This paper is written for the accounting theory course as a course project. This paper discusses the differences between the historical cost accounting approach and the fair value accounting approach. The discussion will focus on the debate on using which accounting approach. We begin by stating the definitions of both concepts and discussing them thoroughly, then we state the main advantages of the two approaches followed by comparison between them. The last section of this paper discusses the disadvantages of each approach, including the main criticism points against them. In the end, we draw a conclusion on the best approach to be used in the Accounting profession based on the previous discussion.
Recognizing assets and liabilities in financial reports is an issue that accounting bodies try to find the best approach for. The accounting regulators look for a method that takes into account the characteristics of the financial reporting such us reliability and relevance. Historical cost method has been used since long ago. Although this method has been criticized by many, it is still seen as a working method due to its simplicity and reduced costs. Nowadays, there are many accounting professionals argue that other methods should be employed as the historical method is no more useful. Fair value method is a strong alternative. The supporters of this method argue that Fair value method provides information about financial assets and liabilities that is more relevant than amounts based on their historical cost. In this paper we will make a comparison between the two methods.
Historical cost Definition
Historical cost is a term used instead of the term cost. Cost and historical cost usually mean the original cost at the time of a transaction. The term historical cost helps to distinguish an asset’s original cost from its replacement cost, current cost, or inflation-adjusted cost. For example, land purchased in 1992 at cost of $80,000 and still owned by the buyer will be reported on the buyer’s balance sheet at its cost or historical cost of $80,000 even though its current cost, replacement cost, and inflation-adjusted cost is much higher today. The cost principle or historical cost principle states that an asset should be reported at its cost (cash or cash equivalent amount) at the time of the exchange transaction and should include all costs necessary to get the asset in place and ready for use
Fair Value Accounting
Fair value accounting is a financial reporting approach in which companies are required or permitted to measure and report on an ongoing basis certain assets and liabilities at estimates of the prices they would receive if they were to sell the assets or would pay if they were to be relieved of the liabilities, it is noted that under fair value accounting, companies report losses when the fair values of their assets decrease or liabilities increase. Those losses reduce companies’ reported equity and may also reduce companies’ reported net income.
The previous definition is consistent with the FAS 157 definition which defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
The goal of fair value measurement is for firms to estimate as best as possible the prices at which the positions they currently hold would change in transactions based on current information and conditions. To meet this goal, firms must fully incorporate current information about future cash flows and current risk-adjusted discount rates into their fair value measurements. When market prices for the same or similar positions are available, FAS 157 generally requires firms to use these prices in estimating fair values. The rationale for this requirement is market prices should reflect all publicly available information about future cash flows, including investors’ private...