Question

Under GAAP, companies may apply various valuation methods in recording transactions and preparing financial statements, for example historical cost, fair market, replacement, depreciated or amortized cost, etc. For each basis in your discussion, cover its definition, describe in general terms when it is proper to use it, and critique the advantages and disadvantages of its use. Address the issue of why we should (or should not) use so many different valuation bases in GAAP. Is it accurate to claim that GAAP is still based on historical cost? should be in essay format

Answer 1

Definitions and use of different Cost Concept

Historical Cost Concept: -

Definition

Recording of transaction based on its original price or purchased price is called Historical Cost Concept.

Use

It is used for accounting and presentation if financial statements.

Advantages of use

1. Easy to use. No need of Market research.
2. Preparation of Financial statement is comparatively fast than other cost methods.
3. Cost and time saver.

Disadvantages of use

1. Does not take care of Inflation.
2. Insufficient provision of depreciation.
3. Unrealistic profit /loss in profit & loss statement.

Fair Market Cost Concept: -

Definition

Cost of which an asset or liability can be measured on the market condition is called Fair Market Cost.

Use

It is used for sale of assets or settlement of disputed dues or liabilities.

Advantages of use

1. Take care of inflation
2. Realistic approach
3. Show true picture to acquire new asset.

Disadvantages of use

1. Time taking
2. Not Easy for everyone.
3. Costly method.

Replacement Cost Concept:-

Definition

Replacement Cost is value at which company may replace its present asset.

Use

It is used by insurance companies to pay claims raised by insurers.

Advantages of use

1. Related with current replacement hence realistic.
2. Show realistic valuation.
3. Good method for decision making.

Disadvantages of use

1. Time consuming
2. Knowledge required.
3. Costly as expertise knowledge is required.

Depreciated or Amortized Cost Concept:-

Definition

Depreciated Cost means Cost which is balance after charging depreciation/ amortization on the subject asset.

Use

Used for valuation of assets, competition assessment

Advantages of use

1. Show current position of company
2. Appropriate to take decision for purchase of assets.
3. Tax benefits to use this method

Disadvantages of use

1. Little complex method as there is various depreciation methods are avaialbe.
2. Knowledge required for implementing.
3. Costly than historical cost method.