Fair Value Accounting vs. Historical Cost Accounting
In financial accounting, both historical cost accounting and fair value accounting are used for financial reporting purposes. In fair value accounting, an organization uses the current market conditions and information to estimate its future cash flows (Donker 2005). Using mark-to-model values, firms are able to estimate the current fair values. A fair value is defined by the Financial Accounting Standards as the estimated receivable price realized after selling an asset or the price that is paid after liability has been transferred in a systematic or orderly transaction (Ryan 2008). Different models of FAV such as income approach, equality approach, full fair value approach, and mixed approach, are used in financial reporting (Donker 2005). On the other hand, historical cost accounting values all financial items based on their exact or historical cost. Both practitioners and academicians have discussed the issue of fair value accounting and historical cost accounting in length. The debate which seems to be unending revolves around issues of relevance, credibility, and reliability in financial reporting. The objective of the essay is to oppose the statement “fair value accounting is a better basis for financial reporting than historical cost accounting”.
Fair value accounting uses value estimates to carry out financial reporting which illuminate current market conditions (Ryan 2008). Compared to FVA, historical cost accounting is more relevant as it uses original costs which are not subjected to estimations. Opponents of fair value accounting or current cost accounting argue that this method of financial accounting is subjective rather than objective (Donker 2005; Chea 2011). In addition, accounting managers have the discretion to determine the current costs which reduce the level of accountability and transparency (Bakar & Said 2007; Christensen & Nikolaev 2008; Christensen & Nikolaev 2011). For the decisions to be objective, an organization should have access to the current verifiable costs. Thus, historical cost accounting is preferred to fair value accounting because of its ability to use original costs. This argument has been supported by Donker (2005) who opines that despite the credibility accorded to fair value accounting, historical cost accounting has the capability to provide reasonably reliable information that is free from bias and human error as managerial judgement is common in fair value accounting but absent in historical cost accounting (Barth, Gomez-Biscarri & Lopez-Espinosa 2010).
According to fair value accounting (FVA) advocates, the method has greater transparency and a higher level of relevance in financial reporting (Christensen & Nikolaev 2008). In addition, the availability of current information on assets increases the level of transparency in financial reporting. However, opponents of fair value according argue that measured fair value placed on assets cannot be sufficiently reliable since it is prone to managerial manipulations (Christensen & Nikolaev 2008). Others add that lack of liquid markets reduces the reliability of the measured fair value of an asset. From this perspective, historical cost accounting is considered the most reliable and relevant method of measuring liabilities or assets which are determined after their maturity date (Donker 2005). Furthermore, personal judgment on market prices of assets valuation is absent in historical cost accounting which makes it more appropriate and relevant. Historical cost accounting in this case prevents available accounting data and information against any form of internal modifications. In addition, managers are less likely to manipulate data as they record liabilities and assets based on the acquisition prices (Bakar & Said 2007).
There has been a paradigm shift from historical cost accounting to fair value accounting in financial reporting as historical cost accounting is regarded as an outdated method that does not consider economic aspects like inflation. However, it still remains as the basis for accounting practice despite its criticisms (Donker 2005). This is because fair value accounting is prone to creative accounting and accounting malpractices which have detrimental effects on the price of company shares (Chea 2011; Christensen & Nikolaev 2008). For example, following the 2007 global financial crisis and credit crunch, fair value accounting received considerable criticism. According to Ryan (2008), the use of fair value on assets led to unrealized losses and gains. The market experienced bubble prices that were not easily recognized while using fair value. In addition, during the housing bubble, the market prices were depressed beyond the fundamental value prices (Ryan 2008). Consequently, this led to unrealized losses which reduced share prices thus affecting asset value. Therefore, compared to fair value accounting, historical cost accounting is highly dependable because it provides a more stable foundation for future accounting prediction (Chea 2011). Uncertainties, future changes in macro-economic factors, and future unforeseen events limit the ability to carry out fair value earnings (Ryan 2008).
According to Elad and Herbohn (n.d), fair value accounting is much preferred in the agriculture sector because the fair value can easily be determined for future decisions. However, IAS 41 has been regarded as highly controversial because it requires biological assets value be based on end of the year values. Therefore, because of this, FAV has especially had to be revisited because it is not reliable for effective decision-making (Elad & Herbohn, n.d).
Economic decisions are essential in the running of an organization as they assist in making future decisions. Bakar and Said (2007) point out that historical cost accounting uses historical costs to evaluate and select decision rules. The point is those past decisions are based on historical costs which provide quality information for effective and quality economic decisions. While making economic and price forecasts, historical costs are used which assist managers in making quality decisions. This is because the original cost is based on what has already been earned and not estimated earnings as in the case of fair value accounting (Bakar & Said 2007). It is impossible to make a future forecast based on fair value prices because cash flows are prone to inaccuracies and subjectivity which result in distortion of income value (Donker 2005). As a result, the credibility and the dependability of FVA in making future decisions remain questionable.
The fair value price information is important in making short-term decisions relative to assets and market value. This reduces the chance of experiencing income smoothing which is highly evident in historical cost accounting (Donker 2005). As noted by Donker (2005), a firm may end up reporting a gain rather than a loss which reduces the level of transparency in the firm’s financial reporting. In addition, FVA is based on market impairments that are limited to future predictability. This increases the level of volatility in earnings which affects financial equity (Donker 2005). The use of mixed attribute model and economic changes as a result of changes in assets and liabilities fair values increase the level of volatility which is less experienced in historical cost accounting (Barth, Gomez-Biscarri & Lopez-Espinosa 2010). Share returns are long-term decisions that are based on historical costs (Bakar & Said 2007). So, change in the value of dividends can be explained easily via the use of historical costs compared to the use of fair value prices which make historical cost accounting more valuable than FVA.
The economic reality in the market is better presented using FVA (Bakar & Said 2007). Given that we are living in economic times which are characterized by increased market volatility and financial changes, FVA depicts the underlying economic certainty. However, the use of fair value estimates in determining market volatility increases the level of agency costs because it lacks verifiability (Christensen & Nikolaev 2011). As a result, historical costs would be more relevant as increases the level of commitment which reduces discretionary assets revaluations. Subsequently, agency costs which are incurred by the shareholders are reduced (Christensen & Nikolaev 2011). Moreover, FVA is believed to be costly when used in reporting financial statements based on non-financial assets (Christensen & Nikolaev 2008). This is an expense to the firm as it has capacity to reduce the value of annual dividends thus affecting investors’ value to the firm.
FAV uses fair values which according to Ryan (2008) are hypothetical values and do not reflect currently achievable asset values. The implication made is that these prices do not necessarily support the current market transactions. For instance, supposing that markets are illiquid as a result of a financial crisis or credit crunch, it becomes difficult to carry out annual financial reporting. Moreover, the use of market bids to prepare financial statements may result in an unbalanced sheet date. This implicates the management and the internal auditors as they have to convince external auditors of the discrepancies in reporting (Ryan 2008). However, in illiquid markets, it is usually easy to use historical cost accounting as it is not subjected to the current values of assets. This assists accountants and auditors in guarding their integrity and professionalism while making financial reporting. Managers are able to predict future operational costs while using historical costs (Bakar & Said 2007). This enables organizations to make reliable future decisions related to investment. In addition, historical cost accounting provides current information such as the exact company’s position and trends in its performance in the market (Bakar & Said 2007).
Therefore, I am opposed to the statement that fair value accounting is a better basis for financial reporting than historical cost accounting. This is because historical accounting forms a basis for fair value accounting and is more accurate compared to fair value accounting since it uses historical costs. In addition, the historical accounting method is free from human errors and bias resulting from accounting manipulation. This makes it more dependable and credible for effective decision-making.
Based on the above analysis, it can be concluded that historical cost accounting is still the most favorable method of financial reporting despite the rapid paradigm shift in the adoption of fair value reporting. Although it is an outdated method, historical cost accounting is still reliable and free from managerial manipulation and other accounting malpractices. Historical cost accounting uses actual transactions compared with FVA is based on fair value prices. This makes it free from errors and bias, thereby increasing
its relevance. Although historical cost accounting is prone to income smoothing, it is less prone to market volatility like FAV. In addition, it is the best method to use while making economic and long-term decisions. Historical costs provide the best basis for determining a firm’s performance, position, and trends.
References
Bakar, N B A & Said, J M 2007, Historical cost accounting versus current cost accounting. Accountants Today, pp. 22-23.
Barth, M E, Gomez-Biscarri, J & Lopez-Espinosa, G 2010, Fair value accounting and firm valuation. Web.
Chea, A C 2011, Fair value accounting: Its impacts on financial reporting and how it can be enhanced to provide more clarity and reliability of information for users of financial statements, International Journal of Business and Social Science, vol. 2, no. 20, pp. 12-19.
Christensen, H B & Nikolaev, V 2008, Who uses fair-value accounting for non-financial assets following IFRS adoption?, University of Chicago.
Christensen, H B & Nikolaev, V 2011, Does fair value accounting for non-financial assets pass the market test?, University of Chicago.
Donker, H 2005, ‘Fair value accounting’, CGA Accounting. Web.
Elad, C & Herbohn, K n.d, ‘Seeing the wood for the trees’, CA Magazine, pp.58-59
Ryan, S G 2008, Fair value accounting: Understanding the issues raised by the credit crunch, New York University