The Traditional Historical Cost Measurement System Accounting Essay
This essay will be concerned with discussing the notion which suggests that that the field of accounting is currently undergoing a truly revolutionary change at the moment, as a result of the fact that there have been some important national and international moves to replace the traditional historical cost measurement system with a system based on current market values. This essay will thus be seeking to describe the nature of this change in systems and would be looking to assess whether the changes which have taken place amount to a revolution. Furthermore, an opinion will be given as to whether the change will most likely gather some momentum which would mean that the current market values measurement system would become the mainstream system. Furthermore, the essay will also be providing an opinion as to whether the change is a desirable one. On the whole, it was found that the changes can be described as a revolutionary change. Furthermore, it is thought that the change would find it very difficult to gain momentum. In addition to this, it can also be said that the change cannot be described as being wholly desirable. There however is still a good chance that the switch from historical cost accounting to current market value measurements is likely to gain some momentum but this will not be any time in the near future. As a matter of opinion, the change is one which should not be endorsed.
In terms of the structure of this essay, the first section following this introduction will be the literature review where 3 academic journals on the subject matter will be critically reviewed. This will be followed by the analysis section where some new stories from the media will be used to back up the final points of arguments that will be presented in this essay.
Under the GAAP system of accounting, assets and liabilities are recorded via historical cost accounting which is a system where assets and liabilities are given at a monetary amount that has been expended or the consideration relinquished at the time the assets or liabilities were acquired. It is clear that in the world of accounting, this historical method of cost accounting has been the traditional way of recording transactions. However, in today's modern business environment, some of the main drawbacks which are linked to historical cost of accounting have become more amplified and as a result, some bodies in the accounting work have been calling for a change. In other words, they have been promoting the introduction of an alternative system of cost accounting which will be based on current market values rather than on historical costs (Shim 1998, p 33).
It should be highlighted that some of these organizations which have been pushing forward this change include the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). In particular, these two organizations have been putting forward the market fair value accounting method which they say is the best replacement for the historical cost accounting method. In the light of this information, it can be thus said that there is some degree of validity to the notion which suggest that moves have been made to bring about change in the world of accounting in regards to moving from historical cost accounting to a current market value system of costing. However, based on this information, it can be said that that the change is revolutionary one since it is completely different from the the principles behind the historical accounting costing methodology (Whiteley 2005, p 21).
At this point, it is worth providing a definition of what is meant by the market value of an asset. The market value of an asset can be described as or liability as the case may is the sum of money which the asset or liability in question can be purchased or sold in a transaction between two agents in the present period. The main argument which have been put forward by the proponents of a current market measurement system in accounting stems from the fact that they believe that investors are most interested in determining the present value of an asset today rather than what value the asset was when it was bought yesterday for instance. It should also be pointed out that there are those which do not support this move towards a current market value measurement in accounting and this means that any revolutionary change as it were, cannot gain substantial momentum because of the opposition being faced by the proponents of a current market value system. It should also be mentioned that because of this opposition, it is perhaps more difficult to say that the change will eventually gather some momentum. Before it can in fact gather momentum, some of the opposition currently faced by the proponents of a current market value system will need to subside significantly (Whiteley 2005, p 27).
Another important point which needs to be made in this matter stems from the fact that both sides, in other words, those who are proponents of historical cost accounting and those who favor the current market value system each point out the flaws in the other system and this in turn means that the debate between the two factions is a continuous one and is not one that is likely to end soon (Sherer 1997, p 67). This fact further buttresses the point that the move from historical cost accounting is not likely to gain any real momentum anytime in the near future. It is clear that those of favor the historical cost accounting method state that the flaws of the current market value system make it inappropriate whilst those who propose the current market value system state that the modern business environment is one which is very complex in nature and as such, using historical cost accounting would be inappropriate (Shim 1998, p 33).
According to the proponents of historical accounting who admit that it does have it flaws, historical accounting does have some exceptional characteristics and conventions which makes it very much useful in today's business environment. Some of these merits that can be associated with the historical accounting methods include that: historical costs accounting is based on actual transactions that have taken place at some point in time, hence, it is free from all forms of managerial bias and will thus provide the most accurate picture in regards to the amounts it records. Furthermore, another main merit of the historical cost accounting method emanates from the fact that there is complete certainty linked to historical accounting and it is also very complementary to the cash flow statement in general. This in turn means that it gives reliability to balance sheet accounts as it records exactly what has been accrued and what has been incurred (Shim 1998, p 36).
Furthermore, another merit which has been put forward in favor of the historical cost accounting method relates to the fact that its proponents suggest that it is very useful when it comes to helping managers make forecasts on operational costs based on historical data. In addition to this, historical costs accounting tends to limit the occurrence of accounting malpractice or outright fraudulent activity since it is often backed by concrete evidence such as invoices and receipts. Finally, in the vase of fixed interest debt. Historical cost accounting quantifies the financial instruments over its life span in terms of its issuance yield all the way to its maturity despite any market fluctuations that may occur during the time period. As such, this steady yield to maturity methodology is one which gives rise to a streamlined and predictable interest cost or return value as well as valuation and this is very much desirable in the case of fixed interest debt (Ramanna 2007, p89)
In the light of the aforementioned merits of historical cost accounting, it can thus be said that the change towards a current market value system will certainly face tremendous challenges before it can gain any significant momentum, it is also because of these merits of historical cost accounting that it can be said that the change towards current market value measurement has not been a rapid and upward moving one, but rather a somewhat stagnant and slow moving change. Besides the merits which can be associated with current market value accounting, what has really lead towards the push for current market measurement as a replacement for historical cost accounting has been the flaws associated with historical cost accounting. Some of these flaws include the fact that historical cost accounts could include transactions which are very much dated and as such, the balance sheet would not be depicting values which are true and fair. It has also been argued by the proponents of current market value measurement that historical accounting is rather limited in its scope since it places all its attention on cost allocation and none of the value of an asset. This in turn leads to a situation where it completely ignores that fact that the current value of an asset may be more or less than what has been disclosed after taking into account depreciation of course. Another problem which has been brought forward in regards to historical cost accounting relates to the fact that it does not take in to account inflation pressures within the economy (Ramanna 2007, p89).
The approach wrongly assumes that the the price of a good will remain constant over a period of time, when it actual fact the purchasing power of assets may diminish if their price should rise due to inflation (PriceWaterHouseCoopers 2006, p 3). This in turn could have some ramifications on the tax bill which firms incur since during times when inflation is on the rise, profits are inflated and tax payments will be higher. Furthermore, another key limitation of historical cost accounting relates to the fact that the information which it reports is somewhat limited since it ignores intangible asset acquisitions which are not generated within an organization (Ramanna 2007, p 90).
However, one of the main arguments which has been put forward against the current market value approach relates to the fact that it is based on the rather subjective approximations of managers which cannot be guaranteed to be accurate. This could have some agency cost ramifications attached to it since managers could use this to their advantage in order extract higher rents where possible (Cosserat 2008, p 34). The market value approach also takes in to full account all the economic realities which are affecting business, especially inflationary pressures. Moreover, the approach is one which also affords more transparency which in turn benefits both regulators and investors since it can foster more market discipline on the part of companies. On the whole, the approach is also useful for investors when making their decisions since current market values of assets helps them to correctly assess the risk-benefit characteristics of any asset they are looking to invest in Furthermore, in relation this point, it is quite clear that market value reflect the future expectations of the income which any asset would generate and this further aids in investor decisions (Ramanna 2007, p 89).
It should be mentioned first of all that the use of current market value approach may not be ideal in today's current market climate because of the recent financial scandals which have enveloped some of the most prominent companies operating today. Furthermore, those who oppose this method of cost accounting suggest that when it comes to measuring appreciation this approach cannot be considered to be accurate. This is despite the fact that it may be suitable for measuring the impairment of assets. In the light of these arguments, it can be seen the perhaps the switch to the current market approach may not be exactly a wholly desirable replacement for the historical cost accounting approach.
It can be said that to some level, the push towards the market value approach can be said to have been halted somewhat in the wake of recent corporate financial scandals which have tarnished the business world in recent times. One of the more prominent examples of such cases is in regards to the Enron-Andersen debacle which occurred in 2001 the scandal came about as a result of an overestimation of the profits of a company by its top executives in order to raise the market value of the company in the eyes of investors in the stock market. Specifically, the company stated that its value was around $80 billion when in fact the company was financially bankrupt. So the situation here was whilst the company was making some huge losses it was fraudulently over-estimating the profits of the company. It can thus be said that if historical cost accounting had been used in this instance, such occurrences may not have happened. As mentioned earlier on in the essay, the main advantages which the current market approach has over the historical market approach is mainly to do with the fact that it aids in investor decisions. However, the Enron-Andersen debacle nullifies these advantages (Dogget 2002).
It can be said that on the whole, there are certainly some merits which the current market approach has over the historical costing approach, however, it can be said that the bulk of these advantages are mainly to do with aiding investors in making the right decisions in terms of whether or not invest within a particular company. In the light of this, it is quite clear that the current market value approach may not be wholly a desirable methodology in place of the historical method. Furthermore, it is quite clear that on the whole the merits which the historical approach has in general are more diverse and more comprehensive in nature than those of the market value approach. Albeit, in the light of these, it is pretty clear that there is not likely to be a complete move towards the market value method any time in the near future. It was also clear at the time that the ramifications of the scandal were extensive since it was an international scale. This point can be buttressed by the fact that investors lost $11 billion (Dogget 2002)
Another example which can be cited is the case of Halliburton which took place in 2002. In this scandal, the company was charging its customers of cost overruns even before they had correctly accounted for these cost overruns and informed the cost overruns and agreed to pay for them. The most important point here in regards to this scandal is the fact that the company was recording these cost overruns as additional revenues even before they were realized. This meant that the company was making some estimation about its financial performance rather than valuing its performance based actual revenues received. As soon as the Securities Exchange Commission (SEC) announced its investigation in to matter, the value of the company's plummeted by a significant degree. It can be said that this accounting approach is somewhat within the 'spirit' of a current market value approach where the valuation of costs and revenues are estimated to some degree. From this perspective as shown by the case also, it can be said that current market approach is more desirable than the historical cost accounting method (Findarticles 2002).
Based on these empirical examples and scandals as highlighted above, it can be said that there is some ground that can be attached to the idea that the historical cost accounting method does not need to be replaced by another system, especially if this system is to be the current market value approach. However, these flaws of the historical cost approach coupled with the merits of the current market value approach do make a case for the current market value approach. Some of the merits of the market value approach which can be summed up in the fact that the approach is a more up-to-date approach and this makes it suitable for the business environment today is one which has not be noticed as far as some of these economic scandals highlighted are concerned. There is no doubt that the economic environment is one which is becoming more volatile and fast-changing in nature as can be seen from the economic debacles which were noted earlier on in this section.. As such, it can be argued that a substantial degree of the volatility and unpredictability of the markets stems from the rise in such incidences which are all created as a result of human action. Therefore, under such circumstances, it is quite difficult to see how a market value approach would be able to make markets more stable and well governed in this regard since a substantial degree of human intuition and estimations are used when it comes to the market value approach. On the contrary, it can thus be said that the approach which is more likely to hinder such economic debacles from occurring in the future is the historical costing method since this approach is one that can be described as being evidence-based.
It is quite clear that both of these approaches have their flaws, but it is difficult to see how the market value approach would be much better than the historical cost accounting method given the empirical issues raise via the economic scandals that have been discussed.
In conclusion, it can be said that there is certainly some change being taken place in the accounting field in terms of moving away from historical cost accounting to market value approach. It can also be said that the change itself is somewhat or a radical one. However, it can be said that this change is not moving at a tremendous pace because they are opposing sides involved which all place their postulate their pros of their favored approach and the cons of the alternative approach. In the light of the pro and cons of both approaches as well as the empirical cases which have been analyzed during the course of the essay, it cannot be said that the market value approach is clearly a more desirable approach than the historical costing method. Therefore, in the light of all this, the opinion which can be given here is that the change from the historical market approach to the current market value approach is not one that should take place at least, not at the present time. However, it can be said that the most likely case scenario that will happen in future is that a complete shift will eventually be made from the historical costing approach to the market value approach. This is likely to take place in the coming years especially if market become more unpredictable and the circumstances which companies face become more dependent on what goes on in international money markets.
Bibliography & Reference:
Shim, Eunsup & Larkin, Joseph M. (1998), Towards Relevancy in Financial Reporting: Mark-to-Market Accounting, Journal of Applied Business Research, Laramie: Vol. 14, Iss. 2; pg. 33-8
Dogget, J (2002) The Enron-Andersen debacle, retrieved from: http://www.worldnetdaily.com/index.php?pageId=12437 on 25th July 2010
Whitley, J.(2005), Internal Auditing's Role in Corporate Governance, Oct2005, Vol. 62 Issue 5, p21-32
Findarticles (2002) retrieved from : http://findarticles.com/p/articles/mi_qn4182/is_20020530/ai_n10152653/ on 25th July 2010
Ramanna, Karthik & Watts. Rossl (2007), Evidence on the Effects of Unverifiable Fair Value Accounting, Harvard business school: working knowledge, p 89-90
PriceWaterHouseCoopers (2006) Financial reporting in Hyperinflationary environments: Understanding IAS 29, PriceWaterhouseCoopers, p 3-4
Cosserat, G (2008) Modern Auditing, John Wiley & Sons, p 34
Sherer, M and Turley, S(1997) Current Issues in Auditing, Chapman, p 67
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