Why is IFRS so strong in using Fair Value instead of Historical Cost for its valuations of Property, Plant and Equipment?
IFRS defines Fair value as the amount for which an asset could be exchanged or a liability settled between knowledgeable willing parties in an arms length transaction. Whereas Historical cost ignores the amount the asset could be sold for in the open market, called fair value, until the asset is actually sold. For Historical Cost the company carries the asset on the balance sheet at the purchase cost less any depreciation taken. At the time of sale, the company records a gain or a loss against the purchase cost of an asset less any depreciation if applicable. For example if Tom purchased an asset for $5,000 and estimated depreciation expense of $500 per yr for 10 yrs the cost of asset after the 1st yr less depreciation is $4500. If the market value of the asset were $4800 after one year in the open market Tom would not write up the asset after the first year, rather the asset would remain at original cost less any depreciation until the asset is sold. If Tom sold the asset for $4800 after one year then Tom recognizes a gain of $300. Therefore assets on the balance sheet are recorded at historical costs until sold. For example: Since everyone in the U.S is currently required to follow the historical cost principle, users of financial statements understand where the asset values are coming from: the price originally paid for an asset(less depreciation where applicable). The historical cost principles follows the accounting quality of reliability since everyone can agree on the original purchase price of an asset. However , the historical price is not necessarily relevant information. Land that was purchased 20 years ago could be worth much more than the balance sheet shows. Likewise a building purchased many years ago and recorded on the balance sheet at the original cost does not reflect the current market price....
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