Fair Value vs Historic Cost

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Review of Business Information Systems – First Quarter 2013

Volume 17, Number 1

Fair Value Accounting vs. Historical Cost Accounting
Paul Jaijairam, Bronx Community College, City University of New York, USA

ABSTRACT This paper reviews fair value accounting method relative to historical cost accounting. Although both methods are widely used by entities in computing their income and financial positions, there is controversy over superiority. Historical cost accounting reports assets and liabilities at the initial price they were exchanged for at the time of the transaction. Conversely, fair value accounting quotes the prevailing price in the market. Nevertheless, while both methods of accounting affect financial statements, the impact of fair value accounting on the balance sheet and income statement is extreme due to the potential volatility of the method. Fair value accounting is deemed superior when compared to historical cost accounting because it reflects the current situation in the market whereas the later is based on the past. In addition, in relative terms, fair value accounting provides users with more current financial information and visibility. Keywords: Fair Value Accounting and Historical Cost Accounting

INTRODUCTION

A

n increasing number of international standards are allowing or requiring the use of fair value accounting for financial reporting purposes. The International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) have agreed to a global uniform framework that establishes a standard definition of fair value that is applicable in ascertaining the worth of assets and liabilities without involving market value. In recent years, there has been substantial controversy over the use of fair value accounting as opposed to the historical cost accounting method. While financial statements are designed to reflect reality, opinions vary as to which method best represents that reality. Because a firm’s choice of accounting treatment for various assets can have a significant impact on its financial statements, and management decisions regarding future corporate actions, it is important that the appropriate method be applied. This paper reviews fair value accounting by comparing it with historical cost accounting and the effects it has on financial statements such as the balance sheet, income statement, and the statement of cash flows. FASB CLARIFICATIONS AND CHANGES FASB defines fair value accounting through the declaration of the statement - Financial Accounting Standard No. 157: Fair Value Measurements. FASB describes fair value as the price at which knowledgeable and willing parties will exchange or settle assets or liabilities. Fair value accounting is the practice of declaring the value of the asset or liabilities (Financial Standards Accounting Board [FASB], 2011). Under fair value accounting, a company resets the prices of certain assets on its balance sheet every quarter to reflect changes in the market price; thus, called “mark-to-market accounting”. For instance, the firm is supposed to determine the value of its security by considering the exit price. This exit price is considered as the fair value of the security based on the assumption that the transaction took place between willing and knowledgeable participants – the buyer and the seller of the security. However, the use of exit price may fail to reflect the fairness of the asset or liability value especially when one participant is not knowledgeable or willing to transact. For instance, forced liquidations of assets may result in markedly lower prices than ones based on fair value on the expected cash flows of the asset. The first definition is inappropriate in determining the fair value of an asset or liability. As a result, the FASB and IASB have agreed on a modified method to determine fair value. Instead of basing market price on an © 2013 The Clute Institute http://www.cluteinstitute.com/ 1...
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