Question

Accounting involves a lot of trade-offs. List the two main options under the measurement principle and briefly discuss the trade-offs between the two options. ( i.e, historical cost and fair value)

Answer 1

Historical cost accounting and fair value, accounting are two methods used to record the price or value of an asset. Both these methods have their advantages and disadvantages which are discussed below

1.Historical cost - Historical cost accounting is an accounting method in which the assets listed on a company's financial statements are recorded based on the price at which the assets were purchased. This method is based on a company's past transactions and is conservative, easier to calculate and reliable. However, the historical cost of an asset may not be relevant. For example, if a company purchased a building 60 years ago, the market value of the building could be worth a lot more than the balance sheet indicates. Hence, when this method is very easy and reliable, sometimes the value does not reflect the true picture of the asset or liability making this method unreliable.

2.Fair value – This is also known as mark to market method. Under fair value method of accounting, recording is done at the current market price of an asset or liability on companies' financial statements. Fair value accounting is a financial accounting approach that companies use to report their assets and liabilities at estimated prices, which they would receive if they were to sell the assets or the liabilities they would pay if they were to be alleviated of their liabilities. Mark-to-market accounting aims to make financial accounting information more accurate and relevant. However, this can be a problem is market prices fluctuate a great deal. Hence, in this method, when there is a big fluctuation in the market, it is very difficult for the Company to handle this. For example, during 2007-08 recession, when there was a rapid decline in the asset prices, it became very difficult to handle such situation as that resulted in huge losses for the companies. When an unpredictable fluctuation in prices occurs, mark-to-market accounting proves to be inaccurate. Unlike mark to market, with historical cost accounting the costs remain the same and may have been helpful during the financial crisis.
Hence, in my opinion, both the methods have their advantages and disadvantages. However, if I were to choose one method, then I would choose fair value method because of the reason that it shows the correct picture and which is the ultimate objective (i.e. true and fair representation of financial statements.) of presenting the financial statements to the shareholders.