Comparing Fair Value Accounting With Historical Cost Accounting In An Essay.

Discuss about the International Accounting Standards Board.

An escalating figure of global standards are permitting or necessitating the utilization of the mechanism of the fair value accounting system with the intention of pecuniary reporting. In particular, the “International Accounting Standards Board (IASB)” as well as the “Financial Accounting Standards Board (FASB)” has approved to a particular worldwide consistent configuration that essentially institutes a customary explanation of fair worth that can be appropriately implemented for ascertainment of overall worth of the assets as well as accountabilities with no involvement of the worth of the market. However, in current period, considerable disagreement has arisen over the utilization of the fair value secretarial in preference to schemes of the historical cost secretarial methods. Whilst the pecuniary declarations are essentially framed to reveal actuality, there are viewpoints that differ as regards the best scheme for representation of the actuality. It is important to apply the suitable method as the choice of the accounting method by a firm for the treatment of diverse resources can have considerable effect on the pecuniary declarations as well as decisions of management concerning upcoming business activities. The current paper therefore intends to evaluate fair value accounting by carrying out a comparative study with the historical cost accounting and aims to evaluate the effects of the accounting methods on different financial declarations namely, the balance sheet, profit and loss statement as well as the statement of the cash flow.

The objective of the present study is

• To critically analyze the way fair value accounting method is utilized by the corporate bodies
• To evaluate the reasons behind the overtaking of the “historical value accounting” method by the fair value accounting technique
• To critically investigate implications between the two accounting methods (historical accounting method and the fair value accounting method) and the future outcomes

In the modern time, the traditional methods of evaluating of financial items for reporting purposes are failing to provide necessary financial information to the users of the reports. Hence, the traditional methods have been amended to update the accounting concepts as per the requirement of time. Amongst these upgraded concepts, fair value accounting and have become most popular and widely accepted all over the world.

However, the rise of the new concept has raised debates amongst the accounting researchers regarding the superiority and accuracy of the new concept and the older one. The objective of this research is to select the best alternative amongst the fair value based secretarial registration and historical cost bookkeeping in different circumstances. As such, the research will also describe the outcomes of the two accounting concepts in various scenarios.

For fulfilling the objective of this research project, the researcher will present various literature reviews on this contexts to identify different aspects of the two accounting concepts. The researcher will elaborately describe the roles of these factors in selection of accounting concepts for different organizations, sectors and industries. Research questions, related to the topic and the objective, will be formulated to achieve the specific outcomes of the research accurately.

Research Problem

Proper evaluation of assets, liabilities and other financial items for reporting purpose is very necessary from the stakeholders’ perspectives. It has been observed that many business firms used to manipulate the financial position by exhibiting improper values of the financial items in the annual report (Chong et al. 2012). Through such means, they used to circulate false information amongst the stakeholders and took advantages of such improper statements. Various accounting standard boards, such as IASB, FASB etc. have identified such malpractices and introduced new set of accounting methods for evaluating the financial items properly through the introduction of fair value accounting (Ronen 2012). However, both the concepts have some limitations. Moreover, there are no such guidelines or instructions, provided by the accounting standard boards, regarding the selection of these accounting concepts. Many firms select such evaluation method, which might not match with the business activities of the firms (Chen et al. 2013).

Therefore, the accounting managers require an in-depth analysis of both the accounting concepts. Through this analysis, they will be able to identify which accounting concept will suit with their business activities and financial structure properly and can exhibit the values of the financial items more accurately.

The following questions are set to identify the basic goal of this research:

• How was fair value being practice in the corporative world?
• Why is historical cost value being overtaken by fair value?
• What are the implications between the two standards and its future outcomes?

The researcher will be able to draw conclusion of this research by analyzing the answer of these questions and achieve the objective the research accordingly.

The fair value accounting concept has been introduced to cover up the several disadvantages of historical cost accounting concept. Fair value can be described as the justified and unbiased estimation of the expected market price of any asset, liability, product or service (Card and Policy 2016).  Fair value accounting concept is developed on the said definition of fair value, where the financial statements represent the fair market value of the assets, liabilities and other financial items. As per FASB, fair value is the price, which is expected to receive for selling any product or rendering services or to pay for transferring any liability in an orderly transaction between two or more than two market participants at a specific evaluation date. The fair value of any item is mainly determined on the basis of the following aspects:

• Manufacturing or Acquisition Cost,
• Cost of replacing the item with same kind of product or service at a certain point of time
• Price of substitutes
• Monetary value of the service, rendered by the item, or production level of the item
• Economic value of the item in terms of current supply and demand chain (Jordan et al. 2013)

It also includes the various risk factors, associated with the estimation and individual nature of the business firms and the industry, in which the firm belongs. However, it should be noted that that fair value can be determined only if the item can be transferred through an orderly transaction. The products, which are not transferrable to the other parties, cannot be evaluated under this concept. The time period of measurement is another important factor. The fair value of any product changes in accordance to the time. The fair value of any business or stock can be evaluated under fair value accounting by using three level hierarchies. The hierarchy includes quoted price, stock exchange price, other reliable and important inputs and forecasting of the future financial performances (Bell and Griffin 2012).

Rationale of the Research

As rightly put forward by Kolačević and Hreljac (2014), the fair value accounting can be considered an enhancement of the conventional outline of bookkeeping that is the essentially the historical accounting method. Hendricks and Shakespeare (2013) opine that under the method of the historical cost bookkeeping, as such beginning price disbursed by a business entity during the acquirement of the resources otherwise liability can be considered a significant aspect that bears significance. Again, the charge mentioned on the balance sheet is the charges of acquirement otherwise a value diminished by depreciation, archaic nature or else exhaustion. As such, the price mentioned on the balance sheet for a particular financial asset does not alter until the liquidation of a security. However, the historical system of cost accounting is uncomplicated to comprehend as it is essentially founded on a preset charge that again is entirely acknowledged, particularly, the real price that necessarily a particular business entity disbursed. In addition to this, the method of historical cost accounting is normally easier to pursue as it generates uncertainty in the upcoming period regarding the correct worth of diverse resources. Furthermore, in the two different methods of fair value bookkeeping as well as historical system of cost accounting, overall worth of the resources represented on the balance sheet is constantly lesser owing to causes such as depreciation, collapsing as well as archaic systems (Hodder et al. 2014). In particular, certain assets namely the securities that are tagged as traded securities or else the “available for sale securities” especially in the financial industry might possibly either appreciate or else depreciate as per the movements of the market. This also has been subject to different mechanisms of the market-based system of pricing. Nevertheless, the worth might also diminish for different securities tagged as the “securities held till the date of maturity” (Ellul et al.  2014). Furthermore, the debt securities are also registered as an amortized shape rather than the depreciation. Again, such securities also comprises of the bonds as well as leases. Again, the accounting regulations call for the need of the business entities to determine whether particular assets namely, the goodwill can be impaired. In case, the business entity needs to register a definite charge for the particular “other-than-temporary impairment (OTTI)” if overall worth of an “impairable” resource declines and is not anticipated to pick up (Müller et al.  2015). This also diminishes the worth of particular asset registered on the balance sheet. The charge for the OTTI is normally stable and cannot be toppled though the particular resource in due course picks up the market value (Zeff 2016). On the other hand, the business entity can also enjoy the advantage gained due to improvement in worth by acquiring the flows of cash from a particular resource otherwise by marketing the resource at an elevated value and thereby gaining considerable capital advantage.

Research Question

In general, it can be approximated that whilst a particular business unit essentially use the method of fair value system of accounting for pecuniary declarations, the worth can alter from time to time can be weighed against the mechanism of the historical system of cost accounting. Again, the worth of different stuff recorded for the purpose of utilizing historical cost system of accounting alter at a inferior price, as a result, it is measured less unstable (Cantrell et al. 2013). In fair value system of accounting, the documented values alter between different periods, that is why, elevated instability. However, the fluctuating movements also stems as this particular accounting mechanism sums up the entire stream of anticipated expected future cash flow that can again be regarded as alteration in the anticipation related to the alterations in the cash flow registered in fair value. However, the instability present in this particular financial announcement does not signify imperfection in the process of pecuniary reporting. In addition to this, the proponents of the fair value accounting take into consideration the fair value accounting to be less instable as it offers results of the corporation that are necessarily not derived from probable broad judgment or else some other mechanisms of valuation (Goh et al. 2015).

As per the stipulations conditioned under the “FAS 159” adoption of secretarial treatment for recording different financial resources do not require compliance with particular fair value accounting regulations. This can lead to remarkable effects on the statement of balance sheet, mainly for the business entities maintaining huge investment folders for instance, cover of insurance or else different “bank-holding” corporations (Liang and Riedl 2013). Again, in case of amortized cost, different financial securities are preserved until the period of maturity. In addition to this, the debt securities are also represented on the balance sheet at the acquirement fee disbursed by company. Therefore, there exists no volatility in the security prices between one quarter and the other. On the contrary, the price of different debt security can get adjusted as per the market price under the mechanism of the fair value accounting mechanism. This kind of twists and turns noted in fair value system of accounting can have noteworthy effect on the functions of the business on a daily basis. However, a statement of balance sheet can be enumerated as a measure of the financial position of the corporation as it is necessarily a vital economic article to any corporation. For example, particular directive as well as regulation has the requirement of the financial institutions as well as insurance corporations to uphold certain stage of equity, generally presented on the balance sheet statement (Ellul et al. 2015). Again, the standard system of accounting also describes equity as the differentiation between resources as well as accountabilities. Therefore, two numerals differ and lead to increase or else decrease. Again, in different areas of non-financial division that includes the industrialized, wholesale as well as retail sector, the worth mentioned in the statement of the balance sheet are considered to bear relatively less significance in preference to financial division although it still exerts influence. Again, the investors as well as creditors depend on the worth of the available resources for determination of the rating for credit worthiness of a particular business concern (Laux 2016). In particular, the lenders take into account the worth of resources as collaterals whereas diverse investors take into account the worth of a diverse asset as the signal of functionality of a business concern in the present period as well as in the future. Again, the decline in the assets can cause difficulties within a particular business entity, for example, a corporation might not be able to dispense loans and attract investors due to pessimism resulting from the decline. In conclusion, it can be said that the fair value accounting can exert influence on the balance sheet of entities and besides this, the financial sector are also likely to more influenced than the non-financial division (Laux 2016).

Concept of Fair Value Accounting

The fair value option election (FVO) selection might have considerable influnec on the overall statement of income statement. Even as certain alterations in worth can be reflected on the balance sheet, alterations OTTI that pass through the statement of income that have a straight effect on net earnings. The rate of different existing securities for sale as mentioned under “FAS 115” suggests that dissimilar trading resources are possessed with the objective of removal in the upcoming period (Blankespoor et al. 2013). Again, securities such as bonds as well as treasury statements essentially are securities. This are recorded at the fair value where transformations can be noted necessarily detected in the statement of income. Consequently, the charges for OTTI for both movements in the market and credit requirements can have important influence on the earnings. Therefore, the several business concerns are cautious regarding the assumption of charges if not watchdogs or else auditors put restrictions and compel them to do so. As per the stipulations mentioned under the FAS 157, there is necessity for both movements in the market as well as credit impairments. Nevertheless, the amendments made during the period 2009 calls for the need of the OTTI charges for essentially the credit impairments (Christensen and Nikolaev 2013). Again, the alterations in the value owing to movements in the market no longer run through the statement of income although are replicated in definite amounts registered in the statement of balance sheet. However, the fair value system of accounting is in line with the existent system of secretarial treatment for different single loan scheme. However, for different single loan scheme, the credit impairments lead to levy of charges in the statement of income. This does not result from transformations in predetermined interest rate (Christensen and Nikolaev 2013).

The employment of the fair value system of accounting does not have a straight effect on the announcement of cash flow of a particular concern. However, the reporting entities can do away with different kinds of charges of OTTI that is pertinent under the fair value system of accounting into the statement of income as a part of the working cash flow. Again, in case of diverse security, FASB suggest loss of credit as a definite change in the flow of cash (Blankespoor et al. 2013). This means that in case if the quality of a bond diminishes the resulting decrease in the value of the market does not form a credit loss if not the anticipated quantity to be acknowledged is less compared to the agreed amount of flow of cash. Therefore, the statement of cash flow only replicates the interest disbursements, dividend as well as realized advantage from marketing securities that are included in the net earnings. Laux (2016) suggests that the usage of the fair value accounting leads to the registration of lower amount of the net earnings figure where the OTTI charges are added afterwards. Nevertheless, the net outcomes reflected by the statement of cash flow by either mechanisms of accounting ( that is the historical cost and the fair value accounting) mechanism are normally identical.

Fair Value System of Bookkeeping as Against the Historical Cost Secretarial Accounting

The main concerns regarding the fair value measurement can be summarized under the following heads:

Unrealised profits:

The revaluation of assets as well as liabilities during the specific date of balance to the up-to-date fair value can direct towards the detection of the unrealized gains. In case of distribution of the unrealized profits to the owners, the capital of a business entity can get eroded (Ellul et al. 2015). Again, the risk of the inappropriate distribution of diverse unrealized profit is under question especially under the circumstances of the bubble price development.

Reliability of measurement:

As rightly put forward by (), the fair value can be considered a hypothetical value that reflects fair conditions as well as positions of different market participants. Again, in different cases, an approximation of different conditions needs to be made in a bid to draw the fair value (Zeff 2016). In addition to this, the reliability of the fair value enumeration is impeded in different inactive and at the same time illiquid market and under mass sale out of a specific asset. Consequently, the failure can be registered as a success and vice versa.

Relevance of measurement:

There are several doubts regarding the relevance of the information presented in the income statements and the efficacy of the net income as a dimension of the managed performance at the time when mixed bases enumerate balance sheet components (Cantrell et al. 2013).

Suboptimal behavior

The mark to market as well as fair value accounting directs towards pre-mature detection of profits in comparison to different traditional historical cost model. The management might be compelled to different unfavorable selections in a bid to meet anticipated or else targeted numbers. The suboptimal behavior is primarily the case of particular financial instruments. Again, certain bodies believe that suboptimal behavior of corporations of different corporations might influence the markets that in turn might cause systematic market risk as well as pro-cyclicality on the collective level (Ronen 2012). However, on the company level, the fair value accounting lead towards increase in the asymmetry in the information and the reduction in the transparency of the financial declarations.

The historical cost accounting is based on the historical costs of the assets, acquired and liabilities, transferred. The concept does not include the time value of money or any other factors, which can reflect the change in the market value of the items. Thus, the method fails to show any rise or fall of the actual market value of the assets and liabilities. The assets or liabilities, measured under this method, are either undervalued or overvalued (Deegan 2013). Hence, the historical cost accounting concept cannot depict the true and fair value of the firm to its stakeholders. Such difference in the book value and market value can be observed more clearly, during inflation period, when the market value rises at a significant rate. In such scenario, the companies may show high profit from the sale of assets under this method, but in reality it may incur loss. Thus, the historical cost accounting can be used to create a false successful image of the company amongst the stakeholders (Ramanna 2013).

The research work will depict the advantages of fair value accounting over historical cost accounting. It will also describe certain drawbacks of fair value accounting and discuss the prospective method to overcome it. Thus, the research can provide a proper solution to the accounting firms for implementing affective evaluation methods as per the requirement of the stakeholders.

The current study depends largely on the review of the literature that essentially concentrates on accounting process of the fair value. Apart from cases where a source was required particularly for definite perspectives on wide issues related to fair value accounting the current segment concentrates on fair value accounting that concentrates particularly on the fair value accounting  as well as financial reporting in corporations. Different sources include the referred research studies, diverse empirical evidences as well as articles from various professional journals (Mackey and Gass 2015). The learner also intends to utilize different decision rules in selection of articles as the available literature related to fair value method of accounting is essentially voluminous. Again, the leaner also intends to use sources that are published during the period 2002 to the year 2010 barring the papers that were required for diverse historical method of accounting as the accounting profession is altering swiftly these days. In addition to this, the learner also intends to refer to different empirical papers of research, research reports as well as other relevant literature on present fair value reporting practices of different corporations as the aim of the learner is to deliver comprehensive understanding regarding the primary issues regarding the fair value accounting. Therefore, in a bid to get clear perspective concerning the present state of the fair value method of accounting, the learner also intends to begin with the review of literature on significant issues related to the present concept. Therefore, it can be hereby inferred that the learner aims to use the literature based research methodology for the present study. This literature based research methodology refers to the process of designing a particular research project where existent literature is considered as the definite population and the leaner can go for sampling, collection of data, analysis of data and ethical considerations (Taylor et al. 2015). Here, the learner also aims to acquire databases that can be utilized and the literature is essentially the textual data that can be mainly used for the present study. The systematic review of the literature can be considered as the research methodology for the present research (Silverman 2016). This can be essentially regarded as a scientific tool that can be used for summarizing, appraising as well as communicating the outcomes as well as implications of different uncontrollable quantity of research.  This process of research therefore helps in framing the process of the research, research questions and carrying out a review that can help in searching the data. This also helps in critical evaluation of the data, assimilation as well as synthesis of the data. Therefore, it is fundamentally the reanalysis of the outcomes and at the same time reanalysis of the empirical findings (Smith 2015). In addition to this, the learner also intends to use the descriptive method for analysis of the acquired data after extraction of requisite data using scientific tool. The descriptive research in this present study comprises of acquirement of different data that illustrate events and thereafter organizes, tabularizes, depicts as well as describes different collection of data. The narrative descriptions of several numbers of cases utilize description as a scientific tool to arrange data into diverse patterns that can emerge during the period of analysis (Gast and Ledford 2014). As such, this pattern can facilitate the mind in comprehending the significant facts of the qualitative study as well as its implications.

Furthermore, learner also intends to adopt the positivism as the basis of the philosophy of research that takes into account authentic knowledge or else the scientific knowledge based on positive affirmation of different theories through stringent scientific mechanism (Billig and Waterman 2014). This technique is justified as this can help in the process of investigation phenomena founded on acquirement of observable, enumerated evidence as well as empirical evidences that are subject to definite concepts of reasoning.

Conclusion

Selecting the suitable accounting method can be intricate, since there are benefits as well as disadvantages to both the systems of accounting. The present study therefore intends to review fair value accounting method in respect of historical cost accounting mechanism. The current segment illustrates the disadvantages of the Historical cost technique although it is regarded as simple to use and to comprehend. Nevertheless, different proponents of particular fair value accounting take into account historical cost accounting mechanism as outdated due to the  flaws present in the scheme and states that this scheme concentrates on allocations of cost instead of the worth of a specific asset. Again, the present study also presents an overview regarding the fair value accounting method that states the present worth of assets as well as liability according to changing circumstances of the market. The present section also outlines the guidelines of the FASB and IASB regarding the valuation of the assets and liabilities. For example, stipulations under FAS 157 require assets as well as liabilities to be measured utilizing the market price. Furthermore, the guidelines conditioned under the FAS 159 mentions the need for enumeration of the worth of assets along with liabilities of entities on agreement basis. The current segment also illustrates that similar to historical cost accounting scheme, the fair value accounting mechanism also exerts influence on the financial declarations, namely, balance sheet as well as income statement. Yet, there is no straight influence on particular announcements of cash flows if not there exists tax advantage at the time of utilizing fair value accounting method. The current study also aims to reflect that Fair value accounting also has disadvantages and imperfections such as the subjectivity as well as complexity. Nonetheless, the standards conditioned under the IASB and FASB have arrived at general process of resolution for addressing the detected issues. In conclusion, it can be said that assessment and at the same time comparison of different issues along with advantages of the two different accounting systems can help in ascertainment of superior method of accounting mechanism.

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