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Companies have the choice of a variety of methods to value their assets, and they also have the choice to use different methods for different assets (Haskins, Ferris and Selling, 2000). Historical Cost Accounting is a universally recognized accounting model which is preferred by most businesses, but throughout time several models have been proposed to replace or operate along side with historical cost accounting (Elliot and Elliot, 2008), the three methods that will be discussed in this paper are Historic Cost Accounting (HCA), Current Purchasing Power (CPP) and Fair Value Accounting (FVA).
The traditional Historical Cost Accounting records transactions at their original historical monetary cost, any items or an event that has no monetary transaction is usually ignored. Historic cost accounting takes income into account only when revenue is realised in cash or some form which will soon become cash for every period. The profit is calculated through matching costs of items consumed with the generated revenues of the period. A prudent view is taken to value assets (CIMA, 2007).
To illustrate more and understand the Traditional Historical Cost Accounting, an example will be adopted from CIMA publications paper P8 financial analysis:
''Company A acquires a new machine in 20X4. This machine costs $50,000 and has an estimated useful life of ten years,
Company B acquires an identical machine in 20X5, except that it buys a machine exactly one year old, with an estimated useful life of nine years. The cost of the machine is $48,000.
Depreciation charges (straight-line basis) in 20X5 are as follows:
Company A 1/10*$50,000= $5,000
Company B 1/9*$48,000= $5,333
Net Book values at the end of 20X5 are:
Company A $50,000-(2*, 5000) = $40,000
Company B $48,000-$5,333= $42, 0000''
(CIMA Publications, 2007, Paper P8, Financial analysis Pg. 243)
According to historical cost accounting, even though both companies use the same machine in 20X5, the income statement will show different profit figures, and the statement of financial position will show different Assets figures (CIMA, 2007).
The historical cost accounting is principally an objective accounting system; its nature is easily understood and is always supported by documented evidence, such as invoices. Therefore Historical Accounting is undisputedly verifiable. Furthermore one of the main characteristics of historical cost accounting is that the profit concept used in HCA is generally easy and well understood (Elliot and Elliot, 2008).
Historical cost accounting assumes that assets and liabilities must be measured according to the amount which was given or received (exchanged) during the transaction ( Sutherland and Canwell, 2004), in other words the historical cost accounting depends on recordable facts about prices paid for assets in the past (Nobes and Roberts, 1997). Historical Cost accounting is believed to have huge limitations especially in times of price variations; these limitations include that the reported results may be distorted, in other words they might not reflect the true value because of matching of current revenues with costs incurred earlier. Also Assets value in the balance sheet (Statement of financial position) may not be realistic or up-to-date, and this would cause calculations to measure return on capital employed and similar rations and measurements to be misleading too. Historic cost accounting is believed to reduce the management effectiveness in achieving operational results, because of holding gains or losses that attribute to price level changes is not identified, and because of not recognizing the losses or gains that arise through holding assets of fixed monetary value. Trend performances over time might give a misleading impression, for changes in the real value of money are not considered (Accounting Standards Committee, 1986).
As a result of using historic cost accounting, the value of the non-monetary assets has no relation with its current value, and that reflects poor guide to the resources available for the entity. The historic cost accounting holds gains from showing in the financial statements until the assets are sold, other effects the historic cost accounting have on financial statements is that the out-of-date costs are matched to current revenues, which overstates the profit figure in the income statement, causing return on capital employed and similar measures to be misleading (CIMA, 2007).
Trend information produced from historic cost accounting is usually distorted, because the historic cost accounting fails to consider the changing value of money overtime (CIMA, 2007).
These limitations may provide misleading information for decision makers; in practise businesses have understood the limitations of historic cost information. Therefore other models were adopted, such as the Fair Value accounting, the IASB currently favour fair value over historical cost, but the IASB does not propose a 'full' fair value accounting. The IASB defines the fair value as 'the amount for which an asset could be exchanged, or liability settled, between knowledgeable, willing parties in an arm's length transaction'. (Gregoriou and Gaber, 2006 p.g. 130).
The definition refers to an observable market value, in practise there are a lot of problems in measuring this market value, for in reality the market value is usually limited (Gregoriou and Gaber, 2006). Fair Value accounting have numerous limitations, many assets and liabilities do not have an active market causing the estimation of the fair value more subjective, making the valuation less reliable. Even though the FASB suggests that reliability is greatly enhanced if market inputs are used in valuation, the management still uses judgement in selecting market inputs, reliability continues to be an issue.( Federal Reserve Bulletin, 2005).
Fair Value Accounting relies hugely on the management through the valuation process which add more concerns to the reliability of information. The management bias, that could be intentional or unintentional, causes inappropriate fair value measurement. This caused numerous examples of overvaluation of assets in the recent years. And without reliable fair value estimations, more misstatements in financial statements which are prepared using fair value measurements will be greater (Federal Reserve Bulletin, 2005).
Moreover, assets and financial instruments became more complex nowadays, making it more challenging to verify valuations that are based on observable market values, for many of the values are based on inputs and methods selected by the management, such valuations are more difficult to verify, all financial statement users will need to emphasize on how assets are measured and how reliable these valuations are when making decision based on them (Federal Reserve Bulletin, 2005).
Taking in consideration, fair value accounting is more reliable and verified in evaluating more liquid financial instruments that businesses have more experience in evaluating, but its reliability and verifiability becomes a bigger issue for less liquid assets. Furthermore, sometimes the financial instruments are coupled with an intangible value, and the accounting framework requires different accounting and disclosure treatment for the different components and in the Fair Value Accounting there is a huge lack of guidance in how to separate and measure the different components, causing questionable and inappropriate practises (Federal Reserve Bulletin, 2005).
Fair values usually reflects point estimates causing financial statements to lack transparency, therefore additional disclosures are necessary in order to bring meaning to fair value estimates, enhancing the reliability of the fair values, these additional disclosures gives users of financial statements a better understanding of the relative reliability of fair value estimates, therefore for users to understand the factors that caused the estimates they must be given adequate disclosure about these factors (Federal Reserve Bulletin, 2005).
On the other hand, from the standards setters' perspective, decision relevance is the main aim of financial reporting. A question must be asked whether fair value accounting increases decision usefulness of financial reports, evidence show that value relevance using revaluation is mixed. Therefore mixed models were created, in which some assets are measured at fair value and other are not (Gregoriou and Gaber, 2006).
Revaluation is not self-evident, there are number of advantages for it, such as revaluation is helpful in fending off hostile takeovers, it might enhance the matching expenses with revenues (caused by the subsequent charging of current values instead of historical costs), it also allows for disclosure of the business actual borrowing capacity and the Fair Value Accounting causes more true and fair view for businesses (Gregoriou and Gaber, 2006).
To critically contrast and evaluate historical cost accounting and fair value accounting, we must compare the effects on the financial statements of both, when the company is successful ( has increasing future cash flows) both models causes the earning-based payments to increase, but the Fair Value model has an advantage caused by having a higher equity to debt ratio, but also the market would regard the firm as unsuccessful causing pricing with discount (Gregoriou and Gaber,2006).
One of the principal advantages for the traditional historical cost accounting is that it is objective, all the accounts are based on verifiable facts, not on subjective opinions, other advantage for the historical cost accounting is that it is very easy to apply and understand (CIMA, 2007).
In order to critically compare both models, the following numerical example would be handy:
Presuming that a company purchased a piece of land for £220,000 one year ago. In order to buy an equivalent piece of land it would cost £260,000, and the land can be sold for £310,000 less £20,000 fees to finalize the sale. The land is 13,000 square feet, the average price for every square foot is £21.55. (Stice E, 2008)
According to Historical Cost Accounting, the Land should be recorded at £220,000. A very reliable figure. (Stice E, 2008)
As for Fair Value Accounting, the Land should be recorded at £280,150 ( 21.55*13000), a figure that includes profit . (Stice E, 2008)
Another model of valuing asset is Current purchasing power, the CPP accounts are all set by adjusting the accounts in order to reflect the value of money at a given time, therefore the measurement unit in CPP is the 'CPP unit'. CPP accounts are all set by updating the income statement items and the non-monetary item in the statement of financial position by the CPP factor (CIMA, 2007).
The CPP factor can be calculated using the following formula:
CPP factor= (Index at the balance sheet)/ (Index at date of entry in accounts)
CPP model adjusts the depreciation of asset by reference to the date of acquisition of the related non-current asset item (CIMA, 2007).
As previously mentioned CPP only adjusts non-monetary items in the financial position statement, non-monetary items include assets such as inventory, plant and equipment, monetary items are not adjusted at all using CPP, because their value in CPP units is the same as their monetary value (CIMA,2007).
Because monetary assets lose general purchasing power during inflation, the CPP accounts compute gains or losses from holding monetary items in inflation; this gain or loss is recognized in the income statement (CIMA, 2007).
Current purchasing power accounting relies on a standard index, therefore CPP accounting is simple to apply and objective. Furthermore CPP is an accounting system which adjusts for the changes in the unit of measurement causing it to be a fair and true system of inflation accounting. CPP also measures the actual impact on the business in terms of shareholder's purchasing power (CIMA, 2007).
As mentioned above CPP measures Value by refereeing to a price index system, the price value of the basket (Group of goods and services) is determined at a base point of time and indexed as 100, the later changes in price are compared regularly with the base period price and the change would be recorded. An numerical example will be adopted from Elliot and Elliot (2008) to illustrate:
The Price level of the basket on 31of March 20x1 is £76 and the following changes happened:
'' £76 at March 20x1
£79 at April 20x1
£81 at May 20x1
£84 at June 20x1
The change of price will be indexed with 31 March as the base:
20x1 Calculation Index
31 March £76 100
30 April 79/76*100 103.9
31 May 81/76*100 106.6
30 June 84/76*100 110.5''
(Elliot and Elliot, 2008, Page 61)
On the other hand, when specific and general prices movement differs, the CPP fails to capture the economic substance, in other words CPP does not give relevant information in times when the business is affected by price changes. Information provided by CPP might be unfamiliar to users (the use of CPP unit). Taking in consideration that CPP does not show the current value of assets or liabilities, because it actually values money and not assets, therefore the physical capital of the business in not maintained (CIMA, 2007).
CPP has a high degree of objectivity, for it has the same principle as historical cost based measurements. The adjustments made to price levels can be verified by referencing them to the index used (in order to measure the changes in the purchasing power of the money), resulting in altering historical cost measurement which are objective. Therefore, CPP accounting satisfies both objectivity and verifiability (Glautier and Underdown, 2001).
Some authorities have an objection over CPP accounting, that there is no actual generalized purchasing power, when holding general purchasing power entities do not see themselves as if they were holding money, in other words the purchasing power of money must be linked to the items which the money is intended to be spent on (Glautier and Underdown, 2001).
Because CPP is based on Historic Cost Accounting but adjusted in order to reflect the general movement of prices, therefore it has the Historic Cost Accounting characteristics, both good and bad, along with its values are updated through arithmetic measure of general price changes. Therefore the impact of inflation on the entity income and capital varies according to the rate of inflation affecting the economy. (Elliot and Elliot, 2008)
The CPP balance sheet cannot be assumed as a current value statement, and that is because of all the mentioned reasons earlier, and especially because that the asset value using CPP accounting is subject to different inflation rates than the inflation in the Index (Elliot and Elliot, 2008).