Comparison of Historical Cost Accounting and Fair Value Accounting - Report Example

Discuss the difference between historical cost accounting and fair value accounting. ii. Discuss advantages and disadvantages with fair value accounting and historical cost accounting with respect to accounting quality. Table of contents Part 1- 3 Part 2- 5 Part 1- Comparison of Historical Cost Accounting and Fair Value Accounting In Fair value accounting, the assets are recorded at an estimated amount at which it is expected to be sold in the market. For calculating this estimated amount various factors are taken into account like utility that is derived from the asset, cost of related substitutes, supply and demand etc. In historical cost accounting, the assets are recorded at their historical value. This means that the value of the asset in the books is actually the “price” at which the asset is acquired. Therefore the basic difference between the two methods is that the former is based on the cost of acquisition of the asset whereas in fair value accounting the asset is recorded at the price that is expected to be realized from the sale of the asset in the market on the date of measurement (Palacky, 2008). The recording of assets based on the concept of fair value accounting is informative and helps in the assessment of the true value of the asset at given point of time. This is not possible for the historical accounting concept as the historical cost of the assets do not give accurate information about the present market value of the asset. The recording of assets in the historical accounting method often understates the value of the assets whereas the recording of assets at their fair values overstates the books of accounts. Under the historical accounting method the time value of money is ignored but this is considered in the fair value method. In the latter the necessary adjustments towards inflation is made in the value of the asset. Thus the assets represent their current market value. Other than the companies belonging to the real estate sector the others mostly prefer historical cost over the fair value method of recording. The historical value of the asset is recorded when it is not possible to find out the fair value of the asset. The application of the historical cost is mandatory in some countries that do not permit any revaluation of the asset. This means that the fair value method cannot be used in such countries. Like under the UK-GAAP, the companies can chose between the two accounting concepts but under German –GAAP, the companies cannot chose between the two methods of recording (Christensen, Nikolaev, 2009). Part 2- The main advantage of the fair value method of accounting is that it records the asset at its net realizable value in the market on the current date. As the assets are recorded at their current value the returns based on these assets are more reliable as compared to the historical methods of recording. This is because the returns calculated under the historical methods are an overestimate because it is calculated on the historical cost of the asset (McKnight, n.d.). As the value of the assets appreciate over time, the return calculated under the historical methods present an exaggerated picture of returns. This method is most suited for the financial institutions and for public limited companies as the information in market forms an important part of the financial data. As per the Financial Accounting Standards the financial instruments must be disclosed at their fair value (Barth, 2001). This method is also best suited for recording the value of properties as they appreciate significantly in a very short time. It is argued that the investors give importance to the value of the asset rather than the cost of the asset. The critics of the method believe that FVA has contributed to the current financial fiasco. As the fair value is based on subjective estimates there are doubts about its reliability. These subjective estimates are not based on any evidence. So it compromises on the basic premise of accounting which states that the information presented in the books of accounts must be based on reliable evidence (Penman, 2006) Moreover, the marking of assets as per the prices that prevail during this crisis is a serious concern. It is argued that the use of this method creates excessive leverage during the period of boom and excessive write-downs during busts. These write-downs, as a result of the fall in the market prices, erode the capital of the banks forcing the sale of assets during distressed times. However the fair value method cannot be solely blamed for the crisis as there is no evidence to suggest the same. Infact the role of FVA in the current crisis was limited due to its limited relevance in the capital requirement and Balance Sheet for banks. The critics of FVA believe that it has a bubble effect on the financial statements. During the boom period the assets are recorded at inefficient prices in the Balance Sheet. This is because the bubble effect flows through the income statement. The drawbacks of this method are tackled to an extent by the Historical cost accounting. It is considered as an alternative for valuing liquid assets likes stock. In a crisis situation FVA cannot be used for measuring illiquid assets then HCA is the only suitable alternative. Often the market price of the assets deviates from the fundamental value due to market inefficiencies like a liquidity crisis which impacts the market price of the asset. But the opponents of HCA feel that the assets recorded at historical values do not present the fundamental value or give the required information. Even the investors are interested only in the true value of the assets and not in their cost of procurement. They are concerned only about the market value of the investments as this helps them in taking important decisions. At times even after the useful life of the asset, it still can be utilized effectively. In this situation if the asset is recorded at its book value it will show a zero utility. Therefore recording the asset at its fair value gives an idea about the effective value of the asset. It has been observed that FVA leads to contagion across financial markets that force the banks to sell their assets at a lower price and this also affects the other institutions that follow FVA method in recording the assets (Laux, Leuz, 2009). From the above discussion it can be summed up that despite the drawbacks of FVA even the implementation of HCA has its set of difficulties. There are problems relating to matching of revenue and expenditure in HCA whereas there is the problem of asset and liability mismatch in FVA. Reference Palacky, G. 2008. Fair Value Accounting: Hero or Villain. CFA Institute Centre for Financial Market Integrity. Available at: http://raw.rutgers.edu/2ndcrc/presentations/Rutgers%20U-FV.hero-villain.ppt [Accessed on January 7, 2009]. Christensen, H. Nikolaev, V. 2009. Who uses fair value accounting for non-financial assets after IFRS adoption?. University of Chicago Booth School of Business. Available at: http://areas.kenan- flagler.unc.edu/Accounting/Documents/ChristensenNikolaev2009_FairPaper.pdf [Accessed on January 7, 2009]. McKnight, J. No Date. Do Accounting Principles Provide Relevant Returns Information?. Central Wisconsin Economic Research Bureau. Available at: http://www.uwsp.edu/business/CWERB/4thQtr97/SpecialReportQtr4_97.htm [Accessed on January 7, 2009]. Barth, M. 2001. Fair Value Accounting: Evidence from Investment Securities and the Market Valuation of Banks. Available at: http://accounting.wharton.upenn.edu/Spring2004/acct902/papers/barth.pdf [Accessed on January 7, 2009]. Penman, S. 2006. Financial Reporting Quality: Is Fair Value a Plus or a Minus?. Laux, C. Leuz, C. 2009. The Crisis of Fair Value Accounting: Making Sense of the Recent Debate. The Initiative of Global Markets. Working Paper No. 33. Bibliography CCH Editorial and Staff. 2008. Top Accounting Issues for 2009: CPE Course. CCH. Read More