In recent years the discussion on the issue of differing accounting concepts and principles has extended in investors pressing the need for harmonization of the reporting and improved comparability of the reports. Both costing methods; historical cost method and fair value accounting are considered inconsistent with each other and have been the reason for gaps between the UK and US accounting models. A comparison of the two accounting systems would be needed to show how and when which model would be more appropriate. The core differences between both concepts are important to be discussed for analyzing the challenges faced in translation from historical to fair value accounting (Penman, 2006).
Historical costing is dependent on the idea that liabilities and assets are booked and measures as per their real price of acquisition. The assets which are likely to bear considerable changes in its worth over time would turn out to be wrongly measured in the statements after their acquisition by the companies (Sanahuja, 2014). The effect of the implementation of historical cost accounting in a generally accepted view on the financial reports is expected to be in the form of understated assets value and overstated the value of liabilities. However, this is aligned completely with the cautiousness concept and the concept of conservatism which would demonstrate the financial standing of the firm in the worst-case scenario. The accuracy and reliability of the certain acquisition value would not be mostly doubtful (Wittington, 2008).
The fair value, on the contrary, allows the managers to represent the investors with a different point of view of the financial standing of the firm while valuation of the liabilities and assets by the current market prices. The analysts define the fair value of the assets as the amount which the asset can exchange or settle with a liability between two knowledgeable parties willing to the arm’s length transaction (Kaya, 2013). The problem arises here is that by using a better enough estimation of the market price. It can be a straightforward operation in many cases; however, it may act as a problem in some other situations as well. The argument lies on how the reliable price can be acquired for a specific asset (Greenberg, Helland, Clancy, & Dertouzos, 2013).
In some cases, the argument lies in the assessment of the markets in the context of being complete, perfect, and comparable. The resistance to fair value as compared to historical cost is open for point of view in favor or against of the parties (Kaya, 2013). The fair value costing method adds relevance to the valuation of the statements. On the other hand, the historical costing method adds reliability to the statements. It will be helpful to explain further the cases in which each of the notions would attach better quality to the financial reports of the company (Alexander, Britton, & Jorissen, 2007).
Each of the methods provides a more appropriate method for a unique situation in which it can provide better results for the financial reports. The assets when booked at the price of acquisition with the implementation of the historical cost poses the risk that on some spot in time the worth may tend to be far away from its real market price (Collis, Holt, & Hussey, 2017).
The example of the Collis shows that the use of technology or any latest equipment can be subject to fast enhancement. However, on a historical cost basis, the value of the asset of this kind may not be depreciated in such value. Even though the condition of the asset would be nearly perfect, the market value, however, would be far lower than its acquisition price. It would be because of the better alternative equipment or technology accessible in the market (Gracanin & Kalac, 2011).
On the other hand, the assets which usually realize over time like the examples of land and a building when dealt with the historical cost system understates the value by using its appreciation price (Gulin & Hladika, 2016). The historical cost system lacks the system to cater to the appreciation of the costs, and thus the possessions are understated in financial reports specifically on the balance sheet amount. In this scenario, the model which fair values the market value of the asset is more appropriate (Ronen, 2008).
Fair value accounting asks for an annual test of the assets regarding impairment and amortization. It also enables flexibility in the scenarios as the assets which appreciate value are also better handled. However, it has its cons as well. One of the major shortcomings of this method is evident as; fair value of an asset in some cases is very hard to find. A study has even considered the translation of the historical cost to fair value as being a tradeoff between the relevance and dependability of the financial reports (Gracanin & Kalac, 2011).
In the end, it can be said that the translation of the historical cost model into fair value valuation would cause an appreciation of the balance sheet amount regarding the assets which appreciate with time like the Land or building. However, this would be reciprocal for the assets which depreciate over time like the equipment, or technology causing devaluation of the balance sheet amount. The situation in which the market worth of the assets fluctuates too much is more suitable for the use of fair accounting. The historical cost would be preferable in which the assets are not expected to fluctuate regarding their value. The translation of the historical cost into fair value accounting is more preferred by analysts for its relevance.
References
Alexander, D., Britton, A., & Jorissen, A. (2007). International Financial reporting and Analysis. Cengage Learning.
Collis, J., Holt, A., & Hussey, R. (2017). Business Accounting. Macmillan Education UK.
Gracanin, S., & Kalac, E. (2011). The Impact of Fair Value Accounting on the Crisisin Banking Sector of Eu and USA. Economic Research, 42(2), 126-153.
Greenberg, M. D., Helland, E., Clancy, N., & Dertouzos, J. N. (2013). Fair Value Accounting, Historical Cost Accounting,and Systemic Risk. Retrieved June 18, 2018, from https://www.rand.org/content/dam/rand/pubs/research_reports/RR300/RR370/RAND_RR370.pdf
Gulin, D., & Hladika, M. (2016, April 22). Challenges In Applying The Fair Value Accounting During Financial Crisis. Retrieved from http://www.uni-miskolc.hu/~microcad/publikaciok/2016/F_feliratozva/F_6_Danimir_Gulin.pdf
Kaya, C. T. (2013). Fair Value versus Historical Cost: Which is actually more “Fair”? The Journal of Accounting and Finance, 1(60), 127-137.
Penman, S. (2006). Financial Reporting Quality: If fair value a plus or minus? Paper for presentation at the Information for Better Markets Conference. Institute of Chartered Accountants of England and Wales.
Ronen, J. (2008). To fair value or not to fair value – a broader perspective. Abacus, 44(2), 181-208.
Sanahuja, A. M. (2014). Fair Value Versus Historical Cost Valuation For Non-Financial Fixed Assets: How Is Financial Information Affected? Retrieved from http://repositori.uji.es/xmlui/bitstream/handle/10234/109761/TFG_Nebot_Sanahuja_Adri%C3%A1n.pdf
Wittington, G. (2008). Fair Value and the IASB/FASB Conceptual Framework Project: An Alternative View. Abacus, 44(2), 139-168.
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