Cost Accounting: Traditional Method vs. Fair Value Model

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Table of Contents

Introduction
Main body
Conclusion
References

Introduction

The October 2007 issue of Entrepreneur Magazine featured an article written by Patrick A. Casabona and Sylvia Gornik-Tomaszewski entitled: “Special Issue: Fair Value in Financial Reporting, Auditing and Tax Accounting” that compared the traditional method with the fair value model of cost accounting. It is an important issue about that is attracting a lot of debate presently all over the world.

Main body

Despite the fact that the fair value method is a newer, supposedly better method than the traditional model and enjoys the backing of major international accounting trend setters, there are many critics who contend that the traditional model continues to make more sense as compared to its new competitor.

The critics of the fair value method state 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 scandal² that shook the world as it shockingly exposed the excesses of businesses during the economically booming 1990s in the United States.

Critics have identified several major flaws in the fair value model of cost accounting that go to show it is not a totally reliable method.

First of all, even the most purposeful assessment of fair value conducted by a business organisation’s management will be incorrect to the degree that the many forecasts and presumptions are incorrect.

Secondly, unscrupulous management personnel can capitalise on the opinions and assessments utilized in the process to distort data and generate favourable results. For example, the DCF 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 can be carried out.

Thirdly, irrespective of the intentions of management, the utilisation of Level 2 and Level 3 modes of measuring fair value as prescribed by SFAS No.157 of the FASB, generate figures that are problematic to verify .

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 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 that have no contractual cash flows.

Conclusion

In conclusion, despite the Entrepreneur Magazine article’s portrayal of the fair value method as much better than the traditional method of cost accounting, there is no doubt that the fair value model has a lot of drawbacks. It is foolhardy and dangerous to totally 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 PA, Gornik-Tomaszewski S. Special Issue: Fair Value in Financial Reporting, Auditing and Tax Accounting. Entrepreneur Magazine [serial on the Internet]. 2007. Web.

Krumwiede T. Why Historical Cost Accounting Makes Sense. Allbusiness.com [document on the Internet]. 2008. Web.

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Cost Accounting: Traditional Method vs. Fair Value Model

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