The basic purpose of accounting is to provide information that is useful to investors, creditors and others in making rational economic decisions. One accounting issue that has been debated on a lot is the historical cost method versus the fair value measurement. The historical cost method has been the basis of GAAP accounting for the past decade but has slowly been disappearing. Today it is starting to be replaced by the fair value method of accounting. When choosing a valuation method, it seems that there is a tradeoff between the two fundamental qualities of accounting theory which are relevance and reliability. In order for information to be relevant, it must also be reliable or faithful in its representation of events. This idea is also supported by FASB’s Conceptual Framework of Measurement. It states that for accounting information to be reliable it must be neutral. That means that is has to be unbiased and not chosen to favor a particular outcome.
Historical cost has been a mainstay of accounting largely because of its objectivity and reliability. Under this approach, assets are presented on the balance sheet at their value at the time of acquisition and are generally represented by their purchase cost. If those who make management and investment decisions had not found financial reports based on historical cost useful over the years, changes in accounting would long since have been made. In theory it is also less subject to manipulation and is based on the idea of making a profit (Cao, 2013).
An alternative valuation method to historical cost is the fair value method. The fair value method is “the practice of measuring assets and liabilities at estimates of their current value (Jordan, Clark, & Pate, 2013).” While the historical cost method is conservative and reliable, measuring at fair value makes accounting information more relevant. FASB has already been making stride towards modernizing GAAP and is working toward having all financial assets and liabilities recognized in statements of financial position at their fair values, rather than at amounts based on their historical cost (“Historical Cost Vs. Current Cost,” 2001). As an example, GAAP and IFRS are currently using fair value extensively in accounts concerning derivatives and hedges, employee stock options, financial assets, and goodwill impairment testing (Jordan, Clark, & Pate, 2013).
When deciding if the historical cost method should be abandoned or modified for a more current cost system, it is important to note the complexity of financial instruments used today and the risk management strategies that make yesterday’s prices obsolete. Looking at the historical cost...