Measurement Principles in Financial Accounting: A Case Study on the Problems with Fair Value Accounting

Measurement Principles in Financial Accounting

A case study on the problems with

Fair Value Accounting

Kurt Vonderheide

12/8/2009

Abstract

The use of historical accounting provides simplified but verifiable information to users of accounting statements. One argument to historical values is that they do not provide true values. This had led to a push to use fair value accounting methods for financial statements. While fair values methods may more accurately reflect true values, scandals such as Enron have brought to light the tradeoffs associated with using this method over historical costs. 

John P. Glynn, a partner at Pricewaterhouse Coopers who heads the firm’s valuation practice, recently stated “When it comes to valuation, what one person thinks can be completely different from the next.” (Der Hovanesian, 2009, p.26). At the heart of financial accounting is the reporting of value on financial statements. There are numerous concepts used by accountants as guidelines by which they work. One of these concepts is that of historical cost accounting.

Generally accepted accounting principles (GAAP) requires that companies account for and report many assets and liabilities on the basis of acquisition price. This is often referred to as the historical cost principle. (Kieso, Weygandt, Warfield, 2009). Historical cost means what it cost the company for the item and is therefore most likely not fair market value. More simply put, if a company purchased a factory for manufacturing purposes, it is recorded on the balance sheet at its acquisition cost. It is not recorded at the price it could be sold for in today’s market, which is its fair market value.

The main reason to use historical values is due to the reliability of the information. That is, one knows without a doubt what the acquisition price was for an asset or a liability. However, this data may not be relevant since it does not consider current market values. While a balance sheet may tell the end user of the financial statement the acquisition cost of an asset like a piece of factory equipment and its depreciation in the following years, it completely ignores the fact that the current market value is higher or lower than the balance sheet suggests.

Furthermore, there is an obvious flaw in historical accounting method as it relates to inflation. The validity of historic value accounting rests on the notion that the currency in which transactions are recorded remains constant. The value of a dollar now is the same over a period of time. This is in direct conflict with economics