Historical cost accounting, however, is an income statement approach, also called information perspective. Historical cost ignores the amount the asset could be sold for in the open market, called the fair value, until the asset is actually sold. The company carries the asset on the balance sheet at the purchase cost less any depreciation taken. At the time of sale, the company records a gain or a loss against the purchase cost of the asset less any depreciation if applicable.
For example, if Sunny purchased an asset for $5,000 and estimated depreciation expense of $500 per year for 10 years, the cost of the asset after the first year less depreciation is $4,500. If the market value of the asset were $4,800 after year one in the open market, Sunny would not write up the asset after the first year. Rather, the asset would remain at original cost less any depreciation until the asset is sold.
If Sunny sold the asset for $4,800 after year one, Sunny recognizes a realized gain of $300.
Fair value: Fair value accounting or Present value accounting is a balance sheet approach to accounting, also called a measurement perspective. In recent years, international standard setters and regulators such as the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have begun to favor the use of fair value accounting over historical cost accounting in financial reporting. A key reason for this shift in methodology is to improve the relevancy of the information contained in financial reports. The general principle underlying the shift is that up-to-date information improves investors' and regulators' abilities to make informed decisions.
Historical Cost and Fair Value Accounting: Relevance and Reliability Revisited
The historical cost principle follows the accounting quality of reliability since everyone can agree on the original purchase price of an asset. However, the historical price is not necessarily relevant information. Land that was purchased 20 years ago could be worth much more than the balance sheet shows. Likewise a building purchased many years ago and recorded on the balance sheet at the original cost does not reflect the current market price.
For this reason, many accountants and users of financial statements argue that the market price, or fair value should be used when reporting financial information. The fair value is more relevant, but is not necessarily reliable
More fundamentally, historical cost accounting is a way to “smooth out” current period cash flows into a measure of the longer run or persistent earning power that is implied by those cash flows. Too smooth out of cash flows, the accountant has to calculate accruals, that is, to much costs and revenues. At this point historical cost accounting faces a major challenge. Because of, without historical cost accounting usually there is no unique way to match costs with revenues.
Proponents of historical cost accounting believe that this method is superior to market valuation for several reasons. One of the main reasons proponents favor this method is because they believe that it is more reliable. They believe it is more reliable because it is based on transactions that have already occurred, are verifiable and free from management bias. The opportunity for manipulation of asset values by management is a major concern of those who do not approve of the market valuation of company assets.
Those persons who believe market valuation (Fair value or Present value) is the best method of accounting cite many valid reasons for this belief. Proponents of market valuation argue that because historical cost valuation can include data that is up 10 years old, this data does not provide the most relevant information to investors. They also argue that historical accounting methods do not take into account the possibility that an asset's value may actually be higher or lower than what is reported on company books.
Reference:
Financial Accounting Theory-Third Edition by William R. Scott
http://business-accounting-guides.com/historical-cost/
http://www.ehow.com/info_7948456_market-value-vs-historical-cost.html
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