Comparison of Historical Cost Accounting And Fair Value Costing - Research Paper Example

Cost Accounting Methods Comparative Study of Historical Cost Accounting And Fair Value Costing Shirley Bongbong For Academia - Research Cost accounting is the method used by entrepreneurs to monitor cost in order to quantify and qualify decision making process in running their respective businesses. Variable cost normally details the expenses classifications like labor, raw materials, electricity, and all other cost that tends to vary with regards to amount and usage. Fixed cost are those that normally does not rise or fall in terms of production history like depreciation of plant and equipment, space or factory rental or lease and many others. Cost accounting has helped a lot of entrepreneurs in their endeavor to analyze the cost of products to be more competitive in the market. The aim is always to get the edge on the competition, getting ahead in the market in terms of product costing, design and packaging, quality and availability. However, improving the efficiency of manpower and machine while reducing cost and without sacrificing customer value is one important point in cost accounting that makes review of a company's financial profile as delicate and argumentative between departments as ever. I. Historical Cost Accounting Historical Cost Accounting is the traditional cost accounting method wherein the assets are being valued at their original cost less their accumulated depreciation. Herein the revenues, expenditure and asset acquisition / disposition are being recorded according to their actual value or amount received and paid to complete the transaction. It allocates a company's fixed cost in a certain period to the cost of items produced during that period and records their result as total production cost. A. Historical cost dictates that values of assets and purchases be entered in books as to their historical costs or value at time of acquisition. Example: I purchased a 100 sqm lot for $5k per sqm in 1995, however its value has appreciated to $20k per sqm in 2006. The amount of the lot or the book value of the asset that will be recorded in the books is still in the value of $5k per sqm. Advantages: This will let us record the book value as to its historical cost or actual value and thereby make our books consistent as to the assignment of values with regards to our company's assets. The value is reliable and is not bias. Disadvantages: This will tend to hide the current market value of the property or asset as defined. B. Historical cost does not record the fair market value of the property and thereby there is no realization of income present from the actual cost to the present market value difference. Disadvantages: From the example above, an income realization of $20k less $5k can be determined if present market value is used. However, it is being denied in simplicity and in its form. C. Historical cost principle is simply the opposite of the current cost accounting principle. In historical cost accounting, the values were recorded and entered as to its value in history or the value at the time of purchase and acquisition while in current cost accounting, the value of the assets were recorded as to the time it was being booked or the statements were being generated and prepared. Disadvantages: This is simply made to elaborate the big difference in cost settings when an asset is being acquired years ago and when the asset is being valued as to its present market or appraised value or its value at the time of the preparation of the financial statements. Historical cost simply does not recognize the present market value of the acquired assets. Value of asset in 1995 is $5k per sqm. Value of asset in 2006 is $20k per sqm. (present true market value) D. Considering the depreciation and the appreciation of a property, it ignores the fact that the value of a property could very well rise up or go lower on its time of operations. Disadvantages: The concentration is mainly in cost allocations and not in the value of the asset. Simply assigning for booking entry with no connotation whatsoever of the present value of the asset. Value of asset in 1995 is $5k per sqm. However in 2007, there was a dispute over road access to the land and the state economy is not well. (Just an example) Value of asset has been decreased to $3k per sqm. It is like using the inflation rate or the defined location as one of the factors for determining the market value of a certain property. E. It relies on the assumption that the firm will continue to exist and so continue to use the historical cost of valuation for its assets unless terminated and liquidated. This is the only time that the present market value will be realized. Any subsequent changes in their bookings will never be recognized and adjusted in the preparation of its financial statements. This will also entail disregarding work-in-process value of goods. Disadvantages: Example if the company decides to terminate production for liquidation. Date: Work-in-process number of shirts is 10 pieces Computed and expected output (continuous operation): 20 shirts At any given day the computation of the incomplete cycle of production could be less in value, but in historical cost it is always the assumption costs of completed production. There is no impact on cost reduction and does not support time equation of idle labor and unused machinery. F. Defies the issue of inflation in its wider concept. This could render yesterdays financial cost obsolete. Implicate the problem of defining the parameters of comparative information expressed in monetary units with different purchasing powers or currencies. Advantages: Computation for inflation cost is near to true value as it is base on graphical historical cost. It can very well give the consumer price index in the inflation calculator from a marked period to a certain period. G. Audit standards to classify companies in financial distress is not well meaning in its true form. Disadvantages: There is a substantial doubt about the operations of the company for the next fiscal year in the audit evaluation report. In fact, bank requires audit reports for all loan applications to know whether a certain company has the ability to operate long term or for a long period of time. H. Pure historical cost consolidates everything like fixed and variable cost into one. See to compare and analyze the illustration below: (Management and Accounting web, http://www.maaw.info/5partsofcostsystem.htm) II. Fair Value Costing Fair value costing warrants the use of the current market values as the object in assigning accounting measurements. It is the used of the price or prevailing market value of a certain commodity at the period of transaction. Example: Price at acquisition 1995 is $4.00 Resale value 2007 is $10.00 Fair market value used $10.00 A. Accuracy in projecting future cash flows. Advantages: Assumptions and estimates use in value measurement is more practical and realistic in translating financial statements. B. Analysis of the efficiency and effectiveness of management is done using the present market value of the assets and products concern. Advantages: Audit reports are fair and practically can predict the financial situation of a company whether it be a state of financial distress or forecasting high yield operations. Fair value is more accurate when it comes to feedback value and predictive value. The statement of assets and liabilities is more accurate and relevant too. C. Computation of Income is more accurate. Advantages: In the statement of accounts definition and values of the assets and liabilities is more accurate and is relative to the prevailing market values. The inputs used to measure for a certain period of time is more relevant and precise. D. Assignment of values for assets and liabilities are more relevant at time of transfer or sale or time of measurement. Advantages: The unit of measurement being used is the extent to which the asset is being aggregated. If it is a real estate property, it is being measured by means of its location, prevailing zonal value or market value of the property belonging to same location at said measurement date or sale or at the time of the transfer of asset. E. Price of asset is not adjusted or added to the cost incurred in the realization or closing of the transaction. Advantages: Unlike in the historical cost, any expenses incurred during the realization of the transaction are not added to the cost of the asset. Rather it is being recorded as separate expense entry. Transaction costs are not considered as an attribute of the asset or liability. F. Fair value measurement applies to the use of the highest and best use of the asset by the market participants which entails the use of the most appropriate and highest value bid for the particular asset. This would mean maximization of the value of the asset by which the asset will be used. The asset in discussion could mean the asset in-use or the asset in-exchange. G. Valuation techniques used are more relevant using the market approach, income approach and cost approach. Market approach uses prices and information related to identical or comparables assets or liabilities. Income approach value is based on the current market expectations or projections about those future amounts. Cost approach uses the idea of current replacement cost. This means using the values or amount that will require replacing the current asset. Advantages: Valuation techniques improve if for example a data previously used for a certain transaction becomes obsolete and is no longer used. The present market value prevails as basis for measurement. H. Fair value clarifies any amount used in measurement for an orderly transaction between the market participants with regards to sell of its assets or liability. Advantages: Fair value is consistent with the use of its measurement in terms of prevailing market value. The market participants can be more relevant and consistent in its units of measurement. Conclusion: Historical cost is widely cited and used in accounting literature which means that unadjusted historical cost is still the most widely used in accounting. However, values used in the assets and liabilities and preparation of financial statements are still the most controversial subject of relating. In the cost of resources used or assumed during the work-in-process or production, the total production cost is still used. This affects inventory cost and income. Historical costs leave an audit trail. Historical cost is most accurate in forecasting income and market trends since it is more accurate and less prone to error besides being consistent in its form. Historical cost defies present market value of assets booked. It is useless in computation for economics subject to inflation. There seems to be a problem in monitoring price indexes across nations. Fair value cost analysis seems to be more accurate and simple in form and is more practical. This conforms to the capital maintenance theory that favors assignment of values to its prevailing market cost. This proves that historical cost is meaningless when it comes to relative current exit values. Failure to use fair value accounting will give misleading statements of income and asset and liabilities thus misleads earnings management and opportunities consideration. Fair value always considers the exit value of a certain asset. Fair value accounting departs from historical cost. Fair value gives fair audit reporting and classifications. It is hereby concluded that fair value or exit value is more relevant and updated in the use of cost accounting entries and computations especially hyperinflation. Management of the income and opportunities of a company is very important factor in determining its consistency and relevance to the market players and market indexes. In a lot of aspects we can note that fair value far exceeds the advantages over the use of the historical cost accounting methodology. References: Kathryn Snavely, Historical Valuations as supported by the going concern concept, Historical Cost Accounting, Wikipedia, Inflation Accounting, Management and Accounting web, Fair Value Accounting in the United States, Statement of Financial Accounting Standards No. 157, Fair Value Measurements, Read More