Fair Value vs. Historical Cost Accounting
Difference between historical cost and fair value accounting
In order to make the most profitable and rational decisions entity’s stakeholders have to evaluate organisation’s financial statements. Today’s world of rapidly changing prices has made it difficult to estimate what something is actually worth. Thus leading to debates at what price – historical costing price or market value – assets and liabilities should be reported. Therefore, before making any evaluations about reported transactions it is important to understand the difference between historical cost and fair value accounting.
Penman (2007, p.34) in his research same as Laux and Leuz (2009, p.827) in their article referred to fair value either as defined in IFRS or in FAS 157 – both similarly identifying it as a price at which an asset could be sold or a liability could be paid to an independent, unrelated and well-informed stakeholder at the current date. Whereas historical cost accounting, as mentioned by Marshall, McManus and Viele (2011, p.48), responds to cost principle and indicates assets and liabilities at their original acquisition price not taking into account increases or decreases in their market value.
Regarding only conceptual side of fair value and historical costing price Penman (2007, p.36) indicated that when using fair value accounting shareholder receives the most necessary data through balance sheet and determines equity’s value viewing the book value. In contrast, historical cost application shows the information through income statement, where earnings report value-added through arbitrage made by buying products from suppliers and selling them to customers at different price. Additionally Penman’s interpretation represented that in historical cost accounting current income is used to predict future income – at fair value predictions are not necessary since balance sheet provides the valuation. However, fair value income statement indicates the change in value during the
In order to make the most profitable and rational decisions entity’s stakeholders have to evaluate organisation’s financial statements. Today’s world of rapidly changing prices has made it difficult to estimate what something is actually worth. Thus leading to debates at what price – historical costing price or market value – assets and liabilities should be reported. Therefore, before making any evaluations about reported transactions it is important to understand the difference between historical cost and fair value accounting.
Penman (2007, p.34) in his research same as Laux and Leuz (2009, p.827) in their article referred to fair value either as defined in IFRS or in FAS 157 – both similarly identifying it as a price at which an asset could be sold or a liability could be paid to an independent, unrelated and well-informed stakeholder at the current date. Whereas historical cost accounting, as mentioned by Marshall, McManus and Viele (2011, p.48), responds to cost principle and indicates assets and liabilities at their original acquisition price not taking into account increases or decreases in their market value.
Regarding only conceptual side of fair value and historical costing price Penman (2007, p.36) indicated that when using fair value accounting shareholder receives the most necessary data through balance sheet and determines equity’s value viewing the book value. In contrast, historical cost application shows the information through income statement, where earnings report value-added through arbitrage made by buying products from suppliers and selling them to customers at different price. Additionally Penman’s interpretation represented that in historical cost accounting current income is used to predict future income – at fair value predictions are not necessary since balance sheet provides the valuation. However, fair value income statement indicates the change in value during the
Bibliography: Krumwiede, T. (2008). Why historical cost accounting makes sense. Strategic Finance (August), 33- 39. Laux, C. & Leuz, C. (2009). The crisis of fair-value accounting: Making sense of the recent debate. Accounting, Organizations and Society,34(6–7), 826-834. Marshall, D. H., Mcmanus, W.W., & Viele, D. F. (2011). Accounting: What the numbers mean?(9th ed.) Penman, S. H. (2007). Financial reporting quality: is fair value a plus or a minus? Accounting and Business Research, Special Issue: International Accounting Policy Forum, 33-44.