Fair Value and Historical Cost Accounting - Essay Example

? FAIR VALUE AND HISTORICAL COST ACCOUNTING By Location Question The debate between Fair Value and HistoricCost Accounting In the recent past, fair value accounting concept has been gaining popularity. In fact, the international accounting bodies such as Accounting Standards Board (IASB) and other international boards prefer fair value accounting to historical cost accounting. According to Henderson (2008), the justification for this trend is that fair accounting system seems to be offering better relevancy and reliability of the information contained in the financial reports. Moreover, it is apparent that up-to-date information has the capacity to improve investors’ ability to make informed pronouncements regarding the business performance. The other stakeholders such as employees, suppliers, and stockholders also find fair value accounting more realistic in predicting the trends in business. It is, therefore, easier to ascertain if the business is a going concern concept is on course or otherwise. According to the international accounting standards, fair value refers to the value of an asset or liability, which forms the basis of exchange between willing parties trough arm’s length production. In other words, in free market transactions the fair value is equal to the market prices, which is determined by the forces of demand and supply. The fair value accounting has several models, which include equity approach, mixed approach, income approach, and full fair value. The equity approach incorporates the realized and unrealized profit or losses in the revaluation reserve (Bazley & Hancock, 2013). When any transaction is realized, the changes in fair value will be reflected under equity. Under equity approach, not all the realized gains have any effect on the income statement. The mixed approach on its part, allows all changes in the unrealized fair value to be incorporated in the income statement while the changes in the realized profits or losses are reflected in the income statement as opposed to equity. On the other hand, income approach takes into consideration in the income statement, all the changes in the fair value because of holding losses or gains (Britton & Jorissen, 2007). Finally, under full fair value model, all the changes are incorporated in the income statement including the internally generated goodwill. Proponents of fair value asserts that historical approach has lost its meaning since it does not take into consideration the relationship between market capitalization and the firm’s reported financial performance. For instance, if the firm depreciation policy is based on historical cost accounting, then it becomes increasingly hard to determine the actual market value of equity net worth for the firm. Moreover, it is very hard to ascertain the true financial position of the firm if the firm values its assets based on historical cost accounting (Britton & Jorissen, 2007). On the other hand, the opponents of fair value accounting approach asserts that fair value accounting cannot bridge the gap between market value of all equity and market capitalization. The reason for this is that most accounting practices through the fair value approach do not report the internally generated good will. Due to this fact, it becomes increasingly hard to have a convergence between net assets of the business and the market value for the business. The debate on historical cost and fair value accounting takes into consideration the concept of reliability and relevance. The fact that fair value accounting approach incorporates existing market conditions; it has a better platform to predict the future patterns of the business as compared to the historical approach to accounting. It is therefore widely viewed that historical approach is the most relevant approach used to determine the net assets. However, when the assets are held to maturity, the historical cost approach becomes more relevant since fair value approach is susceptible to market volatility. Proponents of historical cost accounting hold the view that the approach guarantees reliability of the information, which is reasonably error and bias free. Historical approach gives analysts the free hand to use their skills and knowledge to use managerial judgment, private information, and future cash flows to predict future business prospects (Britton & Jorissen, 2007). Pundits in favor of fair value approach to accounting argue that historical cost accounting offers leeway that allows for manipulation of business performance through reporting. It is worth noting that under historical approach to accounting it is possible to conduct earnings management or income smoothing to portray a false impression that the business is performing well when this may not be the case in most instances. For instance, if the firms are showing poor financial performance, the management can influence the reported profits by selling an asset; the net selling price of the asset is a profit if reported to boost the profit reported by the firm. However, such a move will is not possible under fair value accounting because the value of asset is already at its fair value. Those opposed to fair value accounting are of the view that the approach makes it very hard to predict the future business patterns besides increasing the volatility of the earnings. The basis for fair value accounting is in most cases unfounded because they are based on very volatile elements such as interest rates, credit quality, exchange rates, and stock performance. These elements are very volatile and as such, they make it hard to predict future earning patterns or the going concern prospects of the business. The basis of the debate between fair value accounting approach and historical accounting approach is the need to reflect the true position and performance of the business. Higgins (2004) asserts that regardless of the approach that the business employs, it is important that there is no clever accounting to influence the earning of the business. Such a move will mislead the investors to make wrong investment decisions that will regret later besides damaging the reputation of the business. Question II Return on investment (ROI) This ratio makes comparison between the profit realized in the business and the amount of capital investment in the business. There are several accounting policies, which influence the determination of return on investment since they affect computation of net income for the business. Such policies include accrual concept and taxation. The other factor critical to this ratio is measurement of investment in terms of which assets to include in the computation of investment. According to Bazley and Hancock (2013), the major merit of the ratio is its simplistic nature, which makes it easily understandable by majority of the users of the financial statements. The other important merit is that it allows comparisons across different organization and over the years, which in essence enables forecasting. Despite its merit, it has its downsides; the main demerit is that it is more appropriate for short-term focus. Moreover, the cash flows are not discounted to cater for changes in the value of the money over the years. It is given by the formula ROI = Operating Income/Investment Economic Value Added It is referred to as Economic Value Added; it measures the financial performance of the company based on income after deduction of capital cost and taxes. The ratio hence gives a true picture of business performance in the industry. In order to make normal profits the business is expected to register economic value added of zero. This is a hypothetical condition since businesses are known either to register profits or losses. Britton and Jorissen (2007) say that if economic value added is negative then it implies that the business unit is making losses. On the other hand, if the business units register a positive economic value added then it means that business is making supernormal profit. Businesses are expected to breakeven; implying that costs should equal to income (Britton & Jorissen, 2007). The main merit of Economic Value Added is that it gives the true picture of the business performance since it is arrived at after deduction of all costs including cost of capital and taxes. On the other hand, it is hypothetical since it assumes that the business should register Economic Value Added of zero to operate at economic profits yet this is never the case in real business world. It is given by the formula EVA (NOPAT) = Income - (Cost of Capital) (Total Invested Capital) Comparison between Return on Investments and EVA Accounting ratios are critical to the business because they help users of financial statement to analyze the performance of the business over a given financial period. The users of financial statement include internal users such as employees and management as well as the external users such as investors, the government, suppliers and the general public. The calculation of financial ratios is made possible by the two main financial statements namely statement of financial position and statement of income. The ratios include return on investments and EVA. These two ratios are critical because they give comprehensive situation of the business, which enables users of the financial information to make meaningful conclusion about the business performance within its industry of operation (Siddiqui, 2006). Both the ratios, EVA and ROI are critical ratios, which assists the various stakeholders of the business to ascertain whether the business is making profits or otherwise. Every organization irrespective of its size has its own shareholders. The shareholders depend on the financial reports to make informed choices about the business. Return on investment is a good ratio in that it takes into consideration the actual return on investors. The investors depend on such information to ascertain whether they are getting return on their investment or otherwise. Moreover, the ratio helps potential investors to make informed decision on whether to invest on the business or otherwise. EVA appears hypothetical in nature because it pursues economic profits for business yet this is a very rare occurrence in real business practice. However, when the ratio is applied in management it will ensure that the business operates efficiently with a view to attain economic profits for the business. References Bazley, M. & Hancock, P., 2013. Contemporary, Accounting. Boston, Massachusetts: Cengage Learning. Britton A. & Jorissen A., 2007. International Financial Reporting and Analysis. Boston, Massachusetts: Cengage Learning EMEA. Henderson, H. D., 2008. Supply and demand. Chicago: University of Chicago Press. Higgins R., 2004. Analysis for Financial Management. New York: McGraw-Hill Irwin. Siddiqui, S., 2006. Financial Management: Theory and Practice. London: New Age International. Read More