Fair Value vs. Historical Cost Accounting Essay

1191 Words Feb 6th, 2013 5 Pages
Difference between historical cost and fair value accounting

In order to make the most profitable and rational decisions entity’s stakeholders have to evaluate organisation’s financial statements. Today’s world of rapidly changing prices has made it difficult to estimate what something is actually worth. Thus leading to debates at what price – historical costing price or market value – assets and liabilities should be reported. Therefore, before making any evaluations about reported transactions it is important to understand the difference between historical cost and fair value accounting.
Penman (2007, p.34) in his research same as Laux and Leuz (2009, p.827) in their article referred to fair value either as defined in IFRS or in FAS
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Moreover, the author noted that when using fair value it is easy for management to manipulate with earnings, overstate or understate values as for their own good. Furthermore, Marshall et al. (2011, p.201) referred to historical cost as being not only more reliable but also more consistent and conservative than fair value.
Still, Laux and Leuz (2009, pp. 827-828) have mentioned some important advantages that fair value has over historical cost. Authors noted that because of the timely information provided by fair value it stimulates frequent corrections and increases transparency. These advantages lead to relevancy of fair value accounting, whereas lack of transparency and not up to date information makes historical cost accounting less relevant. However, authors stated that relevancy can be applied to fair value only when regarding liquid assets, otherwise fair value accounting can generate misleading information. Besides they have also noted that, while historical costs remain stable during all times fair value prices can be deformed by inefficient markets, liquidity problems or investors irrationality increasing volatility in financial statements. What is more, Laux and Leuz (2009, p.832) presented that unlike fair value accounting historical cost accounting permits to realize gains at the most suitable timing and results in more flexible and discrete impairment testings. Nevertheless, in the article it is said that fair value not only provides more reliable and

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