Historical Cost and Fair Value

historic Cost and Fair prise1.0 INTRODUCTION in that location harbor been many discussions and debates concerning delectation of pretty harbor write up against pulmonary tuberculosis of diachronic be method of explanation. Some pick bring together observe whilst nearly possess a preference for historic bell bill. Both systems of military rank rich person been criticized and as well embraced.It is evident that a quality description and quantitative training ab protrude the nature of the fiscal as dress circle is essentially important and the amount that is appraised from the chosen method acting acting of rating is admitd in the fiscal statements. The question stock-still remains as to which measuring rod method must one use to cope with todays interlacing pecuniary instruments and risk trouble strategies. We must acknowledge that we ar in an era where we use many complicated financial instruments and risk focus strategies which render that yesterdays prices may break beget obsolete and many commonwealth now demand historic personify be either abandoned, re haveed, limited or re named by current wrong system to reflect a more than than right financial insurance coverage (Muller, K. A., 2008).The issue of assets and liabilities military rating has convey more pressing now than it was ever before. The FASB1is slowly modernizing the GAAP2principles and in doing so, it is attempting to make financial statements more meaningful and bring books in frontier with the international standards.Historical court and honest judge methods of valuation have two been around for a yearn duration. The woof of whether to switch to sightly lever method is af modal(a)ingly an important decision where all perspectives have to be equally evaluated in tump overing the transition from an existing to a peeled method of financial asset valuation. History has proven that the historical comprise principle has worked absolutely fin e all this patch. 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 tooshie should drive the want to pick a varying method of financial asset valuation and what could be loftyly considered being the opportune time for the switch in choice of model.With the ever increasing concerns amidst two the public and confidential sectors pertaining to the adequacy of financial statement reporting by respective financial institutions, a considerable attention has been receive by the FASB, SEC3and an separate(prenominal) regulating bodies.The adaption of the IFRS4in the European Union with effect from 1st of January 2005 birthed a number of signifi lavt changes in how squiffys must report their financial positions (Muller et al 2008). bar of financial assets is the core issue of relevance in financial method of invoice and reporting today.In order to decide which method of valuatio n one must choose, it is imperative that at that place must be a sound fancying of the unobjectionable encourage and historical hail method of valuation for financial assets.This seminar attempts to carry surface an in depth look into on the just note nurse and historical personify method of valuation, infrastand the at a lower placelying assumptions of each, identify the strengths and weaknesses of both.Various companies has been seeked and contacted in order to obtain feedback on their chosen method of financial asset and liabilities valuation. Responses received be summarized in analysis and findings section of this account and has been deliberated upon in understanding how companies and organizations in Fiji be valuing their assets and liabilities for reporting in their financial statements.Also encompassed atomic number 18 various writings and resource materials that we have studied. These have been re intellectioned and key essence and aspects of topic under register has been entailed in section entitled Literature Review.1.1 THEORETICAL UNDERPINNINGS chronicle is highly purposive field and any assumption, principle or functioning is accordingly justified if it adequately serves the end in view (Paton, 1922). There ar many accounting conventions under the Generally Accepted chronicle Principles (GAAP) which is now known as IFRS.Historical Cost Convention is the pompous valuation concept whose resources be treasured in accordance with the damage of acquisition by the enterprise (Glautier and Underdown, 1982). Assets atomic number 18 recorded at their schoolmaster cost at the time of purchase. This convention is highly preferent for the historical cost method everywhere reasonable apprise.The Conservatism Convention assumes that accountants are pessimistic in measuring revenues and expenses. Revenues are not recorded until they were ab break through certain but expenses were recorded as soon as they be fall remote. If acco untants had to choose for cadences of cost for assets and liabilities they would have chosen the lowest for assets and highest for liabilities or soly gull historical cost method.The historical cost of method is well pet over the unobjectionable(a) foster method as the invoice as a Historical record is concerned at providing a airless record of transaction of an entity rather to provide a valuation of the firm at a pass alongn period of time (Godfrey et. al, 2006 pg 18).While historical cost method may give nigh indication to shareholders of the stewardship of management in the management of costs and money capital under the control, the records give no indication of the factual worth of the enterprise as a going concern except to the extent that operating get is a bodeive devise (Budge and Hendriksen, 1974).Objective of stewardship is metrical footd on agency opening. Managers choice of accounting method usually comes as agency theory. Agency theory provides a neces sary explanation of why a selection of extra accounting method might matter, and hence was an important facet for the growth of Positive accounting theory. It is assumed that under agency theory geniuss go forth assume that the agents ( adept) will be driven by ego interest and in that respectfore the headers will anticipate that the managers, unless restricted from doing separatewise, 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 measuring rod ass for higher(prenominal) profit for the remuneration purposes. It could be meliorate if the particular method much(prenominal)(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 habitual in the Positive explanation Theory literary works to explain and predict whether an organization would support or oppose a particular accounting method.A higher profit is precise under the management assumption or bonus plan hypothesis. The preparers of the reports will use such accounting methods that increase current reported income. Such method increases the present entertain 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 also preferent 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 coven ant. The tighter the covenant constraint, the greater the hazard of a covenant violation and of incur of costs from technical defaults. Mangers choosing income increasing accounting method relaxes debt constraints and reduces the technical defaults (Deegan 2002).The semipolitical 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 problem practices that generate excessive profit for the evaluates of owners while at the same time providing limited returns to others parties pertain in the transaction.Chambers Theory of Continuously modern-day history made feeling about what people need in terms of instruction. Chamber makes an assumption about the objective of accounting is to clear future actions. He prescribed that all assets should be measured at net mark et tax and that such instruction is more multipurpose for informed decision making than information based on historical cost which could be misleading.A number of prescriptive theories were developed which adoptive Decision Usefulness approach to Accounting Theory. Chambers Blueprint paper published in 1955 is arguably among the first to emphasis decision service program .He wrote It is thitherfore 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 reli capacity, relevance, timeliness and comparability.Finally, there are several(prenominal) other theories to accounting which could explain the choice for the kind of measure base or method. Cost Attach theory, Investo r theory, True income theory, Behavioral Accounting theory, Measurement theory, Accounting as Magic and communication theory and others. Measurement is a hub of Accounting which has a lot of accounting theory underlying standard basis. The minimum occupyment for giving theoretical justification to an allocation 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 limited reviewThere has been much discussion about sane rank accounting. Disclosing assets at their lovely value as opposed to their historical cost is preferred by some but opposed by others. The use of decorous value accounting has been around for decades primarily for financial assets. In juvenile years, both the Financial Accounting Standards progress (FASB) and the International Accounting Standards Board (IASB) have moved towards more extensive use of picturesque value accounting.Ac cording 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 Introduction to Corporate Accounting Standards. The book provides many of the theoretical affirmations for the accounting. Historical cost is generally delineate as the amount at which the asset or liability was in the beginning obtained. Where the historical cost is expected to be different from the final value when the item is no longer on the balance sheet, some amortisation or depreciation of the value is expected. This can result in an amortised cost or depreciated cost value. These values are generally more faith fully determinable, but less relevant than passably value.Casonbona et al (2007) define dependable value as the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arms length transaction. This assumes that it represents market value in a sufficiently productive and efficient market. Where no market exists, the reliable value would need to be conceptually estimated.In making comparisons between the two, Toppe Shortridge et al (2006) refer to an argument of relevance over reliability. They argue that the proponent of picturesque value accounting believe that historical cost financial statements are not relevant because they do not provide information about current values. Theorists and practitioners against sportsmanlike value argue that the information provided by fair value financial statements is unreliable because it is not based on arms length transactions. They have it off that if information is unreliable it should not be apply to make financial decisions. However they also argue that the proponents of fair value accounting would assume 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 part of the attach tos value. Specifically, unless the values of fixed assets are assumed to remain the same over time, historical cost information is relevant just up on obtaining the asset.A number of studies have been conducted to argue that one method is more appropriate 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(p) reflect the economic substance of the transactions, the actual cash flow and the meshing process. Chisnall (2001) also supports this view and argues that the banking industry as an casing would be stovepipe to use modified historical cost as a better basis on which to measure banking book performance in pr imary coil 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 hunting lodge accepts the subjectivity of the market and thus 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 arrive at different estimates of the fair value although both would have followed the objectives of fair value beat.There are many issues involved with fair value accounting. Some argue that fair value is g ood 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 quantity in financial accounting uses the example of non-financial assets. In her study she notes that IAS 41- Agriculture sets a precedent in application of the fair value measurement to biologic 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 silver screen the value of biological assets of enterprises in the market environment.Muller et al (2008) essay the cause of and consequences of investment place 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 airplane propeller. The study recorded 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 apply fair value to report larger gains than companies using 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 lay out that companies using fair value accounting rely more on debt financing 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 demandi ng fair value accounting for non-financial assets.This study was based on a assay of 1,539 companies. It identified each companys valuation practice by reading the accounting policy section in its annual report. No companies in the test used fair value accounting for intangible 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 number for the companies using fair value as opposed to a matched attempt of companies that alone 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 stricken whe n its carrying amount is higher than its fair value less the costs to carry 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 melody under fair value accounting companies revalue assets either up 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 occur 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 arsenal 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 wrongly increase the confidence of investors and therefore increase its capital.Historical costs are beneficial as it is widely understood by investors and companies. Historical cost does not rely on estimating the value of assets and thus allows less get on 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 awake 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 edifice 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 think 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 OBJECTIVES postTo discuss the principle of historical cost and fair value methods of measurement and determine whether it is appropriate to use both methods when amass a set of financial statements.OBJECTIVESThe scope of our research aims to address the succeeding(a) 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 roll up 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 a nd accountants.Review of literatureWe reviewed the research papers and journals carried out by several researchers on fair value and historical cost.Online ResearchAccessing the internet played a vital fictional character in obtaining current and up-to-dateInformation regarding historical cost and fair value.5.0 ANALYSIS AND FINDINGSQuestion 11. What method of measurement does your company before long 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 adv antages of historical cost method have been quite connatural and we have analysed the advantages in the following categories showing 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 exceeds the constraints identified in Question 3 while 32% (8 out of 25) thought otherwise. The major reasoning being that historical cost is clean easy to use and understand and also in Fiji, there is constraints for overlook of active markets for some classes of assets, thus for valuation purposes, adopting to fair value becomes an dearly-won for task for entities.What are the benefit s (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 are 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 outline the benefits and limitations 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. come alongmore, the entities (respondents) also sketch 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 tete-a-tete 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.Several companies refused to figure as they required going through the protocol of seeking consent from human resource department which was time cons uming.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 disadvantaged 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, then this paper would have been more creditable and informative. exuberant information based on foreign markets. This is a limitation as findings to Fijis context could not really be made. base 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 interview some companies however it was faineant 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 recommend 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 measurement 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 outdo 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 exemplar sample of all stakeholders given our small sample size.7.2 CONCLUSION split 100 of the IASB poser 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 whelm large majority 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 military rating 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 prefe rred 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 method 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 fight 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. point though fair value may be relevant, its reliability is indeterminate 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 disadvantages inherent in the two as well.