Question

Discuss one perceived benefit of historical cost accounting. How does this perceived benefit relate to the hierarchy of accounting qualities

Discuss one perceived benefit of fair value accounting. How does this perceived benefit relate to the hierarchy of accounting qualities

Describe a situation in which historical cost accounting may be misleading to users of financial statements.

Describe a situation in which fair value accounting may be misleading to users of financial statements.

Answer 1

Historical Cost Accounting

A Historical Cost principle requires that an accounting records to be maintained at the original cost of the asset when acquired by the company. According to this principle all business transactions must be recorded in the books of accounts at their monetary cost of acquisition Tis principle is called historical because the balance of assets and liabilities is carry forward from year to year at its acquisition cost irrespective of increased or decrease in the market value of assets

Part A: Perceived Benefit of Historical Cost Accounting

There ae various benefits of Historical cost accounting such as this valuation approach is reliable verifiable and definite. The below is detailed overview of reliability benefit of Historical Cost Accounting;

• The reliability of accounting information; The use of this concept maintains the reliability of accounting information. The values recorded in the financial statements are not subjective to increases and decreases in the values. The values are easily verifiable by simply referring to the source document such invoice purchase orders sales and/or purchase contracts etc to verify the accuracy of the amounts recorded in the financial statements.

Part B: How does this relate to hierarchy of accounting qualities

• The reliability feature of the historical cost principle provides managers with a reliable, objective data that solely helps in identifying the accurate changes in the organisations performance. Based on the changes in performance suggested by this method can be compared while reporting and measuring economic information. This is the traditional accounting method however this is still more preferred by accounting profess as no other method of accounting can provide accurate information at a glance on the changes in trends in the organisational performance like the historical costs method do.

Part C: A situation in which historical cost accounting may be misleading to users of financial statements;

• As described above that the Historical Cost principle requires that an accounting records to be maintained at the original cost of the asset when acquired by the company, so it does not consider the inflation factor as because of which there would be a rise in prices for an asset an asset purchased at a point in time may be expensive in future. Also, it should be equally considerable that the effect of inflation may not be the same for all the companies in the market and historical cost accounts become almost unhelpful when comparing corporate performance. Therefore, in an economic environment, where the prices are constantly rising the historical cost accounting may be misleading to users of financial statements.

Fair value accounting;

The Fair value account is another alternative approach to measure requires accounting records of changes in assets and liabilities value over the period of time. As per Fair value accounting principle the organisations report their assets and liabilities at estimated prices which expected to be received if they sell the assets or they would pay if their liabilities would alleviate.

Part A: Perceived Benefit of Fair Value Accounting

Accurate valuation; Fair value accounting provides accurate asset and liability valuation on an ongoing basis to users of a organisation reported financial information. When the price of an asset or liability has increased or is expected to increase, the organisation marks up the value of the asset or liability to its current market price in order to reflect what an organisation would receive if it sold the asset or would have to pay to relieve from its liabilities.

Part B: How does this relate to hierarchy of accounting qualities

An accurate valuation makes Fair value accounting as clear concept because when the value of an asset goes up, the company makes an adjustment of the increase, so that it reflects the current market value. Vice versa, when a decrease occurs, the value of the asset or liability is marked down to show the changes in the value. This provides the accounting professionals with an accurate valuation of assets and liabilities at any given point of time.

Part C: A situation in which fair value accounting may be misleading to users of financial statements;

The financial crisis of 2007-2008 is the good example of a situation in which fair value accounting may be misleading to users of financial statements. In 2007-2008 Financial Crisis the organisations and banks were using fair value accounting that caused the increase in performance metrics up until the financial crisis. As organisation’s asset prices were increasing due to the boom in the housing market, the gains calculated using the fair value approach were realized as organisation’s net incomes. However, a rapid decline in the asset prices, which blamed fairly value accounting principle.