In accounting the term measurement can be seen as the process of determining the monetary value at which the elements (includes assets, liabilities, revenue, expenses, gains and losses) of the financial statements are to be recognized and recorded in the statements of financial position and income statements. There are a number of measurement bases as used in accounting today.
Historical cost.
Here, assets are recorded at the amount cash equivalent that was paid for a particular element. Thus, the cost considered is that which was incurred to acquire the products or elements at the time of their acquisition.
Liabilities are recorded at the amount of proceeds received in exchange for the obligations or in some circumstances (for example, income taxes), at the amount of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.(Casabona, Patrick A.,G).
The historical cost argument heavily borrows from the principle of objectivity in accounting (Wild, J.J 2007). The principle requires that the value of transactions, assets and liabilities be verifiable. It thus implies that the valuation must be independent of the person valuing the asset or liability (elements). In many instances, different parties would in most cases disagree on the expected cash flows from an element but agree on the historical cost. This is because historical cost is objective and verifiable.
Those who do support the historical cost as good measurement tool for elements do argue that it is important for users to have confidence in financial statement. This confidence can only be maintained if accountants do recognize changes in assets and liabilities on the basis of completed transactions only. However, prevailing market values are in most cases a matter of individual opinion. It is this freedom in opinions that has sprung up the question of whether it is wise to value assets at costs or at estimated market value (fair value). This is a classic illustration of "trade off" between the relevance and the reliability of accounting.
Measurement using fair value method
Fair value can be defined as the total price received after selling an asset or honoring a liability in an orderly transaction. This is therefore the prevailing value of and asset, liability or a stock in any market. Thus in financial reporting, the accountants give the consideration and use the prevailing market price in preparing the financial reports. Orderly transaction as used in accounting is the mutual agreement done under prevailing market conditions without any external influence or pressure.
Determining Fair Value
The process of determining an asset or liability value on a fair value basis is heavily reliant on the ease of determining its price (asset or liability). Thus fair value is the price that the seller(s) or buyer(s) are willing to trade at in a perfect markets situation.
Argument for using fair value
Fair value measurement offers important piece of information concerning assets and liabilities than historical cost does. This is because the fair value actuaully does take into account the prevailing market conditions providing comparability of the financial reports across different firms and times. Accounting is heavily reliant on the assumption of going concern which states that an entity is expected to be in operation for a foreseeable future. Thus, the reports prepared and produced using the fair value measurement improves their relevance such that they can be used for analysis on performance within a firm or across the industries.
Historical measurement required the preparers of the financial reports to provide notes at the end of their reports explaining various decisions and methodologies used. Thus, the notes or foot notes provided ended up containing all the information about the fair value of all financial elements since they indicated how the value of each has been determined. This fulfilled the principle of full disclosure which states that all accounting reports must fully disclose every fact with a likely hood of influencing the judgment of any reader or user of the statements. The reports are required by this principle to adequately disclose all the materials and relevant facts concerning financial position and the results of all operations be communicated to the users.
The advantages of using the fair value in financial reporting
Presents more accurate valuation in assets and liabilities
Use of fair value in financial report allows the firms to report figures in their financial reports which are accurate, timely and much more comparable. This is not always the case when financial reports are prepared using the historical model especially so if the market conditions are heavily skewed towards one extreme. For example, in the recent global economic crisis experienced in most developed countries US included, use of historical cost measurement would have resulted in gross undervaluation of assets of many firms. However, fair value model would have given the correct figures in any valuation and hence such a financial report prepared under fair value would have been much more relevant.
Reduces manipulability by firms
It reduces manipulability of companies' income since the gains and losses on their assets & liabilities are captured in the period they do occur but not when they are earned. This goes against the tenets of generally accepted accounting principles (GAAPs) which state that "the point of recognition of revenue should be the point that revenue can be reasonably and objectively be determined". Generally revenue is recognized at the point of sale since at this point, the earning process is essentially complete and the exchange value can be determined.
Disadvantages of using fair value in financial reporting
Not a reliable measure in turbulent economic times
Markets are sometimes dominated by bubble prices especially I turbulent and high inflation economic times. These can either be highly inflated or highly deflated as a result of market instability. When the optimism occurs, the market experiences excess liquidity and this can lead to over valuation of an asset or liability. This basically captures the wrong bloated figures throwing us back to the very situation we were avoiding. Bubble pricing has emanated mostly from short irrational decisions by investors. This sees the prices of some critical factors in an industry rise resulting to the bubble prices which eventually burst when the market forces take over. Fair value reporting done in such situations is grossly misrepresented and may not capture the "fair value" of the given asset or liabilities.
Financial reports prepared using the fair value models have been known to be grossly affected by the prevailing economic situations in a country or globe. During the global economic crisis, fair value valuation was highly affected negatively since the investor confidence was eroded. This resulted to low liquidity of assets and liabilities tended to be highly costly to the investors. This has led to argument that firms should report based on amortized costs.
It does not add value to assets with no market value
Fair value pricing becomes irrelevant to use to assets without any market value. This is because determination of prices for assets with inelastic demand becomes problematic and highly subjective. This eventually affects the price at which an asset can be recorded in the balance sheet.
