Fair Value versus Historical Cost Accounting and Deprival - Essay Example

? THE PROS AND CONS OF FAIR VALUE VERSUS HISTORICAL COST ACCOUNTING AND DEPRIVAL VALUE Introduction Organizations are expected to keep track of their state of affairs and performance over specified time duration using numerical financial reports. Standard setters have also increased their emphasis on measurement through established standard frameworks like the United States Financial Accounting Standards Board or FASB, the International Accounting Standards Board or IASB and or the UK Accounting Standards Board or ASB (Van Zijl & Whittington 2006). Financial reporting requires extremely accurate form of measurement to deliver information to lenders and shareholders who are obliged to know how wisely their money is being spent (Barth 2007). Van Zijl & Whittington (2006) reveal that the current form of measurement is increasingly emphasizing on the use of current value to replace historical costs. The principle reason behind the establishment of accounting standards was to ensure that financial information produced by organizations are accurate, reliable, complete, timely and relevant. In addition, accounting standards would ensure that organizations not only demonstrate accountability but also maintain it while meeting statutory reporting requirements such that the stakeholders are accounted for organizational financial performance to support decision making (Cooper 2007). Currently, the measurement basis for measuring amounts in financial statements includes among others historical cost, amortized historical cost, fair value and value in use. This paper evaluates the pros and cons of fair value versus historical cost accounting and deprival value. 1.0. Current cost should be used in financial reporting Historical cost accounting works well for liabilities that are not traded; representation of liabilities for contractual business obligations like long term deferred revenue, and other complex issues of life insurance and pension liabilities (Macve 2010). However, more emphasis is given to existing stakeholders and stewardship compared to service to investors in capital market and usefulness in economic decisions emphasized by fair value approach which replaces historical costs (Whittington 2008). Historical cost accounting and deprival value characterize the conceptual framework of ASB while fair value is a recent concept that is available only for the last 20 years in FASB, the IASB and the ASB and is increasingly applied in financial reporting. Penman (2007) argues that while historical cost accounting has been used in items whose measurement using fair value would be unreliable or expensive to quantify, fair value is considered to be informative given that it is applied within mixed measurement system. Defining and measuring current value Fair value is defined by Penman (2007) as the amount that would be obtained from selling an asset or the amount that would be given away in defrayal of a liability in a transaction deemed as methodical and between wiling and well-informed participants. As a result, fair value accounting information reflects the future and not the past, events or transactions (Whittington 2008; Barth 2006). Barth (2007) reveals that the measurement decisions are made by standard setters through focusing on the application of the definitions of elements in financial reporting and the qualitative attributes of accounting information on the basis of financial reporting objective. The use of qualitative attributes is intended at recognizing the desired measurement characteristics while the financial reporting objective brings out the context within which the evaluation of measurement will be evaluated (Barth 2007). 2.0. Importance of deprival value concept Van Zijl and Whittington (2006) argue that deprival value is the implying measurement at substitute cost for an asset that has a recoverable amount superior than the costs to be incurred for replacement. The value of an asset is restricted to replacement costs since the loss incurred in losing an asset should not surpass the loss of replacing it. In cases where the replacement value of an asset exceeds the recoverable amount, it is not justified to replace the asset since the asset would be valued at a lesser value, the recoverable amount. The use of deprival value is considered as customized replacement cost since it has to be subjected to a test for recoverable amount (Van Zijl and Whittington 2006). Relevance and usefulness of deprival value to users of financial information Deprival value is relevant and useful to financial information users since it is used to resolve the fair value issue of determining the choice of market in which fair value should be assessed especially whether to use market entry or exit (Broadley 2007). With deprival value, the objective is to evaluate the value added to a business from owning the asset while fair value is predicated on the basis of observable price (Broadley 2007). Through the use of observable prices, liquid markets must exist such that fair value is credible (Weetman 2007). However, Broadley (2007) asserts that the presence of deep and liquid markets is questionable for transactions and at this point, deprival values become useful. 3.0. The position of deprival value today Currently, deprival value is being replaced by fair value. Weetman (2007) reveals that deprival value has been applied in the maintenance of relevant financial discipline by UK standard setters while the US standard setters have not given it much interest. According to Cooper (2007), the deprival value was intended at promoting coordination through the use of standards. However, Weetman (2007) reveals that attention is shifting to fair value approach despite deprival value being far much adequate in reporting liabilities whose well-offness is to be assessed. In addition, deprival value is perceived as insufficient especially where recovery cost for long-term assets involve estimating future values like depreciation. Through the use deprival value, subjectivity results especially when the market entry price differs from market exit prices for all markets. Subjectivity lets management to provide additional information while it introduces earning management and diminishes the criticality of accounting numbers as a contracting measure (Weetman 2007). 4.0. Importance of fair value as a measurement basis According to Barth (2007), IASB considers fair value in numerous situations of measurement since its application lessens the effects of inconsistency in modern day mixed measurement owing to application of multiple attributes of measurement. The variations resulting from the use of mixed measurement methods are as result of evolution of convention and variations in practice (Barth 2006). Barth (2007) asserts that the use of fair value is simpler and appealing and erodes any difficulties that could translate to the users of the financial statement like interpretation of accounting summary values. Landman (2007) asserts that fair value focuses on determining the price for asset sale or liability payment at measurement date and the price must reflect its value fully. Fair value is free from subjective intents and convictions of the assets’ current owner since it is an objective measure (Van Zijl and Whittington 2006) that assumes the absence of crucial information asymmetry. This implies that fair value is founded notional market price is achieved by assuming that the asset buyer has use for it and it is not sold for scrap purposes. For the investors, fair value enables investors to evaluate disposal options in that they can sufficiently determine future cash flows after assets disposal. In addition, since investors use the balance sheet to assess organization’s investments and financial reliabilities, using fair values is convenient (Cooper 2007). 5.0. Fair value enhances reliability and relevance Amongst all measurements bases used for financial reporting, fair value meets the conceptual framework criteria better especially in terms of relevance and faithful representation (Barth 2007). Relevant information has predictive value that enables users to confirm or correct their evaluations in the past timelessly. Faithful representation comprises of verifiability, neutrality, and completeness and makes fair value to represent assets and liabilities faithfully through the manifestation of threat and probability-weighted assessment. Fair value verifiability is direct or indirect where indirect verifiability determines the level of bias or error on inputs to the measurement technique. Conversely, direct fair value verifiability relies on the substantiation of measurement. Fair value enhances reliability since it is founded on the price to use when there are accessible reliable acquisition and disposal prices. Van Zijl and Whittington (2006) point out that fair value is founded on the clarity of asset measuring objective, at the amount that reveals relevant costs of transaction. In addition, Cooper (2007) reveals that fair value approach’s reflection of current economic conditions makes it relevant especially when measuring assets. Relevance is applicable for business assets especially when not intended for immediate sale. In this case, fair value is economically relevant for users focusing on making economic decisions, an advantage not provided by historical costs (Cooper 2007). The relevance and reliability of fair value reporting approach is also demonstrated in the fact that fair value reveals information about the stewardship of management and equity value through the statement of all assets and liabilities as their value to stakeholders on the balance sheet (Penman 2007) 6.0. Deprival values cannot be an alternative measurement to fair value Barth (2007) asserts that apart from historical costs, other better alternatives to fair value exist given the existence of several shortfalls on historical costs. First, historical costs are not similar to amortized and impaired amounts that are used to subsequently measure items that have already been recognized initially. As a result, historical value cannot represent amortized values in the financial statements (Barth 2007). Secondly, there is not clarity as to whether historical costs contain the Framework’s specifications on accounting information qualitative characteristics. Thirdly, it is recognized that some assets and liabilities like derivatives have no costs and historical cost offers no way of recognizing and reflecting them in the balance sheet. Through research on accounting measurements, it is possible to obtain the extent and viability of each measurement bases in numerous contexts to meet the qualitative characteristics of accounting information. Research will also assist in the determination of real world economic phenomenon relevant for users of financial accounting. Bibliography Barth, ME 2006, Including Estimates of the Future in Today’s Financial Statements, Accounting Horizons, 20 (3), pp. 271–285. Barth, ME 2007, Standard-setting measurement issues and the relevance of research. Accounting and Business Research, International Accounting Policy Forum. Pp. 7-15. Broadley, P 2007, Discussion of ' Financial reporting quality: is fair value a plus or a minus', Accounting and Business Research, International Accounting Policy Forum. pp.45-48.  Cooper, S 2007, Discussion of ' Standard-setting measurement issues and the relevance of research, Accounting and Business Research, International Accounting Policy Forum. pp. 17-18 Landman, WR 2007. Is fair value accounting information relevant and reliable? Evidence from capital market research. Accounting and Business Research, International Accounting Policy Forum. Pp. 19-30. Macve, RH 2010, The Case for Deprival Value, Abacus, 46 (1), pp. 111-119. Penman, SH 2007, Financial reporting quality: is fair value a plus or a minus? Accounting and Business Research, International Accounting Policy Forum. Pp. 33-44. Van Van Zijl, T. and Whittington, G 2006, Deprival value and fair value: a reinterpretation and a reconciliation, Accounting and Business Research, 36 (2), pp. 121-130. Weetman, P (ed.) 2007, ‘Comments on Deprival Value and Standard Setting in Measurement: From a Symposium to Celebrate the Work of Professor William T. Baxter’. Accounting and Business Researc,. 37 (3), pp. 233-242. Whittington, G 2008, Fair Value and the IASB/FASB Conceptual Framework Project: An Alternative View, ABACUS, 44 (2), pp. 139–1 68. Read More