Sample Answer
A Critical Evaluation of an Ongoing Accounting Controversy
Introduction
Financial accounting has long been shaped by disagreements about how best to measure economic reality. One of the most enduring controversies is the choice between fair value accounting and historical cost accounting. These two approaches rest on very different theories about what financial statements are supposed to represent. Fair value attempts to show current market-based estimates, while historical cost focuses on the original transaction price. Both are grounded in legitimate reasoning, supported by respected scholars, and criticised for their limitations. This essay reviews the key arguments in the literature, explains how current standards under US GAAP and IFRS address the issue, evaluates the strengths and weaknesses of these approaches, and concludes with a justified opinion about the most appropriate method.
Literature Review: Competing Theoretical Views
The debate between fair value and historical cost has been active for decades. Historical cost accounting dominated the twentieth century and is supported by theorists such as Samuelson (1965) and Sterling (1970), who argued that original cost offers verifiable, objective and dependable numbers. The key strength of this approach is reliability. Since the amounts come from documented transactions, managers have limited room for bias.
Fair value accounting, developed more fully in the late twentieth century, is supported by scholars such as Barth (1994), Watts and Zimmerman (1979), and others who argue that fair value provides more decision useful information for investors. This theory is grounded in relevance. It assumes that current market values reflect real economic conditions far better than historical prices.
Opponents of fair value often highlight the issues raised by Penman (2007), who argued that market-based estimates can be unstable, hard to verify and vulnerable to managerial manipulation. When active markets do not exist, the estimates require models and assumptions that may produce large variations across firms and time.
Supporters of fair value counter that historical cost can be outdated and misleading, especially for long-lived assets. As Lev and Zarowin (1999) argued, historical cost information loses relevance as markets and business conditions change. Revaluations under fair value could therefore better represent an entity’s current economic position.
The theoretical debate centres mainly on reliability versus relevance, objectivity versus timeliness, and faithful representation versus predictive usefulness. These tensions have shaped current standards in both GAAP and IFRS.
GAAP vs IFRS: Current Treatment
Fair Value Under GAAP
US GAAP applies fair value selectively. Financial instruments are often measured at fair value, especially when held for trading. GAAP uses a strict hierarchy that favours observable market inputs. However, most non financial assets continue to rely on historical cost. Property, plant and equipment remain at cost minus depreciation, with fair value only appearing in impairment testing.
Fair Value Under IFRS
IFRS is more open to the use of fair value. Entities may choose the revaluation model for property, plant and equipment. Investment property is commonly measured at fair value. IFRS also uses a fair value hierarchy similar to that of GAAP, but it allows revaluation gains to be recognised in other comprehensive income.
Historical Cost Under Both Systems
Historical cost remains the default for many categories of assets in both frameworks. Inventories, fixed assets under the cost model, and intangible assets without active markets are generally recorded at historical cost.
