Cost Model vs. Fair Value Model

Attribute	Cost Model	Fair Value Model
Measurement Basis	Historical cost	Current market value
Valuation	Based on original cost	Based on market value
Recognition of Gains/Losses	Gains and losses recognized only when asset is sold	Gains and losses recognized as they occur
Relevance	Less relevant in rapidly changing markets	More relevant in rapidly changing markets

Introduction

Cost Model and Fair Value Model are two commonly used accounting methods to value assets. Both models have their own set of attributes and advantages, which make them suitable for different situations. In this article, we will compare the attributes of Cost Model and Fair Value Model to understand their differences and similarities.

Cost Model

The Cost Model, also known as the Historical Cost Model, values assets based on their original purchase price. Under this model, assets are recorded on the balance sheet at their historical cost, which includes the purchase price plus any additional costs incurred to bring the asset to its present condition and location. The main advantage of the Cost Model is its simplicity and ease of use. It provides a stable and reliable valuation of assets over time, as it does not take into account changes in market conditions.

However, one of the limitations of the Cost Model is that it may not reflect the true economic value of assets, especially in cases where the market value of the asset has significantly increased or decreased since its purchase. This can lead to understating or overstating the value of assets on the balance sheet, which may not provide users with a true picture of the company's financial position.

Another drawback of the Cost Model is that it does not consider the concept of impairment. If the market value of an asset drops below its carrying amount, the Cost Model does not allow for any write-down in value. This can result in assets being carried on the balance sheet at a value higher than their recoverable amount, leading to potential misrepresentation of the company's financial health.

Fair Value Model

The Fair Value Model, on the other hand, values assets based on their current market value. Under this model, assets are revalued periodically to reflect their fair value, which is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The main advantage of the Fair Value Model is that it provides users with more relevant and up-to-date information about the value of assets.

One of the key benefits of the Fair Value Model is that it allows for greater transparency and comparability of financial statements. By valuing assets at their fair value, users can better assess the company's financial position and performance, as it reflects the current market conditions. This can be particularly useful for investors and stakeholders who rely on accurate and timely information to make informed decisions.

However, one of the challenges of the Fair Value Model is the subjectivity involved in determining the fair value of assets. Market conditions and other external factors can influence the valuation of assets, leading to potential fluctuations in their reported value. This can make it difficult to assess the true economic value of assets, as fair value may not always reflect the actual selling price of an asset in the market.

Comparison

When comparing the Cost Model and Fair Value Model, it is important to consider their respective attributes and how they impact the valuation of assets. The Cost Model provides a simple and stable valuation of assets based on historical cost, while the Fair Value Model offers a more relevant and up-to-date valuation based on current market conditions.

• Cost Model values assets at historical cost
• Fair Value Model values assets at current market value
• Cost Model may not reflect true economic value of assets
• Fair Value Model provides more relevant information to users
• Cost Model does not consider impairment
• Fair Value Model allows for greater transparency and comparability

Overall, both the Cost Model and Fair Value Model have their own set of advantages and limitations. The choice between the two models depends on the specific needs of the company and the users of the financial statements. While the Cost Model may be more suitable for assets with stable market values, the Fair Value Model may be preferred for assets that are subject to frequent market fluctuations.