Get help from the best in academic writing.

Benefits and problems concerning traditional approach to budgeting

In order to advise two different businesses about the benefits and problems associated with traditional approach to budgeting and budgetary control, i have collected and compiled the information regarding budgeting and divided it into different parts so that the reader may easily understand .
1.INTRODUCTION : A budget is a planning and controlling tool for an oraganisation.This tool can work effectively only when it is used with due care.It is not only the a cost monitoring mechanism but also an integral part of an organisation’s planning and control activities.It aims at achieving organisational objectives and motivating the personnel concerned.For the success of budgetary system gathering the essential informationand choosing an appropriate budgetary system etc.are necessary.
The ideal budegting system is one that encourages goal congruence(i.e. a situation where the personal goals of the employees match the oraganisational goals).Ensuring the greater participation of the supervisory level in the management process can ensure goal congruence.
Budgets may be of different types to suit the different practices followed by different organisations.An organisation using a conventional systemof budgeting may somtimes need to switch over to another to suit its requirements.Changing a budegtary system is not a simple task.An oraganisation has to face certain difficultiesin the form of resistance to change by the personnel of the organisation,changes required in the existing support systems etc., inorder to change its budgetary system.The Success of a budget is also largely dependant on the level of accuracy in estimating the revenues and costs for the budget period.There are several statistical techniques which may prove useful in forecasting the figures to be incorporated in budgets.
2. TRADITIONAL BUDGETING: 2.1. Introduction: First of all we begin this topic with the simple definition of budget.In short budget can be defined as Quantitative economic plan made with regard to time. Therefore, for something to be characterised as a budget it must comprise the quantities of economic resources to be allocated and used, it has to be expressed in economic i.e. monetary terms, it has to be a plan – not a hope or a forecast but an authoritative intention, and it must be made within a certain period of time (Harper, 1995, p. 318). Only a plan that has such characteristics can be called a budget.
However, if a budget is looked upon in its wider context, it can be defined as a management tool that puts executives in control of the financial health of their company. It is an objective measure of the financial structure of company’s operation and a tool that forces management to be accountable in a structured and objective way. Budgets as management tools by themselves are neither good nor bad. How managers administer budgets is the key to their value. When administered wisely, budgets facilitate planning and resource allocation and help to enumerate, itemize, dissect and examine all of the products and services that a company offers to customers (Seer, 2000, p. 187). In short and taken at its simplest level, a budget is a mathematical exercise, but in reality it is much, much more than numbers on spreadsheets, which is what following text will definitely show.
The purpose of budgeting is that it gives management an idea of how well a company is meeting their income goals, whether or not expenses are in line with predicted levels, and how well controls are working. Properly used, budgeting can and should increase profits, reduce unnecessary spending, and clearly define how immediate steps can be taken to expand markets (Thomsett, 1988, p. 5). In order to achieve this, management needs to build a budgeting system, the major objectives of which are to (Viscione, 1984, p. 42):
Set acceptable targets for revenues and expenses.
Increase the likelihood that targets will be reached.
Provide time and opportunity to formulate and evaluate options should obstacles arise.
Since budgeting as a process is very complex, it comes as no surprise that budgets are trying to fulfil numerous functions such as (Harper, 1995, p. 321, and Churchill, 1984, p. 162):
Planning – a budget establishes a plan of action that enables management to know in advance the amounts and timing of the production factors required to meet desired level of sales.
Controlling – a budget can be used to help an organization reach its objectives by ensuring that each of the individual steps are taken as planned.
Coordinating – a budget is where all the financial components of an organization Individual units, divisions, and departments – are assembled into a coherent master picture that expresses the organization’s overall operational objectives and strategic goals.
Communicating – by publishing the budget, management explicitly informs its subordinates as to what exactly they must be doing and what other parts of the organization will be doing. A budget is designed to give managers a clear understanding of the company’s financial goals, from expected cost savings to targeted revenues.
Instructing – a budget is often as much an executive order as an organizational plan since it lays down what must be done. It may, therefore, be regarded by subordinates as a management instruction.
Authorising – if a budget is a management instruction then conversely it is an authorisation to take budgeted action.
Motivating – in that a budget sets a target for the different members of the organization so that it can act to motivate them to try and attain their budgeted targets.
Performance measuring – by providing a benchmark against which actual performance can be measured, a budget clearly plays a crucial role in the important task of performance measurement.
Decision-making – it should never be assumed that a budget is set in concrete and when changing course a well-designed budget is a very useful tool in evaluating the consequences of a proposed alternative since the effect of any change can be traced throughout the entire organization.
Delegating – budgets delegate responsibility to the managers who assume authority for a specified set of resources and activities. In this way budgets emphasise even more the existing organizational structure within the company.
Educating – the educating effect of a budget is perhaps most evident when the process is introduced in a company. Operating managers learn not only the technical aspects of budgeting but also how the company functions and how their business units interact with others.
Better management of subordinates – a budget enhances the skills of operating managers not only by educating them about how the company functions, but also by giving them the opportunity to manage their subordinates in a more professional manner.
The requirements that all these functions impose upon a budget make it difficult for one system to meet them all. It is precisely because these requirements differ, that role conflicts in budgeting system arise. These need to be appropriately dealt with so that dysfunctional behaviour like budget padding or other damaging budget games for the company do not appear. Since there are three major roles for any budgeting system, at least three conflicts may arise (Barrett, Fraser, 1977, p. 141):
Planning versus motivation For a budget to be most effective in the planning role, it should be based on a realistic assessment of the company’s operating capabilities and on management’s judgment about what is most likely to happen in the future. Yet this kind of budget runs the risk of setting targets so low that motivation is adversely affected since to motivate properly, budget objectives should be set higher than those for planning and be difficult yet attainable. On the other hand, these difficult yet attainable objectives lead to an overly optimistic budget and run the risk of falling short and under using company resources.
Motivation versus evaluation There is a widely held belief that budget objectives should be set as fixed standards against which performance can be judged. Managers are also likely to be more committed to achieving this kind of objective since they know that the performance standards by which they are evaluated are not constantly changing. On the other hand, managers’ motivation can be impaired by rigid application of a “fixed standard” philosophy which doesn’t consider the impacts of uncontrollable or unforeseeable events and doesn’t allow for their removal from budget standards.
Planning versus evaluation The planning role’s requirement of providing realistic assessment of future prospects can conflict with the need to eliminate the effects of uncontrollable or unforeseeable environmental variables from the budget used for evaluation purposes. Yet, because they are separated in time, the conflict between these requirements is considered a minor one since it can be considerably reduced if appropriate adjustments are done at the end of the budget period.
As can be seen in the previous paragraph, functions that typical budgets want to cover are very wide. It comes then as no surprise that those budgets are being used today in practice for many purposes. Bunce, Fraser and Woodcock’s (1995) survey showed that general uses of budgets can be divided into financial and operational type of uses. Figure 2 clearly indicates that, of the various uses of budgeting for management, the most important are those financially oriented like the use of budgets for financial forecast, cost control, cash flow management, and capital expenditure supervision. The operational management uses of budgeting have been less common but the interviewed companies have concluded that, in today’s business environment, they are of growing importance. The need to improve performance is intensifying to the point that it is no longer enough just to control costs, but
That company must also pay attention to things like strategy, communication, and employee evaluation. These are purposes for which budgets have not been used so much in the past.
As stated in the opening definition, budgets are plans set for a certain period of time, such as a month, quarter, and year and so on. This time period is then usually broken into smaller sub periods. The most frequently used budgets are annual budgets that are subdivided by months for the first quarter and by quarters for the remainder of the year. Of course, actual time periods for which budgets are made depend mostly on their purpose and use, and it is solely the decision of individual companies as to what time periods will be utilized for their budgeting process.
2.2. History of budgets: The English word “budget” stems from the French word “bougette” and the Latin word “bulga” which was a leather bag or a large-sized purse which travellers in medieval times hung on the saddle of their horse. The treasurer’s “bougette” was the predecessor to the small leather case from which finance ministries even today in countries like Great Britain and Holland present their yearly financial plan for the state. So after being used to describe the word wallet and then state finances, the meaning of the word “budget” in 19th century slowly shifted to the financial plan itself, initially only for governments and then later for private and legal entities (Hofstede, 1968, p. 19). It was only then that budgets started to be considered as financial plans and not just as money bags.
The use of budgets as financial planning and control tools for business enterprises is historically a rather young phenomenon. In the US, early budgetary principles in companies were mostly derived from the budget techniques in government. The other source of budgetary principles for business in the US was the Scientific Management Movement, which in the years between 1911 and 1935 conquered the US industry. Many historians agree that early budgeting systems can be seen as a logical extension of Taylor’s Scientific Management from the shop floor to the total enterprise. However, it was not until the depression years after 1930 that budget control in US companies started to be implemented on a large-scale.Budgets with their focus on cost control simply became a perfect management tool for that period of time (ibid., p. 20). In Europe the idea of using budgets for business was firstly formulated by the French organization pioneer Henri Fayol (1841-1925). There was, however, little application in practice. Another practical stimulus came from the ideas of the Czech
entrepreneur Thomas Bata (1876-1925) who introduced the so-called departmental profit-and-loss-control as a tool for decentralizing his international shoe company into a federation of independently run small businesses. Nevertheless, the main inducement for the development of budgets and their implementation in European companies came from across the Atlantic in the years following the Second World War (ibid., p. 21).
Companies like Du Pont and General Motors in the U.S., Siemens in Germany, and Saint Gobain and Eléctricité de France in France, which pioneered the M-form (multidivisional) organizational structure in the 1920’s, first started to use budgets to support their rapid growth as they expanded into new products and markets. This was to help them to reduce the complexity of managing multiple strategies (Hope, Fraser, 1997, p. 20). The enormous diversity in the product markets served by these vertically integrated corporations required new systems and measures to coordinate dispersed and decentralized activities. In this kind of environment, budgets and ROI measure rightly played a key role in permitting central management to coordinate, motivate and evaluate the performance of their divisional managers, and perform a proper allocation of internal capital and resources (Johnson, Kaplan,1991, p. 11). However, it is was only in the 1960’s that accountants started adding to budgets
other functions (like management performance evaluation and motivation) in addition to those functions for which they had originally been devised – planning and control (Hope, Fraser,1999b, p. 50). In that period, budgets became the central and most important activity within management accounting or in the words of Horngren, Foster and Datar: “the most widely used accounting tool for planning and controlling organizations” (2000, p. 178). This is exactly how budgets have remained to this day. The only thing that has changed in the meantime is the competitive environment in which today’s companies operate and which has provoked many discussions about budgets’ disadvantages and their alternatives, some of which will be presented in later parts of this assessment.
2.3. Budgeting Process: The process of budgeting generally involves an iterative cycle which moves between targets of desirable performance and estimates of feasible performance until there is, hopefully, convergence to a plan which is both feasible and acceptable (Emmanuel, Otley, Merchant,1990, p. 31). Alternatively, if we look beyond many details and iterations of the usual budgeting process we can see that there is a simple universally applicable budgeting process, the phases of which can be described in the following manner (Finney, 1994, p. 16):
Budget forms and instructions are distributed to all managers.
The budget forms are filled out and submitted.
The individual budgets are transformed into appropriate budgeting/accounting terms and consolidated into one overall company budget.
The budget is reviewed, modified as necessary, and approved.
The final budget is then used throughout the year to control and measure the organization.
The inevitable dependence of individual budgets on one another requires that budgets be prepared in a hierarchical manner. Figure 3 indicates a common hierarchical form of the budgeting process together with the necessary data flow between particular budgets and phases of their making. This picture shows that despite having only a few general phases, the budgeting process, due to its linearity and iteration loop, is in fact a very complex and time consuming process.
Since it is so complex and important, the budgeting process requires lots of decision making on the particular choices that developers of budgets have at their disposal. Churchill (1984, p.151) has provided a list of eight budget choices that managers have to be concerned with when setting up the budgeting system. Thereby, these concerns vary according to whether the company intends to use its budgets primarily for planning or for control. These budget choices are:
Whether it is to be prepared from the bottom-up or top-down,
How it is to be implemented,
How the budget process is linked to the strategic planning process,
Whether it should be a rolling budget and how often it should be revised,
Whether performance should be evaluated against the original budget or the one relating to the actual activity level of the organization,
Whether compensation/bonuses should be based on budgeted performance,
What budget evaluation criteria should be used, and
What degree of ”stretch” should be incorporated into the budget.
In general, accounting theory suggests that large companies should be concerned more with operational efficiency and emphasize coordination and control aspects of budgets, while smaller innovative firms should concentrate more on the planning aspects of their budgets.
2.4. Types Of Budgets: A budget is not a unitary concept but varies from organization to organization. The basic concept of budgeting involves estimating future performance, comparing actual results with the estimate, and analyzing the differences between them. Factors that are relevant in determining the type or style of an organization’s budget and its effects include: the type of organization, the leadership style, personalities of people affected by the budget, the method of preparation, and the desired results of the budgeting process (Cherrington, Cherrington, 1973, p. 226).
In general, budgets can be classified into two primary categories (Cohen, Robbins, Young,1994, p. 171):
Operating budgets:
Operating budgets consist of plans for all those activities that make up the normal operations of the firm. The main components of the firm’s operating budget include sales, production, inventory, materials, labour, overheads and R

Historical Cost and Fair Value

1.0 INTRODUCTION There have been many discussions and debates concerning use of fair value accounting against use of historical cost accounting. Some prefer fair value whilst some have a preference for historical cost accounting. Both methods of valuation have been criticized and as well embraced.
It is evident that a quality description and quantitative information about the nature of the financial asset is essentially important and the amount that is appraised from the chosen method of valuation is included in the financial statements. The question however remains as to which measurement method must one use to cope with today’s complex financial instruments and risk management strategies. We must acknowledge that we are in an era where we use many complicated financial instruments and risk management strategies which render that yesterday’s prices may have become obsolete and many people now demand historical cost be either abandoned, reviewed, modified or replaced by current cost system to reflect a more accurate financial reporting (Muller, K. A., 2008).
The issue of assets and liabilities valuation has become more pressing now than it was ever before. The FASB [1] is slowly modernizing the GAAP [2] principles and in doing so, it is attempting to make financial statements more meaningful and bring books in line with the international standards.
Historical cost and fair value methods of valuation have both been around for a long time. The choice of whether to switch to fair value method is interestingly an important decision where all perspectives have to be equally evaluated in considering the transition from an existing to a new method of financial asset valuation. History has proven that the historical cost principle has worked absolutely fine all this while. This now poses us a question as to why the consideration and speculation to switch to a new method of financial asset valuation. What theories and what basis should drive the motivation to choose a varying method of financial asset valuation and what could be ideally considered being the opportune time for the switch in choice of model.
With the ever increasing concerns between both the public and private sectors pertaining to the adequacy of financial statement reporting by respective financial institutions, a considerable attention has been received by the FASB, SEC [3] and other regulating bodies.
The adaption of the IFRS [4] in the European Union with effect from 1st of January 2005 birthed a number of significant changes in how firms must report their financial positions (Muller et al 2008). Measurement of financial assets is the core issue of relevance in financial accounting and reporting today.
In order to decide which method of valuation one must choose, it is imperative that there must be a sound understanding of the fair value and historical cost method of valuation for financial assets.
This seminar attempts to carry out an in depth research on the fair value and historical cost method of valuation, understand the underlying assumptions of each, identify the strengths and weaknesses of both.
Various companies has been researched and contacted in order to obtain feedback on their chosen method of financial asset and liabilities valuation. Responses received are summarized in analysis and findings section of this paper and has been deliberated upon in understanding how companies and organizations in Fiji are valuing their assets and liabilities for reporting in their financial statements.
Also encompassed are various literature and resource materials that we have studied. These have been reviewed and key essence and aspects of topic under study has been entailed in section entitled Literature Review.
1.1 THEORETICAL UNDERPINNINGS Accounting is highly purposive field and any assumption, principle or procedure is accordingly justified if it adequately serves the end in view (Paton, 1922). There are many accounting conventions under the Generally Accepted Accounting Principles (GAAP) which is now known as IFRS.
Historical Cost Convention is the conventional valuation concept whose resources are valued in accordance with the cost of acquisition by the enterprise (Glautier and Underdown, 1982). Assets are recorded at their original cost at the time of purchase. This convention is highly preferred for the historical cost method over fair value.
The Conservatism Convention assumes that accountants are pessimistic in measuring revenues and expenses. Revenues are not recorded until they were virtually certain but expenses were recorded as soon as they become remote. If accountants had to choose for measurements of cost for assets and liabilities they would have chosen the lowest for assets and highest for liabilities mostly adopt historical cost method.
The historical cost of method is well preferred over the fair value method as the Accounting as a Historical record is concerned at providing a faithful record of transaction of an entity rather to provide a valuation of the firm at a given period of time (Godfrey et. al, 2006 pg 18).
While historical cost method may give some indication to shareholders of the stewardship of management in the management of costs and money capital under the control, the records give no indication of the real worth of the enterprise as a going concern except to the extent that operating profit is a predictive devise (Budge and Hendriksen, 1974).
Objective of stewardship is based on agency theory. Managers’ choice of accounting method usually comes as agency theory. Agency theory provides a necessary explanation of why a selection of particular accounting method might matter, and hence was an important facet for the development of Positive accounting theory. It is assumed that under agency theory principals will assume that the agents (principal) will be driven by self interest and therefore the principals will anticipate that the managers, unless restricted from doing otherwise, will undertake self serving activities that could be detrimental to the economic welfare of the principals (Deegan 2002).
Since the behavior of this principal cannot be predicted as their salaries are tied to accounting figures and monitoring the principal behavior is difficult. The preparers of financial reports will choose measurement basis for higher profit for the remuneration purposes. It could be better if the particular method such as historical cost is stated in the contract of the principal for reporting purpose.
Watts and Zimmerman identified three key hypotheses that have become frequent in the Positive Accounting Theory literature to explain and predict whether an organization would support or oppose a particular accounting method.
A higher profit is precise under the management hypothesis or bonus plan hypothesis. The preparers of the reports will use such accounting methods that increase current reported income. Such method increases the present value of bonuses if the compensation committees do not adjust for the methods chosen. This hypothesis predicts that if managers are rewarded in terms of performance with accounting figures than mangers will chose methods to increase accounting profit with an attempt to increase bonus.
A higher profit is also preferred by Debt Equity hypothesis which predicts that the
higher the firm’s debt equity ratio the more likely the managers’ use accounting methods that increases income. The higher the debt to equity ratio, the closer the firms to the constraints in debt covenant. The tighter the covenant constraint, the greater the possibility of a covenant violation and of incurring of costs from technical defaults. Mangers’ choosing income increasing accounting method relaxes debt constraints and reduces the technical defaults (Deegan 2002).
The Political Hypothesis predicts the larger firms rather than small firms are likely to choose accounting methods that reduces reported profit. Reducing reported profit could decrease the possibility that people will argue that the organization is exploiting other parties by applying business practices that generate excessive profit for the benefits of owners while at the same time providing limited returns to others parties involved in the transaction.
Chambers Theory of Continuously Contemporary Accounting made judgment about what people need in terms of information. Chamber makes an assumption about the objective of accounting is to guide future actions. He prescribed that all assets should be measured at net market value and that such information is more useful for informed decision making than information based on historical cost which could be misleading.
A number of prescriptive theories were developed which adopted Decision Usefulness approach to Accounting Theory. Chambers “Blueprint” paper published in 1955 is arguably among the first to emphasis decision usefulness .He wrote: ‘It is therefore corollary of the assumption of rational management that there shall be an information providing system, such as basis for decision and as a basis for reviewing the consequences of decision’. It is suggested that accounting information should be relevant, verifiable, free from bias and quantifiable. The choice of Accounting Methods depends on factors such as reliability, relevance, timeliness and comparability.
Finally, there are several other theories to accounting which could explain the choice for the kind of measurement base or method. Cost Attach theory, Investor theory, True income theory, Behavioral Accounting theory, Measurement theory, Accounting as Magic and communication theory and others. Measurement is a hub of Accounting which has a lot of accounting theory underlying measurement basis. The minimum requirement for giving theoretical justification to an allocation method are that it should be possible to specify unambiguously and in advance, the method to be used and to defend that choice against all competing alternatives.
2.0 LITERATURE REVIEW There has been much discussion about fair value accounting. Disclosing assets at their fair value as opposed to their historical cost is preferred by some but opposed by others. The use of fair value accounting has been around for decades primarily for financial assets. In recent years, both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have moved towards more extensive use of fair value accounting.
According to Godfrey et al (2006) the use of historical cost for valuation of non-monetary assets has come from several sources, these include the 1940 book by Paton and Littleton, An Introduction to Corporate Accounting Standards. The book provides many of the theoretical arguments for the accounting. Historical cost is generally defined as the amount at which the asset or liability was originally obtained. Where the historical cost is expected to be different from the final value when the item is no longer on the balance sheet, some amortization or depreciation of the value is expected. This can result in an amortised cost or depreciated cost value. These values are generally more reliably determinable, but less relevant than fair value.
Casonbona et al (2007) define fair value as the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction. This assumes that it represents market value in a sufficiently robust and efficient market. Where no market exists, the fair value would need to be conceptually estimated.
In making comparisons between the two, Toppe Shortridge et al (2006) refer to an argument of relevance over reliability. They argue that the proponent of fair value accounting believe that historical cost financial statements are not relevant because they do not provide information about current values. Theorists and practitioners against fair value argue that the information provided by fair value financial statements is unreliable because it is not based on “arms’ length” transactions. They contend that if information is unreliable it should not be used to make financial decisions. However they also argue that the proponents of fair value accounting would claim that it is more relevant to decision makers even if it is less reliable. These arguments include that fair value accounting would produce balance sheets that are more representative of the company’s value. Specifically, unless the values of fixed assets are assumed to remain the same over time, historical cost information is relevant only up on obtaining the asset.
A number of studies have been conducted to argue that one method is more appropriate than another.
Ebling (2001) argues that accounting rules around the world are moving steadily towards fair value accounting and away from historical cost accounting. In his study he argues that the banking systems figures would become more volatile. The banks would see their business managed against long term objectives and not “short term” measures and it is historical costs that better reflect the economic substance of the transactions, the actual cash flow and the earnings process. Chisnall (2001) also supports this view and argues that the banking industry as an example would be best to use modified historical cost as a better basis on which to measure banking book performance in primary financial statements. The issue of volatility has surfaced in recent times with the example of the collapse of Enron as an example.
Barr (2009) reflects that fair value can be an accurate way to value assets but it needs time to be fully perfected. With Enron fair value accounting was used to mislead investors, regulators and the general public. Kemp (2008) argues that fair value accounting works best where the legal framework of society accepts the subjectivity of the market and thus divergent values as in Europe, as opposed the USA with its very open legal system.
The disadvantages of fair value are also highlighted. It is argued that valuation is a subjective judgment and therefore as an example if two evaluators were to conduct the valuation process they may arrive at different estimates of the fair value although both would have followed the objectives of fair value measurement.
There are many issues involved with fair value accounting. Some argue that fair value is beneficial to investors when they are trying to evaluate risk, return and valuation of a business.
Dvorakova (2007) in her study of historical costs versus fair value measurement in financial accounting uses the example of non-financial assets. In her study she notes that “IAS 41- Agriculture” sets a precedent in application of the fair value measurement to biological assets and agricultural production. The study states that the fair value measurement has been required by IAS 41 because historical cost measurement is not able to cover the value of biological assets of enterprises in the market environment.
Muller et al (2008) examine the cause of and consequences of investment property companies’ choice to use the historical cost or fair value standard to account for their primary asset, real estate. The examination exploits the European Union’s adoption of International Financial Reporting Standards which require companies to make this choice under “IAS 40 – Investment Property”. The study showed that companies are more likely to use the fair value standard when a company shows a greater commitment to reporting transparency. It showed that some companies however were also opportunistic in using fair value to report larger gains than companies using the historical cost standard.
Christensen and Nikolaev (2009) studied whether and why companies prefer fair value to historical cost when they can choose between the two valuation methods. Their study show that with the exception of investment property owned by real estate companies, historical cost by far dominates fair value in practice. They state that fair value accounting is not used for plant, equipment and tangible assets. They found that companies using fair value accounting rely more on debt financing than companies that use historical cost. This evidence is consistent with companies using fair value to show asset liquidation values to their creditors and is not consistent with equity investors demanding fair value accounting for non-financial assets.
This study was based on a sample of 1,539 companies. It identified each company’s valuation practice by reading the accounting policy section in its annual report. No companies in the sample used fair value accounting for intangible assets. Only 3% used it for assets such as plant and equipment. With very few exceptions fair value is used exclusively for property. The study also looked the balance sheets of the companies and found that that the total assets and shareholders equity were, respectively, 31% and 88% higher on average for the companies using fair value as opposed to a matched sample of companies that only use historical cost accounting. The study also proves that a mixed approach is taken to the use of fair value under “IAS 16 – Property, Plant and Equipment”.
The study further states that companies that follow historical cost accounting must periodically test their asset for impairment. An asset is considered impaired when its carrying amount is higher than its fair value less the costs to sell and the present value of future cash flows it is expected to generate. With historical cost accounting companies will in practice value assets close to fair value if depreciated historical costs exceed fair value. In contrast under fair value accounting companies revalue assets either upwards or downwards depending on the change in the fair value estimate.
Beier (2008) talks about measurement issues with existing mixed standard models. He
states that mismatches may occur because some assets and liabilities are reported at historical costs and some are marked to fair value. Examples he gives include;
Financial institutions report many assets at fair value and the debt used to finance those assets is reported at historical cost;
Debt nominated in a foreign currency is translated at spot rate while assets financed with that debt is translated at historical rate;
Derivative used to finance inventory are reported at fair value while such inventory is reported at historical cost.
Grover (2008) in his look at the debate of fair value versus historical costs states that while there needs to be consistency in accounting it may be necessary to measure certain balance sheet items at fair value and other at historical cost.
It can be argued from the literature and studies conducted that fair value and historical costs both have their place in accounting. There are many different and unique kinds of businesses so one universal standard for valuing assets may be suitable for some but not for others. Fair value is beneficial due to its ability to provide an up to date value of business assets, but fair value may also inaccurately inflate the value of a company due to mistakes or misrepresentations and in doing so can falsely increase the confidence of investors and therefore increase its capital.
Historical costs are beneficial as it is widely understood by investors and companies. Historical costing does not rely on estimating the value of assets and thus allows less room for fraudulent activities to occur. However the use of this standard can underestimate the value of a company since an increase in the value of an asset is not recorded until the asset is sold or traded. Although this may cause investors to wary of a company who has a deflated value it does provide more stability in the market.
If both accounting standards are used it can improve meaningful information for decision making. The use of fair value allows for an up to date value of assets and produces relevant costs. As an example if a company owned a building the fair value of that building will be the opportunity cost of that building in terms of it being sold or rented or used for something other the companies intended use. As historical value is more widely used and understood it can be used as an external use of reporting value of assets. Historical costs can be used as the base in reporting value and fair value used as an estimate or projected value of assets to investors.
3.0 RESEARCH OBJECTIVES AIM To discuss the rationale of historical cost and fair value methods of measurement and determine whether it is appropriate to use both methods when compiling a set of financial statements.
OBJECTIVES The scope of our research aims to address the following issues;
Discuss the rationale of historical cost method.
Benefits and constraints of historical cost method.
Discuss the rationale of fair value method.
Benefits and constraints of fair value method.
Whether it is appropriate to use both methods when compiling a set of financial statements.
Benefits and constraints of using both methods.
4.0 RESEARCH METHODS In compiling this research project, we used the following techniques to obtain data which are as follows:
Questionnaire Distribution We compiled questions and distributed to 30 reporting entities in Suva and Nasinu area. These were given specifically to financial statement preparer’s namely financial controllers and accountants.
Review of literature We reviewed the research papers and journals carried out by several researchers on fair value and historical cost.
Online Research Accessing the internet played a vital role in obtaining current and up-to-date
Information regarding historical cost and fair value.
5.0 ANALYSIS AND FINDINGS Question 1: 1. What method of measurement does your company currently use? Upon analyzing the outcomes of the 25 received responses from the reporting entities, 1 uses fair value method, 17 companies adopt to using historical cost as measurement basis while 7 stated that they use both methods that is fair value and historical costs. The table below shows the methods used by the companies in compiling the financial statements.
Key: HC – Historical cost
FV – Fair value
Both – Historical cost and fair value
What are the benefits (advantages) of historical cost did you consider prior to implementing this measurement basis? The responses received in regards to the advantages of historical cost method have been quite similar and we have analysed the advantages in the following categories showing the number of respondents.
What are the constraints (disadvantages) of historical cost measurement basis that your company may have faced? The responses received in regards to the disadvantages of historical cost method have been quite similar and we have analysed the disadvantages in the following categories showing the number of respondents.
The respondents of 68% (17 out of 25) agreed that the benefits of using historical cost (Question 2) as its measurement basis outweighs the constraints identified in Question 3 while 32% (8 out of 25) thought otherwise. The major reasoning being that historical cost is fairly easy to use and understand and also in Fiji, there is constraints for lack of active markets for some classes of assets, thus for valuation purposes, adopting to fair value becomes an expensive for task for entities.
What are the benefits (advantages) of fair value did you consider prior to implementing this measurement basis? The responses received in regards to the advantages of fair value method have been quite similar for most companies and we have analysed these advantages in the following categories showing the number of respondents.
What are the constraints (disadvantages) of fair value measurement basis that your company may have faced? The responses received in regards to the disadvantages of Fair value method have been quite similar and we have analysed these disadvantages in the following categories showing the number of respondents.
Do you consider that the benefits outweigh the constraints in using fair value as the measurement basis? Considering that only 32 %- 8 (1 – FV and 7 both) out of the 25 companies use fair value, they responded that the benefit of the fair value identified in Question 5 does outweigh the constraints in Question 6 while the 68% (17) thought otherwise. We consider that the major factor behind this is due to lack of active markets for some assets whereby this becomes a cost constraint for entities and the complex nature of the methods used in fair value.
Do you consider that it is appropriate to use both methods when compiling a set of financial statements? If so, please outline the benefits and limitations of using both methods i.e. historical cost and fair value? Of the 25 respondents, 19 (76%) of them view that it is appropriate to use both methods i.e. historical cost and fair value when compiling a set of financial statements while 6 (24%) of them view otherwise. The major reasoning being that this would be more reliable and relevant for decision making process such as for assets like Property Plant

[casanovaaggrev]