Question

Explain the concepts of historical accounting principle and the current value accounting principle, what are the two measurements for current value accounting, and compare these two principles regarding their decision usefulness for investors.

Answer 1

Historical cost measures the value of the original cost of an asset, whereas current value accounting principle measures the current market value of the asset.

Measurement Principle

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. Under generally accepted accounting principles (GAAP) in the United States, the historical cost principle accounts for the assets on a company's balance sheet based on the amount of capital spent to buy the asset. 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 land 25 years ago, the market value of the building could be worth a lot more than the balance sheet indicates.

For example, suppose company ABC bought multiple properties in New York City 65 years ago for $50,000. Under historical accounting, the cost of the properties recorded on the balance sheet is $50,000. However, a real estate appraiser inspects all of the properties and concludes that the expected market value is $50 million. Due to this discrepancy, some practitioners record assets on a mark-to-market, or fair value, basis when reporting financial statements.

Current value accounting records 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.

For example, under historical accounting, company xyz records its assets located in New York City at a value of $50,000. However, under market-to-market, or fair value, accounting, the assets are recorded as $50 million on its balance sheet.

The problems of fair value accounting were exposed during the 2007-2008 financial crisis. Companies and banks were using fair value accounting, which caused the increase in performance metrics up until the financial crisis. As companies' asset prices were increasing due to the boom in the housing market, the gains calculated using the fair value approach were realized as companies' net incomes. However, there was a rapid decline in the asset prices, and mark-to-market accounting was to blame. 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.

Decision of investors

under the historical cost concept of actual value of orginsation is not known to investors as it shows the historical cost of its assets in the books of account and in case of current value accouting it shows the fair value of asset in financial statement asd represents true value of the organisation.