IS MARKET VALUE THE BEST ALTERNATIVE TO HISTORICAL COST? By: Md.

Abdul Ahad, Id: 9061 MBA, 9 Batch, Dept. of Accounting & I.S, University of Dhaka, Bangladesh ahad9061@gmail.com
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INTRODUCTION According to GAAP, assets and liabilities have been recording through historical cost accounting: a system where assets and liabilities are recorded and presented at the monetary amount paid or the consideration given at the time of their acquisition. This is so conventional method that people are familiar working with it. But it possess some strong flaws in context of the contemporary business environment which have madeaccounting bodies, especially FASB & IASB, to search for a number of alternative accounting methods. One of these alternatives is market (fair) value accounting that has been thinking as the best alternative to the historical cost accounting. The market value of an asset (liability) is the amount at which that asset (liability) could be bought or sold (incurred or settled) in a current transaction between willing parties. The strongest argument for a move to market value accounting is that investors need to know what an asset is currently worth is rather than is worth when it was acquired. However, the supporters of historical cost have strongly disagreed with this movement to market value accounting. Therefore, there is an ongoing debate between historical cost and market value accounting. This paper explores the arguments for and against historical cost and market value; and tries to find out whether market value is superior to historical cost.

PROS & CONS OF HISTORICAL COST ACCOUNTING AND MARKET VALUE ACCOUNTING The debate between historical cost & market value accounting is ongoing and will not end soon. Because patrons of historical cost accounting contend that it is a best measure than market value accounting by identifying the flaws of market value. In contrast, proponents of market value accounting argue that historical cost accounting is meaningless in todays complex business environment due to its several significant limitations and they think that market value is the best approach to replace traditional historical cost accounting.

ARGUMENTS FOR HISTORICAL COST ACCOUNTING Despite of having several limitations & flaws in historical cost accounting, its patrons still think it as the standard form of accounting due to its several unique features and conventions. They believe that historical-cost financial statements are more reliable than market value statements. The supporters of historical cost accounting think it possess the following unique advantages: As historical cost accounting is based on actual transactions, the recorded amounts are reliable and verifiable and free from management bias. Historical cost accounting leads to absolute certainty and it fits in perfectly with the cash flow statement. It tells exactly what has been paid or received and therefore there is no doubt about balance sheet amounts. (Williamson: 2003)

Is Market Value the Best Alternative to Historical Cost Accounting?

Historical cost helps the managers to forecast future operational cost based on past data. Without knowing the original cost, future projections are almost hampered. Under historical cost accounting, there is no scope for manipulation, because the data is supported by sufficient evidences such as: invoices, receipts etc. For fixed interest debt, historical cost accounting measures financial instruments at its issuance yield to maturity over its life, regardless of market yield movements. This constant yield to maturity approach produces a smooth and predictable interest cost or return outcome and valuation. (Australian Office of Financial Management: 2004-05)

ARGUMENTS AGAINST HISTORICAL COST ACCOUNTING The strongest argument against historical cost accounting is it does not provide information that is relevant to investors. Critics have pointed out the following significant flaws & disadvantages in historical cost accounting: Historical Cost Accounting values can relate to transactions that could be a year old or 10 years old. So, the acquisition value may be out of date and thus balance sheet represents out of date values.(Williamson: 2003) Historical cost accounting is only interested in cost allocation and not in the value of an asset. So, it discloses the acquisition cost of an asset and its depreciation in the following year, but ignores the possibility that the current market value of the asset may be higher or lower than the disclosed amount. Historical Cost Accounting has also flaw in terms of inflation. It is based on the assumption that the purchasing power remains same over a period of time. But in reality, an asset purchased at the current point of time may be more expensive in future due to inflation. Historical cost financial statements are unadjusted for this inflation. As a result, in the time of high inflation, profits are inflated and thus the tax bill tends to increase. When an entitys financial instruments are concerned, historical cost prices reflect both an old interest rate and an outdated assessment of the amounts, timing & uncertainty of future cash flows. (Hague & Willis: 1999) Intangible assets acquired outside of business combination (internally generated) are not reported in historical financial statements. Reliable forecast of the future income effects of a financial instrument is unlikely to be possible from the simple extrapolation of past gain and losses based on historical cost.

Shim & Larkin (1998) show the deficiencies of historical cost financial statements through this illustration: A company reports its inventory on the balance sheet at a historical cost of $ 10,000. The fair market value (FMV) of this inventory may be is only $7,000. On the other hand, a corresponding current account payable of $10,000 appears as a liability on the credit side of the balance sheet. It is likely that the "FMV" of the liability is at or near $10,000. From an historical cost perspective, the debit balance

Is Market Value the Best Alternative to Historical Cost Accounting?

(inventory) and the credit balance (accounts payable) are offsetting. However, from a market value perspective, the debit balance of $7,000 (inventory) is less than the offsetting credit balance (accounts payable) of $10,000.

ARGUMENTS FOR MARKET VALUE ACCOUNTING Proponents of market value accounting argues that this measurement is more relevant than historical cost as it provides up-to-date information consistent with market and as it takes into account the inflationary adjustment to the acquired cost. Critics have argued that this method increases volatility and thus reduces stock price. But its proponents contend that market value reveals economic realities that are hidden by historical cost accounting. The patrons of market value accounting have been continuing their supports to it for its following advantages: Market value measurement is more relevant to investors and creditors as it reflects the current market price of an asset or liability. It provides more transparency to users. If all financial instruments can be measured at market value; regulators, depositors & investors may have achieved greater regulatory and market discipline. (Jackson : 2000) Measurement of financial assets and liabilities at market value in the balance sheet should better capture an entitys exposure to risk and increase its visibility in the balance sheet.(IASC discussion paper :1997) Generally, an investor assesses the risk that he is ready to accept in exchange for a particular return. The assessment is based on the information available to him. The information about the market value at the reporting date, the changes in that value and the components of that changeall provide the investors with valuable information for his decision making. (Hague: 1999) Market value measurement is useful to determine and record asset impairments. The market value of any financial asset or liability embodies the market exception of future income return from that instrument taking into account the current market rate of return for commensurate risk. Therefore, if an investor knows the market value of a financial instrument and has information about its terms & risks, he has the basics for evaluating the markets expectations. (Hague & Willis: 1999) Shim et al (1998) argues that the market value accounting better presents the economic reality of transactions and, therefore, tends to provide more useful and relevant information than does historical cost financial reporting. They also argue that as business environments are changing rapidly and become increasingly volatile, the financial statements of firms should portray the underlying economic reality of the firms rather than the summary of past transactions. They admit, however, that due to the subjectivity of certain measurements, market value financial reporting may be less reliable. But they strongly support that a certain amount of subjectivity also exists in historical cost accounting. Therefore, they suggest that if the objective of financial reporting is to provide useful information to the users, existing historical cost accounting need to be substantially changed in the direction of market value financial reporting.

Is Market Value the Best Alternative to Historical Cost Accounting?

White (1991) argues that the existing measurement framework (historical cost) is seriously deficient, because it is backward-looking rather than focused on current market values. He advocates the use of market value accounting even at the expense of some estimation errors. He also argues that the purpose of an accounting system is to present the current economic reality of a corporation so those private and public decisions have a proper basis. The current accounting standards therefore should be replaced with systems of market value accounting that specifically attempt to capture current economic reality.

ARGUMENTS AGAINST MARKET VALUE ACCOUNTING The market value dissenters argue that the information provided by market value financial statements is unreliable; because it is not based on arms length transactions & there is a huge possibility for management to manipulate the bottom line. They contend that if the information is unreliable, it should not be used to make financial decisions. Some critics are concerned that the precipitous adoption of market value accounting will have adverse effect on both banks and the financial system as a whole. These critics believe that earnings based on market values for investment securities are likely to be more volatile than those based on historical cost. (Yuko & Tatsuya: 1998) Critics have pointed out the following flaws of market value accounting: Market values are basically based on unverifiable subjective estimates of managers. Agency theory suggests that managers will take advantage of this unverifiability to manage financial reports in order to extract rents. (Ramanna & Watts: 2007) Developing reliable methods for measuring market value in order to increase the reliability and credibility of investors in the information reported in financial statements are too critical, especially in the light of recent scandals in financial reporting. (Shortridge et al: 2006) When quoted market price for an asset or liability is not available, market value is measured based on an estimate by using the best information and techniques available in the circumstances. But most often difficulties occur when making estimates of market value by using inappropriate models like: cash-in method or using appropriate models inappropriately, e.g., using assumption that doesnt reflect the risk in the underlying asset. (Jackson: 2000) Although market value is able to provide relevant and reliable measures of impairments of an asset or a liability, it cant provide the same relevant & reliability in case of measuring the appreciation. Valuing tangible and intangible assets at market value is extremely difficult and time consuming. Some one who accepts the market value for balance sheet measurement of financial instruments has faced greater difficulty in accepting the performance reporting effects. (Hague: 1999)

CONCLUSION & RECOMMENDATIONS

Is Market Value the Best Alternative to Historical Cost Accounting?

Although historical cost accounting has some distinguishing features for which its patrons think it better method for measuring assets and liabilities, it cant provide relevant information to investors. Market value accounting can able to eliminate this limitation by providing current and inflation adjusted information to investors. Therefore, market value is the best alternative to historical cost. But there are also several significant problems within market value accounting in its current application which make more users reluctant to use market value in measuring assets and liabilities.

As investors are the major users of financial statements, priority should be given to their wants, that is, which measurement they prefer- historical cost or market value. Empirical evidences show that investors want both measurements. They want reliable and transparent market value information to determine the actual value of their investment. They also want historical cost information that helps them to determine whether management has discharged the stewardship entrusted to them. Therefore, assets and liabilities should be measured and reported at market value and these measurements must be reliable, verifiable & transparent and these measurements should not be at the cost of abandoning historical cost information.

A process can be created and implemented whereby historical cost and market value information is reported side by side, which will enhance relevance, reliability and comparability. In addition, some actions should be taken to eliminate the current limitations in market value accounting. These may be: Establish more robust accounting, valuation and auditing guidance. Provide more education to preparers, auditors and users about market value accounting. Therefore, it will not be good for any one if the debate between the two approaches will be ongoing. Rather, Focus should be given to implement market value accounting in reporting all assets or liabilities to reflect their true value without eliminating historical cost accounting.

REFERENCES Australian Office of Financial Management (2004-05), Introduction to market value accounting, www.aofm.gov.au/content/publications/reports/annual reports/2004-05 Bies, Susan Schmidt (2004), Remark on Market Value Accounting, www.federalreserve.gov/board Chasen, Emity (2008), Is Market Value Accounting Really Fair? www.moneynews.com Colleen, Cunningham (2004), Market value accounting: Fair for whom? Financial executive International Compbell, Susan, The Implications of Market Value Reporting, Association of Investment Management and Research Hague, Ian P.N & Willis, Diana w (1999), Financial Instrument - Old Price or New? CA Magazine IASC Discussion Paper (1997), Accounting for Financial Assets and Financial Liabilities. Jaskson, M Day (2000), Market value Accounting - Lets Work Together and Get It Done, U.S Securities & Exchange commission, www.sec.gov/news/speech/speech436.htm

Is Market Value the Best Alternative to Historical Cost Accounting?

Katsu, Yuko & Yonetani, Tatsuya (1998), Market Value Accounting and Regulatory Capital Requirements, Economic policy review , Federal Reserve Bank, New York Shim, Eunsup & Larkin, Joseph M. (1998), Towards Relevancy in Financial Reporting: Mark-toMarket Accounting, Journal of Applied Business Research, Laramie: Vol. 14, Iss. 2; pg. 33 Shortridge, Rebeca, Toppe; Schroeder, Amanda & Wagoner, Erin (2006), Market Value AccountingAnalyzing the Changing Environment, The CPA Journal Ramanna, Karthik & Watts. Rossl (2007), Evidence on the Effects of Unverifiable Fair Value Accounting, Harvard business school: working knowledge White, Lawrence J. (1991), The Value of Market Value Accounting for the Deposit Insurance System, Journal of Accounting Auditing & Finance Williamson , Duncan (2003), Brief Notes on Historical Cost Accounting, Accounting business spreadsheeting, www.duncanwill.co.uk