Cost Accounting: the Fair Value Model

Cost accounting all over the world is carried out by using the traditional method or the fair value model. There has been a lot of debate as to which model is better suited to businesses in the current world environment.

Article on Cost Accounting

The October 2007 issue of Entrepreneur Magazine featured an article that compared the traditional method with the fair value model of cost accounting. The traditional method, which was recommended by international account standard-setting bodies, was predominantly followed up to and during the 20th century. This method perceives a business entity’s Income Statement as its fundamental financial statement that divulged valuable data about its accomplishments and monetary worth to stockholders. The entity’s Balance Sheet was perceived as a document subsidiary to the Income Statement as it depicted information like expenses paid in advance, unearned income, accumulated expenses, and accumulated income. Financial reports generated by this method were and are still considered by many as dependable, comparatively easy to investigate, and easy to comprehend (Casabona & Gornik-Tomaszewski).

Many considered that the traditional method was suitable provided the business entity’s assets were largely recognizable and tangible. But with the rising importance of intangible assets like brands, copyrights, and patents this cost accounting method was perceived to have provoked discrepancies such as under-valuation and under-recording of assets to suit the entity’s aims and plans, resulting in large differences between the entity’s book and market values. This led to a widespread call for a more suitable cost accounting model that could provide more reliable information, as a result of which the fair value method was born. Under the new model, the significance of the Income Statement and Balance Sheet got interchanged, with the latter becoming the fundamental document while the former assuming the role as its subsidiary (Casabona et al.).

The fair value method was quickly accepted as a valuation attribute by international accounting standard setters like the FASB {Financial Accounting Standards Board}, GAAP {Generally Accepted Accounting Principles} and IASB {International Accounting Standards Board}, thereby boosting the new cost accounting model’s popularity all over the world so much so that it was even widely regarded as a key global accounting convergence between the FASB and IASB. However, it soon became apparent that the fair value method is not reliable mainly because its subjective assumption approach led to estimation mistakes, which in turn spawned inaccurate data in the Balance Sheet and Income Statement. This was especially so in the case of investment securities that were bought and sold in active markets. This deficiency made eminent global financial analysts like Theresa P. Ahlstrom, Managing Partner of KPMG {Long Island Branch} confirm that while the fair value model is better than the traditional model, it is still in need of several refinements before it can emerge as a reliable cost accounting method (Casabona et al.).

The Traditional Model is better than the Fair Value Method

Even though the fair value method is a newer, supposedly better method than the traditional model and enjoys the backing of major international accounting trendsetters, many critics contend that the traditional model continues to make more sense as compared to its new competitor.

The critics of the fair value method contend that it lags far behind the traditional model insofar as the two most vital foundations of financial reporting are concerned – reliability and relevance. They underline their stance by blaming the fair value method as a significant cause of the Enron scandal (Krumwiede) that shook the world as it shockingly exposed the excesses of businesses during the economically booming 1990s in the U.S.

Critics have identified several major flaws in the fair value model of cost accounting. First of all, even the most purposeful assessment of fair value by a business entity’s management will be incorrect to the degree that the many forecasts and presumptions are incorrect. Secondly, unscrupulous management personnel can capitalize on the opinions and assessments utilized in the process to distort data and generate favorable results. For example, the DCF {Discounted Cash Model} model’s assessment of cash flows can be manipulated to either overstate or understate amounts according to management’s wishes, or huge write-downs during a particularly poor performance period {called ‘big-bath procedure’} can be carried out.

Thirdly, irrespective of the intentions of management, the utilization of Level 2 {observable inputs from active markets for similar data [such as sales prices] except assets and liabilities} and Level 3 {unobservable inputs} modes of measuring fair value as prescribed by SFAS {Statement of Financial Accounting Standards} No.157 of the FASB, generate figures that are problematic to verify {even verification done by a third party auditor would require significance dependence on assessments carried out by management}. Fourthly, it is understandable that any shift towards a fair value model could be incompatible with a principles-based accounting standards-setting procedure. Lastly, assets that feature contractual cash flows are problematic to value. It is significant to note here that the SEC has acknowledged this particular deficiency in the fair value model by suggesting {in its letter dated March 2008 addressed to prominent financial institutions} the provision of a variety of estimates in case of securities. The SEC’s admission gives rise to a potentially greater problem, namely, the difficulties that will arise while valuing assets {like intangible and a majority of long-lived assets} that have no contractual cash flows (Krumwiede).

Conclusion

In conclusion, there is no doubt that the fair value model has a lot of drawbacks. It is foolhardy and dangerous to rely on a cost accounting method that can significantly precipitate massive accounting scandals such as the Enron fraud. Hence, until its drawbacks are properly circumvented and it is then properly and conclusively proved by the international accounting trend-setting bodies that the fair value model is error-free and therefore worth adopting, it is highly recommended that business entities continue using the presently more trustworthy traditional cost accounting model.

References

Casabona, Patrick A. & Gornik-Tomaszewski, Sylvia. “Special Issue: Fair Value in Financial Reporting, Auditing and Tax Accounting.” Entrepreneur Magazine. 2007. Web.

Krumwiede, Tim. “Why Historical Cost Accounting Makes Sense.” Allbusiness.com. 2008. Web.

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