Introduction
The field of accounting has developed over a long period from a simple bookkeeping to a much more complex accounting and financial reporting. Therefore, the development of accounting and financial reporting has led to the need to have a standardised way of handling accounting that is acceptable all over the world. This need has led to the development of the Generally Accepted Accounting Practices (GAAP) as a standard guide for use as a basis by all national accounting bodies globally. The use of specific standards is meant to provide a standard measuring that will provide an accepted consistent valuation system to facilitate trading on the international business stage as evidenced by AASB 102 Inventories (2007, p.1). GAAP allows institutions to have a consistent reporting standard, which reflects the financial position of the institution that can be accurately interpreted by other people outside the organisation as well as in different parts of the world. The financial accounting standards board (FASB) regulates accounting and financial rules.
Valuation Methods for Assets and Liabilities
When doing financial reporting, there are standards of value that are acceptable and applicable during reporting. The standards vary due to their implied meaning and that their application must be indicated as part of the notes in the statement so that the user of the report is in a position to understand fully the valuation method used and values in the statement. In the preparation of a financial report, the values of plants, property, and equipment are usually included by virtue of them being assets. In fact, AASB 116 Property, Plant, and Equipment specifies the standard parameters that have to be considered when determining an asset (2007, p.1). The difference however occurs because some assets appreciate over a given period while others depreciate over a given period. Several valuation standards are available for use in reporting the value of assets. However, the standards have advantages as well as disadvantages. Some of the standards include fair value and historic costing.
Fair Value
Fair value is a valuation method that started in the 90s. The Financial Accounting and Standards Board (FASB) is currently implementing it. This method of valuation is based on calculating the value of an asset by giving it a value of the cash it will generate were it to be put on the market. According to AASB Exposure Draft (2011), fair value calculations are based on the fair market value assumptions. Thus, when applied in valuation, it can give the right value of an item for reporting in the financial statement. Ryan (2008) postulates, “the goal of fair value measurement is for firms to estimate as best as possible the prices the positions they currently hold based on the current conditions and information.” (p. 3). Fair value follows the guidance of FAS 157 rules that were issued by the Financial Accounting and Standards Board. Fair value has both advantages and disadvantages as viewed by players in the field of finance.
Advantages of Fair Value
Firstly, it is crucial to point out the benefits of fair value to investors. Financial reporting is meant to give investors (both current and potential) the position of the company in terms of whether its financial position is healthy or not. Therefore, it is prudent that the position of the company be as accurate as possible when the report is being prepared. This strategy enables investors to make informed decisions based on a true picture of the valuations they have at hand. Fair value application saves investors the agony of calculating such values like depreciation.
Fair value valuation provides entities with realistic financial statements that enable them to plan diligently. As Rogerson (2008) states, the advantage of using accurate figures and valuations is that it eliminates chances of using values that might have depreciated a long time ago, which might be giving the entity a false position of its assets and liabilities (p. 934). The fair view valuation method therefore presents to the stakeholders the true financial statement of the organization as it stands. In addition, fair value valuation compels the entity to give out a statement that is as true as the facts on the ground. This provision eliminates the risk of entities manipulating their statements for showing healthy financial positions. It therefore enforces a code of ethics that requires entities to report the true positions of their financial positions.
Disadvantages of fair value
Fair value valuation has been regarded to be a destabilising agent of the market because it does not include an allowance for upward or downward projections. Thus, it can easily lead to panic reactions to situations that are not long term. This kind of reaction can have a domino effect on the market thus leading to an unnecessary instability. Moreover, fair value valuations are deemed to provide false valuations of the assets of an entity. Conditions on the market are known to fluctuate occasionally thus giving entities much lower valuations in relation to they are supposed to be. When the conditions of the market stabilise, the situation is reversed thus depicting the fair value valuation as having been misleading.
Historical costing
Historical costing is a kind of valuation that is based on the value of an asset as of the time it was being purchased. If an entity bought machinery in the year 1998 at a cost of $20000, the balance sheet of the entity will read the cost to be $20000 in the year 2013 as much as the present value of the machinery will have appreciated or depreciated. The use of historic cost means that the entity would dispose the asset at hand at a different price than indicated on the balance sheet.
Advantages of historical costing
Historical costing enables a manager give an accurate cost of an item that the entity owns because other costing methods like fair value might give an item a value that has been influenced by other forces. For instance, calculations for depreciation are standard depending on years. Some items in this case might be old though with still a higher value in relation to what comes out after calculating depreciation. There is no room for manipulation under historic costing. All items are valued with documentary evidence showing their original value. This strategy therefore guards against over valuation or devaluation of an item on the balance sheet. Sometimes assets are overvalued as a way of raising the company’s profile thus misleading the people reading the report.
Disadvantages of historical costing
Historical cost method is misleading to the user of the financial statements produced and any other person who might want to know the value of the company because it gives an illusionary picture of the value of an asset, which might be far from the present value. In the case when an item has drastically depreciated, this method of costing will not indicate the true value thus misleading investors on the same. It tends to overvalue the asset base of an organisation in case of valuation of assets. Historical cost provides misleading operation levels for companies. It values equipment at a price that is much lower compared to the present price. This form of undervaluation leads to the use of misleading operational projections, which can easily lead to misleading targets.
Why Historical cost is commonly used
Historical cost is commonly used due to its stable nature. The use of historical cost is popular because it is not affected by instabilities caused by fluctuations of the market. Thus, according to Rogerson (1998, p. 153), valuation can still be maintained at a reasonable level. Most entities tend to stick to historical costing as a way of reducing some taxes on their assets. Assets such as land tend to appreciate over a period. If this land is not in production yet and its value is calculated at fair value, it would attract more taxes in relation to when it is calculated at historical cost.
Recommendations
My recommendations to the use of historical cost are that it should only be used for specific kinds of assets whose value does not have a sharp appreciation or depreciation rate. Where it has been used, there should be a note indicating the age of the asset and the rate of either appreciation or depreciation.
Conclusion
The use of fair value as well as historical cost should not be viewed as a departure to either of them because preparation of financial statements has a provision for notes to indicate under what criteria the statement was produced. These notes will guide the reader of the statement to deduce the true value of the asset in the statement in the end.
References
AASB 102 Inventories. (2007). Australian Accounting Standards Fact Sheet. Australia: CPA Australia Ltd.
AASB 116 Property, Plant, and Equipment. (2007). Australian Accounting Standards Fact Sheet. Australia: CPA Australia Ltd.
AASB Exposure Draft. (2011). AASB 13 Fair Value Measurement and AASB 2011-8Â Amendments to Australian Accounting Standards arising from AASB 13: Tier 2Â Proposals. Australia: CPA Australia Ltd.
Rogerson, W. (1998). Regulating prices to equal forward looking costs: cost based prices or price based costs? Journal of Regulatory Economics, 14(3), 149-163.
Rogerson, W. (2008). Inter-temporal cost allocation and investment decisions. Journal of political economy, 116(5), 931-950.
Ryan, S. (2008). Fair value accounting: understanding the issues raised by the credit crunch. London: Council of Institutional Investors.