Historical Cost Accounting

Differences between historical cost and fair value valuation

Anastasiya Kovalenko

11029021

The choice between fair value and historical cost accounting principles is a subject to a long-lasting debate in accounting literature. The crisis of 2008 has contributed to reinforcement of uncertainties and doubts regarding fair value measurements of items that appear on company’s accounting records (Laux and Leuz, 2009, p. 1). Both fair value method, also referred to as market value approach, and historical cost accounting are widely used by entities for calculating the figures which appear on the financial statement of the company. Although both approaches are equally acceptable by international standards, the question lies not in which method is better but rather how to most effectively imply these methods in order to provide accurate financial information and ensure that risks are reduced to a minimum.

The objective of this paper is to evaluate the differences between two ways of valuation items that appear on balance sheet– against the historical costing price and against the market value. This paper will first explain fundamental differences between historical cost accounting and fair value accounting and then weight advantages and disadvantages of both valuing systems.

Fair-value valuation method is an approach under which assets and liabilities that appear on company’s accounting records are periodically revaluated, and as a result show the possible effect on net income. Historical cost principle, on the other hand, accounts for the value of an asset that is based on its original cost. As a result, accountants often prefer fair value income measurements to historical cost income, which requires conformation to precisely strict rules (Penman, 2007, p. 33).

The evaluation of financial statement is often based on its usefulness for economic decision-making. Therefore, the choice between two valuation methods is often associated with relevance-reliability trade-off.  As one of the advantages of fair value accounting, Herrmann, Saudagaran and Thomas (2006, p.3, p.24) argue for fair value to be a viable alternative for strict historical cost basic, in particular when revaluating long-term assets. They support their argument by providing a framework for evaluation of both methods on the basis of qualitative characteristics of relevance and reliability. One of the main disadvantages of historical cost approach is that it does not provide a relevant and up-to –date entity’s current financial position. Fair values deliver   Furthermore, financial information provided by historical costing principle is often more difficult to compare since the differences and similarities between two economic phenomena fail to be distinguished (Herrmann, Saudagaran and Thomas, 2006, p. 18). The advantage of reliability of fair value accounting is also supported by Christensen and Nikolaev (2013, p. 12). They argue that cost-benefit trade-off takes place when it comes to choosing between historical costing and market value accounting. They state that, on the one hand, fair value approach benefit investors by providing more reliable financial information, but, on the other hand, reliability of information is a costly activity, which contributes to the argument against usage of fair value approach. Consequently, managers need to evaluate net benefits of both valuation methods before setting entity’s accounting model. Penman (2007, p.34) also contributes to a debate of reliability of fair value accounting by referring to investors’ concerns regarding value and therefore giving preferences to fair value approach. The issue of identification of users of financial statements with regard to the choice of valuation approach representation will be discussed in more detail further in the paper.