Question

Measurement is one of the most controversial and sensitive issue in accounting.fair value and historical cost are both extensively used in accounting practice.discuss and evaluate these two different measurement approaches.

Answer 1

Measurement principle is a fundamental accounting principle that is important in determining the value of an asset. There are two measurement principles - i) Historical Cost principle, and ii) Fair Value principle.

i) Historical Cost principle: According to this principle, a company should record its assets at the prices at which they were acquired or purchased. Under this principle, the company does not record the current price of the assets. For example, ABC Ltd. purchased an asset in 2006 at $1000. The price of the asset has increased over the years and has now become $20,000 in 2020. But now the company will record the asset at $1000 and not $20,000.

ii) Fair Value Principle: According to this principle, a company records the assets at their current prices ignoring the prices at which they were bought by the company. For example, XYZ Ltd. company purchased an asset in the year 2000 at $3000 but now the current price of the asset has become $50,000. The company would now record the asset at $50,000 and not $3000.

When a company records the assets at historical prices it may not show a true and accurate representation of the financial statements if the assets were purchased long ago (assume more than 20 years) and their prices have increased to a great extent now. But if there is continuous fluctuation in the price of the assets, it is advisable to follow historical cost principle because in this case, recording at current prices would not be relevant. For example, an asset was acquired at $2000 in 2018. In 2019 its price becomes $3000 and in 2020 it becomes $500. Then the company should record the asset at $2000 and not $500.