. Some advantages are discussed below. Historical cost is based on actual, not merely possible, transactions. It is the acquisition price of the assets. The managers only have to record all the assets and liabilities at their acquisition price.

Hence they are measured and reported objectively. Historical cost is therefore basically verifiable. Thus, this minimizes the risk of manipulation of figures by the managers.

* Historical cost has survived the test of time. Most users of accounting data believe that accounting income is useful and that it constitutes a determinant of the practices and thought patterns of decision makers. Historical cost is an easier and cheaper way of valuation. In respect that the original cost is one that already existed and could not be amended, which is easy to determine and can be verified. Therefore, it requires less estimation for accountants to record the data and easier for auditor to inspect them subsequently. * The accounting system based on historical cost is widely accepted by accountants due to its objective nature, as it is supported by transactions that have already been completed, and it‘s generally easily understandable to its users.

Advantages of Fair Value Fair value accounting approach has many pros including the following points: * It requires or permits companies to report amounts that are more accurate, timely, and comparable than the amounts that would be reported under existing alternative accounting approaches, even during extreme market conditions. * It requires or permits companies to report amounts that are updated on a regular and ongoing basis. * It limits companies’ ability to manipulate their net income because gains and losses on assets nd liabilities are reported in the period they occur, not when they are realized as the result of a transaction. * Gains and losses resulting from changes in fair value estimates indicate economic events that companies and investors may find worthy of additional disclosures. Disadvantages of Historical Cost Financial statements prepared on the historical cost basis do not necessarily lead to a true and fair presentation of an entity’s performance or future potential if capital is not being maintained.Here are some limitations of Historical cost Accounting: * The historical cost method includes a substantial number of subjective estimates such as judgments regarding economic life of the asset, allocation of indirect and joint costs, bad debt reserves, warranty liabilities, etc. * Depreciation charged on historically costed assets is only an arbitrary amount based on out-of-date values and estimated useful economic lives.

* Profit will not reflect the actual ‘costs’ of trading, which include the replacement of assets at some point in time. Overstating profits by undercharging depreciation based on historical cost, and charging cost of sales at historical cost of inventories (and not current cost) can lead to the depletion of an entity’s capital through high tas charges and distributions. * Historical cost accounting makes it difficult for shareholders and analysis to assess the real performance and abiliry of mamagement because changes to current market conditions are not accounted for in the historical valuation basis. * Interpretation of accounts over a period of time is difficult because each year relates to different purchasing powers. Key ratios (such as return on total assets) are inflated under historical rules because profit is overstated (as outlined above) and total assets, (which lead to increased efficiencies and profits), will be penalized under such ratio analysis due to higher total assets, effectively stated at current costs. Disadvantages of Fair Value Fair value accounting approach is still not a perfect one as it has some disadvantages including the following points: * Reported losses are misleading because they are temporary and will reverse as markets return to normal. Fair values are difficult to estimate and thus are unreliable.

* Reported losses have adversely affected market prices yielding further losses and increasing the overall risk of the financial system. * Fair values bring price bubbles into financial statements, in a price bubble; inefficient prices are booked on the balance sheet, with bubble gains flowing through to the income statement. For trading portfolios where investments are held short-term, this may not be a large problem. But where the portfolio is held for the long-term, it is a problem. ConclusionTo sum up, it is difficult to choose between the two methods as both have advantages and disadvantages.

The supporters of fair value argue that financial statements made based on historical cost are not relevant because they don‘t provide information about the current value of elements. On the other hand, the critics of fair value argue that the information provided by financial statements made based on just value are not dependable because they are not based on verifiable transactions and, therefore, they cannot constitute grounds for making decisions.Historical cost accounting has been used for long time. Practitioners seem to be reluctant to replace this method with another one as they are satisfied with it, especially in term of the cost related to it. Moreover, the failure of some methods in the past, such as inflation accounting, has given Historical cost accounting more advantage over other methods. Reference * Nur, A.

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FAIR VALUE ACCOUNTING: UNDERSTANDING THE ISSUES RAISED BY THE CREDIT CRUNCH. New York: New York University Press. * Wikipedia Encyclopedia. (01/06/2012).

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