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Difference between Historical Cost Accounting and Fair Value Accounting

Last Updated : 18 Apr, 2024
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Valuation of assets and liabilities is an important aspect of accounting to prepare financial statements. The two basic methods of accounting are Historical Cost Accounting and Fair Value Accounting. Historical Cost Accounting emphasises recording assets and liabilities at their initial acquisition or incurrence cost, whereas Fair Value Accounting values assets and liabilities at their current market prices.

Difference-Between-Historical-Cost-Accounting-and-Fair-Value-Accounting

Table of Content

What is Historical Cost Accounting?

Historical Cost Accounting is a method of valuing assets and liabilities based on their original or historical cost when they were acquired or incurred. This approach records transactions at their initial value and does not consider changes in market value over time. While it provides a reliable record of past transactions, it may not reflect the current fair market value of assets and can be less informative for decision-making in rapidly changing economic environments.

Key takeaways from Historical Cost Accounting:

  • Historical Cost Accounting emphasis recording assets and liabilities at their initial acquisition or incurrence cost.
  • While historical cost accounting offers stability and simplicity, it may not accurately represent the current market value of assets and liabilities.
  • The historical cost method is often valuable for long-term analysis.

What is Fair Value Accounting?

Fair Value Accounting is an accounting standard that requires companies to measure and report their assets and liabilities at their current market value. In other words, it reflects the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The application of fair value accounting requires careful consideration of market conditions and diligent adherence to accounting standards and best practices. It is important to note that fair value accounting is not without its criticisms. Some argue that it can exacerbate market swings and lead to potential over-valuation or under-valuation of assets and liabilities.

Key takeaways from Fair Value Accounting:

  • Fair Value Accounting values assets and liabilities at their current market prices, providing a more accurate representation of their real-time worth.
  • Fair value accounting is more responsive to market fluctuations.

Difference Between Historical Cost Accounting and Fair Value Accounting

Basis

Fair Value Accounting

Historical Cost Accounting

Basis of Valuation

Fair value accounting values assets and liabilities based on their current market prices or the price they would command in an open market transaction.

Historical cost accounting values assets and liabilities based on their original acquisition cost. The value is determined at the time of purchase and remains unchanged.

Relevance

Fair value accounting is considered more relevant, especially in dynamic markets where asset and liability values can change rapidly.

Historical cost accounting is considered less relevant in situations where the original cost is significantly different from the current market value.

Transparency

Fair value accounting often requires detailed disclosure of the methods and assumptions used to arrive at fair values, promoting transparency in financial reporting

Historical cost accounting is generally less transparent regarding the current market value of assets and liabilities because it does not provide updated values.

Volatility

Fair value accounting can lead to more volatility in financial statements, as the values of assets and liabilities are subject to market fluctuations.

Historical cost accounting tends to result in less volatility because it relies on original purchase prices, which remain relatively stable over time.

Complexity and Cost

Fair value accounting can be more complex and costly to implement, particularly for assets without readily observable market prices.

Historical cost accounting is generally less complex and less costly because it involves recording assets at their initial acquisition cost.

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sukantkumar
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