What is Historical Costing – Fair Value Vs Historical Costing
Under the historical cost concept assets are valued under their original cost under globally accepted accounting principles which also known as GAAP. If your company purchases bought an asset at 10000$ cost ten such asset will be recorded into your accounting box by original price or by purchased price. For example we bought a piece of land for our company and we know that the price of company appreciates with the passage of time but according to historical cost concept we don’t even recognize the rise and fall in the price of the land. Along with some disadvantages there are plenty of benefits too for using historical cost concept. In historical cost concept maintains the objectivity of accounting information. The amounts in our financial system are not gets clouded with subjective increases and decreases with the passage of time so usage of financial records remains easy and understandable for its users. There is no roam for data manipulation in historical cost concept and it is almost impossible for the accountants to manipulate the data of financial statements when historical cost system is applied on financial statements. This is because there are always objective bases of recording business transactions. Historical cost concept also increases the reliability the of accounting information and reported amounts are easily verifiable. We can just simple go back to the source documents of business transactions for example for invoices, official receipts, contracts and work orders. The process to verify the accuracy of reported amounts in your financial statements is simple and convenient. This concept is very simple as transactions are recorded on their original amount and we don’t have to restate them every year.
The consistency and comparability also become very easy when we use historical cost principle as we don’t change financial statements under this method so it is easy to compare current accounting statements with previous accounting periods. It is one of the four basic accounting principle valuations of assets at historical saves us from over valuation of assets when the market is volatile and over valuation can be due to this volatility. Normally historical cost represents that it is purchase price of asset but it includes every cost which company has incurred to make that asset to be in operational condition. Assume that a specific company just purchased a new machine for 20000$ and then they payed 2000$ for delivery of that machine to their warehouse and then 3000$ for installation of newly purchased machine. Now as we can see that originally the price of machine was 20000$ but they had to bear an extra of 5000$ in delivery and installation charges. Company will incur 25000$ cost according to historic cost concept because they will have to include the cost which incurred bring machine into working condition. Most of the time historical cost does not show current fair value of the asset. For example a company has purchased a factory for 50000$ 50 years ago and then after some time this asset is totally depreciated in company’s books of accounts but the factory is still sitting on the valuable land which has been completely written of books.
Disadvantages of Historical costing
Since in historic cost system we use figures from time of acquisition so it is impossible that they show current fair value . This is most likely that the current value of assets will not be realistic.
Overstatement of figures
It is very likely that under historic costing system the assets can be overvalued.
Comparisons over time
Comparisons over time become very hard and sometimes impossible under historic costing system.
Depreciation charge can be u realistically low under historical costing system
The value of non-current assets can be out dated in very quick period of time.
Misleading Operational Levels
Under historic costing operational level of organization don’t represent exact and fair situation.
Advantages of Historical costing
Cost is known
Under historic costing costs of assets, contracts and invoices can be traced very easily
The volatility of pricing goes down under historic costing system. In this way stability in pricings increases .
Since assets are recorded on their original costs so it is easy to compare costs of different period financial statements under historic costing system.
Easy and cheap valuation Method
Historical costing is easier and cheap in cost method for valuation of assets as compared to other methods of valuation.
Since historical costing uses objective system so risk of manipulation in data is very less and impossible in some cases .
As we can see that by using historical cost system there can be many discrepancies and many complications can arise so this situation cause a need for other valuation methods. So the other important and widely used valuation method is market to market or fair value method.
Fair Value Method
There are many accounting approaches that many businesses can use according to their policies. Fair value is one of them in which valuation of assets and liabilities is done on the bases of market value. Valuation is done on fair market prices. But like any other accounting method fair value method also have its pros and cons.
Provides an accurate valuation
The biggest benefit of fair value method is that it provides an accurate valuation of assets and liabilities. When prices goes up in real market or goes down then it will have effect on the balances of financial statements. It helps business owners and stakeholder that where actually a specific business or a company stands right now and what is its actual market value.
Measurement of true income
Same like historical costing it is hard to manipulate the accounting data in fair value method. Measurement of income is way easy in fair value method.
Survival in a difficult economy
In difficult economic situations fair value method can be survival for economy.
Most agreed standard of accounting
In historical costing after passage of time valuation does not remain accurate but this is not the case in fair value method so it is most agreed upon standard of accounting.
Disadvantages of fair value method
a lot of times investors does not understand that company is using fair value method due to which net income drops and it creates dissatisfaction in investors.
The historical perspective of assets and liabilities can barely be noticed in fair value method.
Selection of appropriate accounting method for organization can be a trick task because every accounting method has its merit s and demerits. In this article we made comparisons of historical cost and fair value cost. Historical cost is easy and simple to use for accountants but it create many complications as it does not show fair value of assets and liabilities. Fair value method also creates some issue in subjectivity and complexity but overall it is way better then historic cost as t shows fair value of assets and liabilities and they never get over valued or under valued . in a nutshell we will say that fair value accounting method is superior then historic cost account treatment.