Question

1. Differentiate historical cost concept from the fair value cost concept of measurement. State clearly their advantages and disadvantages.

Answer 1

The key differences between Historical Cost vs Fair Value are as follows –

• Historical cost is the transaction price or the acquisition price at which asset was acquired or transaction was done, while Fair value is the market price that asset can fetch from the counterparty.
• As per Indian GAAP, we are following historical based accounting. However, IFRS, requires fair value based accounting.
• Depreciation on the fixed asset is getting calculated on historical cost while Impairment on the assets is getting derived based on their fair value.
• Professionals are needed for the fair value derivation while even Layman can derive the historical cost.
• In the Balance sheet, Property plant and equipment (PP&E) are to be disclosed at Historical cost while Financial Instruments are to be disclosed at fair value.
• Historical cost derivation is easy and majorly readily available, while fair value calculation is highly complex and requires technical and niche skills.
• Historical Cost calculation does not require any assumptions however Fair value calculation itself is dependent on the various assumptions and various methods of calculation
• One of the Financial statement utility is using the same for comparison. Historical cost-based accounting will not give a better comparison as there can be different methods of depreciation, inventory recording etc. However, Fair value based accounting helps better comparability.

Advantages of Historical Cost Concept

1) It is easy to use and simple to apply as it is not required to reference to market values. They can just record down the original cost of the financial items in financial reports.

2) The financial reports can certainly be prepared more speedily and easily than using other bases of measurement, which are current replacement cost, current market value and net realizable value, so it can contributes to cost savings and time savings.

3) Historical cost accounting concept is easy to understand. users can easily understood and interpret financial reports well even though they do not have any financial background.

4) Thirdly, Historical cost accounting concept is objective, verifiable and reliable. Since the historical cost is record based upon original amount paid, hence the original cost of the assets can confirmed through an original invoice or receipt.

5) Historical cost accounting concept also enables to keep track of their assets. Because the financial items are recorded in financial reporting based on the original cost of the items, therefore the users can compare the current cost and the original cost of the assets.

Disadvantages of Historical Cost Concept

1) Historical cost accounting concept is fixed, Thus, it does not take inflation or changing prices into the account. During the inflation period, the price of the assets is different from changing a lots, it reflects large difference between original price and current price, so it does not seem sensible to record the value of assets by using the historical cost accounting concept when facing changing price.

2) Historical cost accounting concept does not show the true value of company’s assets. It recorded all the assets at the price at the date they are acquired. It is unrealistic fixed assets values, which mean the balance sheet value of the financial assets are differ from the true value.

3) historical cost accounting concept is lead to the insufficient provision of depreciation. The provision of depreciation which is charged on the original cost will not be sufficient for the replacement of the assets.

Advantages of Fair Cost Method

1) A primary advantage of fair value accounting is that it provides accurate asset and liability valuation on an ongoing basis to users of the company's reported financial information.

2) Fair value accounting limits a company’s ability to potentially manipulate its reported net income.

Disadvantages of Fair cost method

1) Fair value accounting can also present challenges to companies and users of reported financial information.

2) The use of fair value accounting may further affect a down market adversely.