Historical Cost versus Fair Value

To understand the evolution of accounting from a historical cost-based system

to one that relies heavily on fair value accounting, it is first important to

review how accrual accounting itself has evolved over the years.

In order to conform to the most widely accepted accounting standards

developed throughout the world, financial statements generally must be

prepared on the accrual method of accounting. But in many cases, especially

with smaller businesses, cash-basis financial reporting may be perfectly

acceptable, because the use of the financial statements is more limited—to

simply monitor financial activities or to report revenues received to a bank

in connection with a loan.

Under the cash basis of accounting, revenues are recorded when they

are collected and expenses are recorded when they are paid. But with

accrual accounting, the timing of revenue and expense recognition is different.

Revenue is recorded when it is earned, which may come either before or

after it is actually collected. Likewise, expenses and/or liabilities are recorded

when the benefits have been received, such as when services have been

provided by a vendor or goods are received. Accrual accounting is the foundation

of all of the world’s commonly used accounting standards, including

both of the systems covered in this book.

But even accrual accounting has undergone much change—and that

change is not limited to the increased use of fair value accounting. The

very concept of when to recognize an asset or liability has evolved. One

of the best examples of this is with asset retirement obligations, a topic

explained in Chapter 13. Prior to the development of the current standards

dealing with asset retirement obligations, the carrying amount of land or a

building was the amount paid to acquire the asset, including any amounts

borrowed. The thought of accruing an additional amount to the asset