According to FASB, the fair or current value is the estimate of the price of an asset or liability if exchanged in arm’s length transaction motivated by normal business considerations. Under current value accounting, entities are required to value and report assets held for sale at their fair values rather than at historical costs as in the historical cost accounting (Schroeder, Clark and Cathey). The current value is more relevant than the historical cost. Firstly, it provides more relevant information about assets and liabilities than the historical cost approach. For assets held for sale, fair value accounting indicates the amount the entity would receive if the asset is sold on the date of reporting. The information is more relevant as it gives a more accurate value of the asset than the historical cost approach. It presents information about the current market conditions thus provides a better basis for forming expectations than the historical cost approach.
The current value is also a clear concept. It is simply the value an entity can get by selling an asset or pay for settling a liability on the reporting date. If market prices of an asset held for sale increases, the valuation of the asset will also rise. Some historical cost concepts are not clear. For instance, determination depreciation and amortization of involves assumptions, some of which are not clear enough.
Fair value accounting is also more transparent than the historical cost accounting. When an asset is valued based on the prevailing price in a liquid market, limited assumptions are made making the approach more transparent (Schroeder, Clark and Cathey). When the prices of an asset are falling in the market, the information is out in the open hence no entity can manipulate its asset and liability values by sweeping the information under the carpet. Without adequate transparency, entities may not revalue their assets held for sale when their market prices fall in the hope that their prices will improve in future. Historical cost accounting involves several assumptions such as the impairment of assets. These assumptions are not made in a transparent manner and are at the discretion of the accountant and the entity involved.
The current value also gives more information about the market conditions than the historical cost (Schroeder, Clark and Cathey). Several participants in the market influence the prices of assets. In most cases, the prices of financial assets as a result of the interaction between buyers (demand) and sellers (supply). On the other hand, the historical cost is only determined by a single entity. Similar assets may have different historical costs owing the cost of purchase, depreciation, amortization, among other factors. Each entity has a depreciation policy that may vary from those of other entities. Thus, the reporting entity is the sole determinant of the value of an asset under historical cost accounting.
Besides, current value accounting is more appropriate for valuing and reporting derivative contracts. The value of derivative instruments changes depending on the changes in market conditions such as interest rates, exchange rates. Sometimes, the values fall to zero or close to zero. Current value accounting reports such changes, unlike the historical cost accounting which ignores derivative instruments whose values are zero or close to zero.
Current value accounting also reduces earnings management by entities. Market price changes are reflected in asset values whether they are sold or not. In historical cost accounting, an entity can engage in earnings management be selectively selling assets whose prices have risen.
Works cited
Schroeder, Richard G., Myrtle W. Clark, and Jack M. Cathey. Financial Accounting Theory And Analysis: Text And Cases. 11th ed. New York: Wiley Global Education, 2013. Print.
