According to GAAP, assets and liabilities have been recording through historical cost accounting: a system where assets and liabilities are recorded and presented at the monetary amount paid or the consideration given at the time of their acquisition. But it possess some strong flaws in context of the contemporary business environment which have made accounting bodies, especially FASB & IASB, to search for a number of alternative accounting methods. One of these alternatives is market or fair value accounting that has been thinking as the best alternative to the historical cost accounting. The market value of an asset (liability) is the amount at which that asset (liability) could be bought or sold (incurred or settled) in a current transaction between willing parties.
As historical cost accounting is based on actual transactions, the recorded amounts are reliable and verifiable and free from management bias. Historical cost accounting leads to absolute certainty and it fits in perfectly with the cash flow statement. It tells exactly what has been paid or received and therefore there is no doubt about balance sheet amounts.
Historical cost helps the managers to forecast future operational cost based on past data. Without knowing the original cost, future projections are almost hampered. Under historical cost accounting, there is no scope for manipulation, because the data is supported by sufficient evidences such as: invoices, receipts etc.
However historical costs do have their own limitations. Intangible assets acquired outside of business combination (internally generated) are not reported in historical financial statements. Reliable forecast of the future income effects of a financial instrument is unlikely to be possible from the simple extrapolation of past gain and losses based on historical cost.
Proponents of market value accounting argues that this measurement is more relevant than historical cost as it provides up-to-date information consistent with market and as it takes into account the inflationary adjustment to the acquired cost. Critics have argued that this method increases volatility and thus reduces stock price. But its proponents contend that market value reveals economic realities that are hidden by historical cost accounting. The patrons of market value accounting have been continuing their supports to it for its following advantages:
Market value measurement is more relevant to investors and creditors as it reflects the current market price of an asset or liability. It provides more transparency to users. Measurement of financial assets and liabilities at market value in the balance sheet should better capture an entity’s exposure to risk and increase its visibility in the balance sheet.
The market value dissenters argue that the information provided by market value financial statements is unreliable; because it is not based on arm’s length transactions & there is a huge possibility for management to manipulate the bottom line. They contend that if the information is unreliable, it should not be used to make financial decisions.
Some critics are concerned that the precipitous adoption of market value accounting will have adverse effect on both banks and the financial system as a whole. These critics believe that earnings based on market values for investment securities are likely to be more volatile than those based on historical cost.
Market values are basically based on unverifiable subjective estimates of managers. When quoted market price for an asset or liability is not available, market value is measured based on an estimate by using the best information and techniques available in the circumstances.
Although historical cost accounting has some distinguishing features for which its patrons think it better method for measuring assets and liabilities, it can’t provide relevant information to investors. Market value accounting can able to eliminate this limitation by providing current and inflation adjusted information to investors. Therefore, market value is the best alternative to historical cost. But there are also several significant problems within market value accounting in its current application which make more users reluctant to use market value in measuring assets and liabilities.
As investors are the major users of financial statements, priority should be given to their wants, that is, which measurement they prefer- historical cost or market value. Empirical evidences show that investors want both measurements. They want reliable and transparent market value information to determine the actual value of their investment. They also want historical cost information that helps them to determine whether management has discharged the stewardship entrusted to them. Therefore, assets and liabilities should be measured and reported at market value and these measurements must be reliable, verifiable &transparent and these measurements should not be at the cost of abandoning historical cost information.
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