Evaluation of Assets: Historical Cost vs Fair Value Method

This article discusses the evaluation of assets using historical cost method and fair value method. It explores the advantages and disadvantages of both methods and the role of conceptual framework in enhancing the public standing of accounting professionals. The article also delves into the practical implications of fair value measurement for assets.

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ASSESSMNET Question:

Answer to Q.No.1
This argument was found in the page No. 171 of the Book, Financial Accounting
Theory by Craig Deegan 2014 related to evaluation of assets by historical cost
method and fair value method (refer to Chambers, 1966). It was argued that
evaluation of assets by historical cost method may lose its relevance during the
period of rising prices. The question raised on this issue was if the financial
instruments priced in erstwhile value do not prove to be useful for evaluating the
same in respect of its current market value or replacement cost. Moreover, if the
current value of any asset is increased comparing to the cost of acquisition during
that period when it is acquired, there is real practical problem to add to the cost of
that asset.
For the purpose of evaluating non-current assets, many countries follow the
hypothesis of revaluing them as per present market value. There are other factors
like the time of acquisition of those assets, the changing value of the local
currency, etc. Valuation of assets is mainly required to feature in the balance sheet
or consolidated financial position of any business entity to derive its net worth. It
is also argued that evaluation process of assets by historical cost method may
conclude to overstating of profit during the time of rising prices. This profit would
automatically be distributed among the shareholders and would lead to erosion of
operating capacity. (Deegan, 2014)
To explain the statement made by Deegan in his book, highlighting the
observation of adopting historical cost method for evaluation of financial
information, it is observed that this system has shortcomings in case of rising
prices of the financial instruments. This observation is supported by the logic of
inflation affected countries, where prices change very often. In this case, if
historical cost method is followed, it will not feature true value of accounting
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information. This situation may cause for inflated profit with subsequent
distribution to the shareholders and erosion of profit would occur to make the
financial statements unjustified. In this context, other stakeholders might be
affected through the fabricated presentation of financial statements. (Brown,
2017)
There are two types of evaluation method for assets- Historical Cost Method and
Fair Value method. To compare the applicability in regard to authenticity, both
prove vulnerable with their merits and demerits. It is the duty of the policymakers
about mitigating the systemic risk for valuation of assets in financial reports. The
international bodies of accounting guidance, IASB has to play prudent role in this
regard to ensure provision of better logical valuation method for the assets of the
business entities to safeguard the interest of the stakeholders. There is a prolonged
debate about the better option of these two; hence the application of them should
be clearly defined by the accounting policymakers with the regulation under
International Financial Reporting Standards. Right from 2005, this body is
engaged in the modification of fair value method in their policies for application.
It is a never ending effort with the required level of amendments to be
implemented to ensure that fair value method would prove its authenticity with
long term sustainability. Basic objective of the policymakers is to mitigate
systemic risk in the financial reporting globally. This objective can be
accomplished by considering the practical concerns of applying fair value
accounting.
Refer to the discussion in the report Fair Value Accounting, Historical Cost
Accounting and Systemic risk by Greenberg,et al (2013), the conclusion is based
on the review of the authors, which observed that both Historical Cost accounting
and Fair value accounting can be able to discharge practical information, at the
same time, they may also be responsible for vulnerable outcome in the form of
misstatement, if those systems are not applied with rigorous effort to ensure
prudence, diligence and strict guideline. To generate high level financial
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information with good quality, both systems demand good support of governance,
diligent application of theories followed by managerial control of the entities.
This process is to be followed by strong self-regulating audit. In case of absence
of those factors, both the systems can produce poor quality of accounting
information with the negative contribution of both the systems resulting to
generation of systemic risk of the entities. To ensure more prudent financial
reporting to mitigate systemic risk, the policymakers should insist on regular
assessment of the accounting standards with the logical problems coming up
followed by subsequent solutions to resolve those. Both systems are good,
provided they are applied with clear and prudent instinct. (Greenberg D, 2013)
Answer to Q. No. 2
To understand the statement made by Deegan 2014 in his book Financial
Accounting Theory (p. 258) regarding the role of conceptual framework to
enhance public standing of accounting professional, we have to discuss the basic
of conceptual framework and the role of accounting professional to implement
that in financial reporting.
Conceptual framework is also known as concept statement. This framework is
interconnected with specific objectives based on accounting fundamentals. The
objectives are meant for identification of goals and reason for proper reporting of
financial information based on the platform of basic accounting fundamentals to
accomplish those objectives. Those referred concepts are responsible for
providing guidance to ensure selection of transactions, circumstances and events
to be considered along with the system of their recognition and measurement
followed by summarization and reporting. (FASB, n.d)
Accounting professionals take care of preparation of financial statement by proper
analysis of the nature of financial information. Their job is completed with the
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production of such financial statement as per the guideline set by conceptual
framework and the principle of accounting. (Davis, 2019)
Now we can explain the subject statement of Deegan 2014 p.258 about the
standing of accounting profession by adopting conceptual framework.
Conceptual framework is set and time-to-time altered as per the demand of the
situation to ensure prudence to the stakeholders of the entities. The accounting
professional has to discharge duties for preparation of financial statements with
due projection and treatment of financial information as per the conceptual
framework set by the policymakers. There are two types of stakeholders
prevailing in the business entities- internal and external. While the financial
statements have to play the role of proper projection of financial position of the
entity through prescribed format as set by the policymakers, the expectation from
the accounting professionals by those stakeholders demands to project proper
financial information enabling the stakeholders to understand the financial
position of the entity to take proper decision for future course of action related to
the specified business entity. Accounting professionals, being considered as the
sole responsible authority to project the financial condition with truth and
transparency of any business entity, need proper guidance and framework to
discharge their duties. Conceptual framework performs this duty to prove the
professionals to justify their action as right, honest and thorough with the
application of set measurements.
Public standing of accounting professional demands execution of duties to project
proper and fair pictures of any entity, so that the stakeholders be able to take
decision on the platform of deliverables by the professionals. Conceptual
framework provides proper platform for this execution of duties. Hence,
conceptual framework is developed for the accounting professionals to provide
proper guidance and stringent boundary to serve the public to ensure better public
standing of those professionals. (Dennis, 2000)
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Conceptual framework is set to ensure international accounting standard and the
platform to implement those standards by the policymakers of global accounting
system. Basic reason for setting this framework is to set such platform, which can
compel global entities across the world to follow same standard of financial
reporting to mitigate ambiguities amongst the stakeholders of the entities in local
or international level. IASB has continuous effort to upgrade conceptual
framework for better deliverance of financial information to the stakeholders.
External stakeholders have to depend upon the published financial statements to
make their decisions. If the same is not maintained with the standardized format
based on conceptual framework, it becomes difficult for the stakeholders to
decide upon their future course of action about the entities depending upon those
financial reports. Hence to safeguard, their interest, conceptual framework is to be
implemented for business entities to maintain their financial information and
deliver subsequent financial report.
To conclude, the role of conceptual framework is elementary to provide proper
financial reports to the stakeholders. The role of accounting professionals plays
vital role on this issue. Under certain situational pressure, if the financial reports
are fabricated to pamper individual interest, the liability dawns upon the
professionals and thus reduces the credibility of public standing of them. In this
regard, conceptual framework gives them right direction and guidance to deliver
as per prescribed framework. Hence basic objective of conceptual framework is to
safeguard the interest of stakeholders of the entity with provision of proper
financial report as per available financial information, with secondary objective to
enhance the public standing of the professionals empowering them with proper
framework to discharge their deliverables. (Deloitte, 2013)
Answer to Q. No. 3
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International Accounting Standard Board or IASB is the platform for setting
internationally acclaimed accounting standards globally to set and implement
standardized conceptual framework for financial accounting and its reporting. In
the practice of accounting, measurement of assets or liabilities plays a vital role to
ascertain the financial position of the business entity. (Deloitte, 2019)
Earlier, the business entities used practicing the method of historical cost.
Historical cost depends upon the original cost of an asset or liability as per
accounting record of the business entity. This concept is mainly derived by the
cost principle that confirms the valuation of asset, equity or liability at the basic
acquisition cost by the entity. Historical cost method demands the necessity of
adjustments during accounting period, like the application of depreciation for
non-current assets to reduce the value of them depending upon the estimation of
their lives of usefulness. (Accounting, 2018)
The more practical method of cost derivation is endorsed by IASB named as fair
value method. This method is known as IFRS 13, which was initially issued in
May 2011 with its expected application for the accounting periods starting on or
after 1st January, 2013. This method endorses the concept of fair value disclosures
or measurement under the basic framework of IFRS. This concept is defined on
the platform of a notion of ‘Exit Price’ by using a ‘fair value hierarchy’ to make
the method more scientific and logical in relation to market value instead of
measurement endorsing entity specific feature. (Deloitte, 2011)
Refer to the question of shifting cost assertion method of assets, liabilities and
equity, the practical implication of historical cost method is getting obsolete due
to its conservative approach. In its place, fair value measurement is being
endorsed by IASB, the international platform for accounting standard, to ensure
conceptual framework to maintain prudence globally. The concept of fair value
assertion is passing through continuous amendment considering different
situations to make it more practical and logical.
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To ensure the application of fair value measurement in respect of assets of any
entity, best example prevails in case of financial industry, where some assets like
securities classified as Trading are always valued as per the market rates. There is
the application of depreciation, which is applicable for securities like leases or
bonds. Here comes the concept of other-than-temporary impairment (OTTI),
which is to be booked in the accounting record in order to maintain the practical
balance of the valuation of the assets by lowering it. This OTTI is fixed and
cannot be reversed through entries, even if the assets recover its market value in
due course. The option for the entity is there to sell those assets in higher prices to
realize capital gain or get benefited through the recovery system by value to
collect cash flows from that asset. (Jaijairam, 2013)
Normally, when any entity chooses to follow fair value accounting method for
evaluation of its accounting items, the values of those elements have the tendency
to change in during change of period as compared to the method of historical cost
accounting. As per earlier discussion, due to the conservative nature of historical
cost accounting method, the changed value of accounting information is
considered to be less unstable. When cost measurement is done through fair value
method of accounting, the derived value changes over time with the tendency of
volatility. This method is responsible for changes in the fair value. Unstableness
featured in the financial statements does not substantiate anticipated flaw in
financial reporting, instead it can always be anticipated through fair value method.
The changeover of valuation method is due to steps taken by IASB to formulate a
standardized system, by which the costing method can be followed globally. Main
objective of accounting information is to provide prudence to the stakeholders of
the entity. The standardized system of evaluation through fair value method can
ensure more realistic, practical and logical approach to ensure transparency for the
stakeholders so far value of assets, liabilities or equity is concerned.
The shortcomings of alternative like fair value method to replace historical cost
method are non-availability of standard platform for the alternative method. The
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evaluation process through historical cost method is more tending towards
formula or system standardized as per hypothesis followed for substantial time.
For fair value, the evaluation process may call for some confusion in regard to the
market value of the assets or other accounting elements. Basic framework is to be
set to ensure concept, which should be clear and distinctly applied. (Deloitte,
2013)
Summary
To summarize three different issues as per questions, following inferences drawn:
Question 1
To choose best option between historical cost and fair value measurement
method, both have certain advantages and disadvantages of their own. Fair value
method provides information considering current or market price, where as
historical cost provides information based on initial value of acquisition. Both are
good so far theoretical part, but prudent, diligent and strict application of them
can derive best possible results for the financial reports to fulfill the needs of
stakeholders.
Question 2
To understand the objective of implementing conceptual framework is basically to
safeguard the interest of stakeholders, who can read and understand the financial
reports for their own decision making. The issue of boosting up public standing
for accounting professional is secondary. If the standards of conceptual
framework are followed by professionals, it will ensure proper financial reporting
to ensure purpose of those reports.
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Question 3
Basic objective to value financial instruments is to ensure proper measurement of
financial instruments for preparation of financial reports. Historical cost method is
prevalent for long period for its standardized system. Fair value method is
introduced to ascertain the realistic value of financial instruments. IASB is trying
to make standardized system through their conceptual framework for
measurement of financial instruments. It is the demand of the situation to apply
the method which would be best suitable for the purpose of valuation of financial
instruments for the stakeholders to understand and decide their future course of
action for any entity.
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Bibliography
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https://www.iasplus.com/en/meeting-notes/iasb/2013/february/cf-purpose-
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