Historical Cost and Fair Value

historic Cost and Fair Value1.0 INTRODUCTIONThere fork everyplace been galore(postnominal) discussions and debates concerning consumption of reason satisfactory cherish accountancy against use of diachronic greet accounting. healthful-nigh prefer delightful foster whilst some have a taste for historical constitute accounting. Both orders of valuation have been criticized and as well embraced.It is evident that a quality description and quantitative randomness ab out the reputation of the financial summation is essentially important and the amount that is appraised from the chosen order of valuation is allowd in the financial supposements. The question how forever remains as to which measurement method moldiness one use to cope with todays daedal financial instruments and risk management strategies. We must acknowledge that we are in an geological era where we use galore(postnominal) complicated financial instruments and risk management strategies which r ender that yesterdays prices may have become obsolete and many people now indigence historical review be either abandoned, reviewed, modified or replaced by current comprise system to reflect a more(prenominal) accurate financial reporting (Muller, K. A., 2008).The issue of assets and liabilities valuation has become more pressing now than it was ever before. The FASB1is slowly modernizing the GAAP2principles and in doing so, it is attempting to devise financial assertions more pregnant and bring books in line with the international standards.historic constitute and bonny jimmy methods of valuation have both been around for a long time. The pick of whether to switch to white(a) harbor method is interestingly an important decision where all perspectives have to be equally evaluated in considering the transition from an existing to a new method of financial asset valuation. History has proven that the historical greet principle has worked absolutely fine all this mend. This now poses us a question as to why the consideration and speculation to switch to a new method of financial asset valuation. What theories and what basis should drive the motivation to strike a varying method of financial asset valuation and what could be rarefiedly considered macrocosm the opportune time for the switch in excerption of model.With the ever increasing concerns between both the public and private sectors pertaining to the adequacy of financial statement reporting by respective financial institutions, a considerable vigilance has been received by the FASB, SEC3and other regulating bodies.The adaption of the IFRS4in the European Union with effect from 1st of January 2005 birthed a number of signifi seatt changes in how firms must report their financial positions (Muller et al 2008). Measurement of financial assets is the core issue of relevance in financial accounting and reporting today.In order to mold which method of valuation one must choose, it is impera tive that there must be a sound recogniseing of the decent nurture and historical woo method of valuation for financial assets.This seminar attempts to carry out an in depth research on the equitable protect and historical cost method of valuation, at a lower placestand the underlying self-reliances of each, identify the strengths and weaknesses of both.Various companies has been researched and contacted in order to obtain feedback on their chosen method of financial asset and liabilities valuation. Responses received are summarized in epitome and findings section of this paper and has been deliberated upon in understanding how companies and arrangings in Fiji are valuing their assets and liabilities for reporting in their financial statements.Also encompassed are various literature and resource materials that we have studied. These have been reviewed and let on essence and aspects of topic under study has been entailed in section entitled Literature Review.1.1 THEORETICA L UNDERPINNINGSAccounting is highly purposive electron orbit and any assumption, principle or procedure is accordingly justified if it adequately serves the end in view (Paton, 1922). There are many accounting conventions under the Generally Accepted Accounting Principles (GAAP) which is now known as IFRS.Historical Cost Convention is the conventional valuation concept whose resources are valued in accordance with the cost of acquisition by the enterprise (Glautier and Underdown, 1982). Assets are recorded at their original cost at the time of purchase. This convention is highly favourite(a) for the historical cost method over light value.The Conservatism Convention assumes that accountants are pessimistic in measuring revenues and expenses. Revenues are non recorded until they were nearly certain but expenses were recorded as soon as they become remote. If accountants had to choose for measurements of cost for assets and liabilities they would have chosen the lowest for assets and highest for liabilities mostly adopt historical cost method.The historical cost of method is well preferred over the intermediate value method as the Accounting as a Historical record is concerned at providing a faithful record of transaction of an entity alternatively to provide a valuation of the firm at a given over period of time (Godfrey et. al, 2006 pg 18).While historical cost method may give some indication to shareholders of the stewardship of management in the management of be and specie capital under the control, the records give no indication of the real worth of the enterprise as a going concern except to the extent that operate profit is a predictive devise (Budge and Hendriksen, 1974).Objective of stewardship is based on agency scheme. Managers choice of accounting method usually comes as agency theory. representation theory provides a necessary explanation of why a selection of particular accounting method might matter, and hence was an important facet fo r the education of Positive accounting theory. It is assumed that under agency theory principals will assume that the agents (principal) will be driven by self interest and therefore the principals will anticipate that the managers, unless restricted from doing otherwise, will undertake self serving activities that could be detrimental to the economic welfare of the principals (Deegan 2002).Since the behavior of this principal cannot be predicted as their salaries are tied to accounting figures and monitoring the principal behavior is difficult. The preparers of financial reports will choose measurement basis for higher profit for the remuneration purposes. It could be better if the particular method much(prenominal) as historical cost is stated in the contract of the principal for reporting purpose.Watts and Zimmerman identified three key hypotheses that have become frequent in the Positive Accounting opening literature to explain and predict whether an organization would supp ort or oppose a particular accounting method.A higher profit is precise under the management hypothesis or bonus plan hypothesis. The preparers of the reports will use such accounting methods that addition current describe income. Such method increases the present value of bonuses if the compensation committees do not adjust for the methods chosen. This hypothesis predicts that if managers are rewarded in terms of performance with accounting figures than mangers will chose methods to increase accounting profit with an attempt to increase bonus.A higher profit is in like manner preferred by Debt Equity hypothesis which predicts that thehigher the firms debt equity ratio the more likely the managers use accounting methods that increases income. The higher the debt to equity ratio, the closer the firms to the constraints in debt covenant. The tighter the covenant constraint, the greater the possibility of a covenant violation and of incurring of costs from technical defaults. Manger s choosing income increasing accounting method relaxes debt constraints and reduces the technical defaults (Deegan 2002).The Political Hypothesis predicts the larger firms rather than small firms are likely to choose accounting methods that reduces reported profit. Reducing reported profit could decrease the possibility that people will argue that the organization is exploiting other parties by applying business practices that generate excessive profit for the benefits of owners while at the same time providing limited returns to others parties involved in the transaction.Chambers Theory of Continuously Contemporary Accounting made judgment about what people need in terms of information. Chamber makes an assumption about the objective of accounting is to guide future actions. He prescribed that all assets should be measured at net market value and that such information is more helpful for informed decision making than information based on historical cost which could be misleading.A number of prescriptive theories were developed which adopted close Usefulness approach to Accounting Theory. Chambers Blueprint paper published in 1955 is arguably among the first to emphasis decision usefulness .He wrote It is therefore corollary of the assumption of rational management that there shall be an information providing system, such as basis for decision and as a basis for reviewing the consequences of decision. It is suggested that accounting information should be germane(predicate), verifiable, free from bias and quantifiable. The choice of Accounting Methods depends on factors such as reliability, relevance, timeliness and comparability.Finally, there are several other theories to accounting which could explain the choice for the kind of measurement base or method. Cost Attach theory, Investor theory, True income theory, Behavioral Accounting theory, Measurement theory, Accounting as Magic and communication theory and others. Measurement is a hub of Accounting whic h has a lot of accounting theory underlying measurement basis. The minimum requirement for giving theoretical justification to an parceling method are that it should be possible to specify unambiguously and in advance, the method to be utilize and to defend that choice against all competing alternatives.2.0 LITERATURE redirect examinationThere has been much discussion about fair value accounting. Disclosing assets at their fair value as opposed to their historical cost is preferred by some but opposed by others. The use of fair value accounting has been around for decades primarily for financial assets. In new years, both the financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have moved towards more extensive use of fair value accounting.According to Godfrey et al (2006) the use of historical cost for valuation of non-monetary assets has come from several sources, these include the 1940 book by Paton and Littleton, An Introductio n to Corporate Accounting Standards. The book provides many of the theoretical arguments for the accounting. Historical cost is generally defined as the amount at which the asset or liability was originally obtained. Where the historical cost is expected to be polar from the final value when the item is no longer on the balance sheet, some amortization or depreciation of the value is expected. This can result in an amortised cost or depreciated cost value. These values are generally more reliably determinable, but less relevant than fair value.Casonbona et al (2007) define fair value as the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arms duration transaction. This assumes that it represents market value in a sufficiently robust and efficient market. Where no market exists, the fair value would need to be conceptually estimated.In making comparisons between the two, Toppe Shortridge et al (2006) refer to an argume nt of relevance over reliability. They argue that the proponent of fair value accounting believe that historical cost financial statements are not relevant because they do not provide information about current values. Theorists and practitioners against fair value argue that the information provided by fair value financial statements is unreliable because it is not based on arms length transactions. They contend that if information is unreliable it should not be used to make financial decisions. However they also argue that the proponents of fair value accounting would claim that it is more relevant to decision makers even if it is less reliable. These arguments include that fair value accounting would produce balance sheets that are more representative of the unions value. Specifically, unless the values of fixed assets are assumed to remain the same over time, historical cost information is relevant except up on obtaining the asset.A number of studies have been conducted to argu e that one method is more confiscate than another.Ebling (2001) argues that accounting rules around the world are moving steadily towards fair value accounting and away from historical cost accounting. In his study he argues that the banking systems figures would become more volatile. The banks would see their business managed against long term objectives and not short term measures and it is historical costs that better reflect the economic philia of the transactions, the actual cash flow and the earnings process. Chisnall (2001) also supports this view and argues that the banking industry as an example would be best to use modified historical cost as a better basis on which to measure banking book performance in primary financial statements. The issue of volatility has surfaced in recent times with the example of the collapse of Enron as an example.Barr (2009) reflects that fair value can be an accurate way to value assets but it needs time to be fully perfected. With Enron fair value accounting was used to mislead investors, regulators and the general public. Kemp (2008) argues that fair value accounting works best where the legal framework of company accepts the subjectivity of the market and hence divergent values as in Europe, as opposed the USA with its very open legal system.The disadvantages of fair value are also highlighted. It is argued that valuation is a subjective judgment and therefore as an example if two evaluators were to conduct the valuation process they may begin at different estimates of the fair value although both would have followed the objectives of fair value measurement.There are many issues involved with fair value accounting. Some argue that fair value is beneficial to investors when they are trying to evaluate risk, return and valuation of a business.Dvorakova (2007) in her study of historical costs versus fair value measurement in financial accounting uses the example of non-financial assets. In her study she notes that IA S 41- Agriculture sets a precedent in application of the fair value measurement to biological assets and agricultural production. The study states that the fair value measurement has been required by IAS 41 because historical cost measurement is not able to cover the value of biological assets of enterprises in the market environment.Muller et al (2008) examine the cause of and consequences of investment property companies choice to use the historical cost or fair value standard to account for their primary asset, real estate. The examination exploits the European Unions adoption of International Financial Reporting Standards which require companies to make this choice under IAS 40 Investment Property. The study constituteed that companies are more likely to use the fair value standard when a company shows a greater commitment to reporting transparency. It showed that some companies however were also opportunistic in victimization fair value to report larger gains than companies u sing the historical cost standard.Christensen and Nikolaev (2009) studied whether and why companies prefer fair value to historical cost when they can choose between the two valuation methods. Their study show that with the exception of investment property owned by real estate companies, historical cost by far dominates fair value in practice. They state that fair value accounting is not used for plant, equipment and tangible assets. They found that companies using fair value accounting rely more on debt pay than companies that use historical cost. This evidence is consistent with companies using fair value to show asset liquidation values to their creditors and is not consistent with equity investors demanding fair value accounting for non-financial assets.This study was based on a sample of 1,539 companies. It identified each companys valuation practice by reading the accounting policy section in its annual report. No companies in the sample used fair value accounting for intang ible assets. Only 3% used it for assets such as plant and equipment. With very few exceptions fair value is used exclusively for property. The study also looked the balance sheets of the companies and found that that the total assets and shareholders equity were, respectively, 31% and 88% higher on average for the companies using fair value as opposed to a matched sample of companies that only use historical cost accounting. The study also proves that a mixed approach is taken to the use of fair value under IAS 16 Property, Plant and Equipment.The study further states that companies that follow historical cost accounting must periodically test their asset for impairment. An asset is considered impaired when its carrying amount is higher than its fair value less the costs to sell and the present value of future cash flows it is expected to generate. With historical cost accounting companies will in practice value assets close to fair value if depreciated historical costs exceed fair value. In contrast under fair value accounting companies revalue assets either upwards or downwards depending on the change in the fair value estimate.Beier (2008) talks about measurement issues with existing mixed standard models. Hestates that mismatches may come because some assets and liabilities are reported at historical costs and some are marked to fair value. Examples he gives includeFinancial institutions report many assets at fair value and the debt used to finance those assets is reported at historical costDebt nominated in a foreign currency is translated at spot rate while assets financed with that debt is translated at historical rateDerivative used to finance inventory are reported at fair value while such inventory is reported at historical cost.Grover (2008) in his look at the debate of fair value versus historical costs states that while there needs to be consistency in accounting it may be necessary to measure certain balance sheet items at fair value and other at historical cost.It can be argued from the literature and studies conducted that fair value and historical costs both have their place in accounting. There are many different and unique kinds of businesses so one universal standard for valuing assets may be suitable for some but not for others. Fair value is beneficial due to its ability to provide an up to date value of business assets, but fair value may also inaccurately inflate the value of a company due to mistakes or misrepresentations and in doing so can falsely increase the confidence of investors and therefore increase its capital.Historical costs are beneficial as it is widely understood by investors and companies. Historical costing does not rely on estimating the value of assets and thus allows less room for fraudulent activities to occur. However the use of this standard can underestimate the value of a company since an increase in the value of an asset is not recorded until the asset is sold or traded. Although this may cause investors to wary of a company who has a deflated value it does provide more stability in the market.If both accounting standards are used it can improve meaningful information for decision making. The use of fair value allows for an up to date value of assets and produces relevant costs. As an example if a company owned a building the fair value of that building will be the opportunity cost of that building in terms of it being sold or rented or used for something other the companies intended use. As historical value is more widely used and understood it can be used as an external use of reporting value of assets. Historical costs can be used as the base in reporting value and fair value used as an estimate or projected value of assets to investors.3.0 RESEARCH OBJECTIVESAIMTo discuss the rationale of historical cost and fair value methods of measurement and determine whether it is appropriate to use both methods when accumulate a set of financial statements.OBJECTIVESTh e scope of our research aims to address the following issuesDiscuss the rationale of historical cost method.Benefits and constraints of historical cost method.Discuss the rationale of fair value method.Benefits and constraints of fair value method.Whether it is appropriate to use both methods when digest a set of financial statements.Benefits and constraints of using both methods.4.0 RESEARCH METHODSIn compiling this research project, we used the following techniques to obtain data which are as followsQuestionnaire DistributionWe compiled questions and distributed to 30 reporting entities in Suva and Nasinu area. These were given specifically to financial statement preparers namely financial controllers and accountants.Review of literatureWe reviewed the research papers and journals carried out by several researchers on fair value and historical cost.Online ResearchAccessing the meshwork played a vital role in obtaining current and up-to-dateInformation regarding historical cost an d fair value.5.0 ANALYSIS AND FINDINGSQuestion 11. What method of measurement does your company currently use?Upon analyzing the outcomes of the 25 received responses from the reporting entities, 1 uses fair value method, 17 companies adopt to using historical cost as measurement basis while 7 stated that they use both methods that is fair value and historical costs. The table below shows the methods used by the companies in compiling the financial statements.KeyHC Historical costFV Fair valueBoth Historical cost and fair valueWhat are the benefits (advantages) of historical cost did you consider prior to implementing this measurement basis?The responses received in regards to the advantages of historical cost method have been quite similar and we have analysed the advantages in the following categories show the number of respondents.What are the constraints (disadvantages) of historical cost measurement basis that your company may have faced?The responses received in regards to the disadvantages of historical cost method have been quite similar and we have analysed the disadvantages in the following categories showing the number of respondents.The respondents of 68% (17 out of 25) agreed that the benefits of using historical cost (Question 2) as its measurement basis outweighs the constraints identified in Question 3 while 32% (8 out of 25) thought otherwise. The major reasoning being that historical cost is fairly open to use and understand and also in Fiji, there is constraints for lack of active markets for some classes of assets, thus for valuation purposes, adopting to fair value becomes an expensive for task for entities.What are the benefits (advantages) of fair value did you consider prior toimplementing this measurement basis?The responses received in regards to the advantages of fair value method have been quite similar for most companies and we have analysed these advantages in the following categories showing the number of respondents.What ar e the constraints (disadvantages) of fair value measurement basis thatyour company may have faced?The responses received in regards to the disadvantages of Fair value method have been quite similar and we have analysed these disadvantages in the following categories showing the number of respondents.Do you consider that the benefits outweigh the constraints in using fair value as the measurement basis?Considering that only 32 %- 8 (1 FV and 7 both) out of the 25 companies use fair value, they responded that the benefit of the fair value identified in Question 5 does outweigh the constraints in Question 6 while the 68% (17) thought otherwise. We consider that the major factor behind this is due to lack of active markets for some assets whereby this becomes a cost constraint for entities and the complex nature of the methods used in fair value.Do you consider that it is appropriate to use both methods when compiling a setof financial statements? If so, please line the benefits and l imitations ofusing both methods i.e. historical cost and fair value?Of the 25 respondents, 19 (76%) of them view that it is appropriate to use both methods i.e. historical cost and fair value when compiling a set of financial statements while 6 (24%) of them view otherwise. The major reasoning being that this would be more reliable and relevant for decision making process such as for assets like Property Plant Equipment, entities consider using historical cost basis of measurement since it is easy and efficient to use while for investments they consider fair value since current and market valuation is needed.Furthermore, the entities (respondents) also outlined benefits and constraints of using both methods i.e. historical cost and fair value which is analysed as follows6.0 LIMITATIONSIn carrying out our research we encountered some problems that we think have inherent this research and is outlined asDifficulties were faced by the group in seeking responses to the questionnaires on the subject matter as some companies were reluctant to provide information due to the busy schedules of their employees and key players from whom information was required and also private companies have strict confidentiality policies which restricted us in obtaining responses.There is a possibility that questionnaires were likely to be filled out by accountants and account officers who do not have knowledge to that extend about their companys policies regarding measurement hence there is a chance for incorrect data. some(prenominal) companies refused to participate as they required going through the protocol of seeking permission from human resource department which was time consuming.Out of 30 questionnaires given, only 25 responses were received. If all had responded, we would have been able to gather more information which would have enhanced our analysis and findings.Likelihood of sampling error as discriminate by geographical area. Due to time constraints we distributed the questionnaires only in Suva and Nasinu areas hence the study of other reporting entities from other regions could not be taken. If the questionnaires had been distributed to other region, and so this paper would have been more creditable and informative.Excessive information based on overseas markets. This is a limitation as findings to Fijis context could not real be made. Based on our readings, overseas markets have efficient markets whereas in the South Pacific it is limited to only one.Our group made an effort to interrogate some companies however it was futile since they were unable to find a mutually convenient time.7.0 RECOMMENDATIONS AND CONCLUSION7.1 RecommendationsBased on the research and in support of our conclusion, we cheer thatThat the professional accounting bodies should continue to address the issue of measurement to provide with a solution. Accounting professional bodies such as AASB, FASB and IASB should be specific in their conceptual framework which measure ment method should be used for different assets and be consistent across all borders.Accounting professional bodies such as AASB, FASB and IASB should provide conceptual framework for measurement such as on scale of businesses that is small size business, medium size and large business.Further studies to be carried out on the mixed method model appropriateness, incorporating the views of other stakeholders such as users given our narrow scope of research as well as need to consult a more representative sample of all stakeholders given our small sample size.7.2 CONCLUSIONParagraph 100 of the IASB Framework states that A number of different measurement bases are employed to different degrees and in varying combinations in financial statements. However, there is a lack of guidance in the framework in providing criteria for selecting measurement basis for particular elements of financial statements. Although accounting practices have changed considerably, still an overwhelming large maj ority of transactions is recorded and reported based on historical cost as it was centuries ago (Ijiri, 1975).Our conclusion is that it is appropriate to use both historical cost and fair value when compiling a set of financial statements. This conclusion is based through prudent evaluation of previous researches and the findings from the responses to our research questionnaire and thus it is conclusive that there is no ideal method for asset measurement.There is satisfactory research to support that fair value provides and enhances the relevance of financial information especially to assets with existing markets. However, this study identifies that in Fiji historical cost is the most preferred method for most firms and this may be of the fact that Fiji has many small to medium scale of businesses.Although fair value is included in the conceptual framework of accounting, there is insufficient empirical evidence and literature that views it to be the best method. Historical cost meth od reduces a number of problems, including information manipulation by managers, which further affects its reliability in decision making. Furthermore, development of rigid accounting standards is imperative to increase reliability of fair value.Paragraph 101 of the IASB Framework states that in preparing financial statements historical cost is usually combined with other measurement bases. Given that the framework does not explicitly refute and dispute such approach, using both fair value and historical cost simultaneously is not exactly deemed to be unprincipled. By using fair value, information becomes more relevant to decision-making process as it reflects up-to-date information. Even though fair value may be relevant, its reliability is questionable due to its subjective nature of determination. Lastly, by using both methods we are able to enjoy the benefits inherent in fair value as well as historical cost. One can argue that by combining the two, the reports become open to d isadvantages inherent in the two as well.