Page 203 - Accounting Principles (A Business Perspective)

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• Gain and loss recognition principle.
• Full disclosure principle.
Whenever resources are transferred between two parties, such as buying merchandise on account, the

accountant must follow the exchange-price (or cost) principle in presenting that information. The exchange-price
(or cost) principle requires an accountant to record transfers of resources at prices agreed on by the parties to
the exchange at the time of exchange. This principle sets forth (1) what goes into the accounting system—
transaction data; (2) when it is recorded—at the time of exchange; and (3) the amounts—exchange prices—at which
assets, liabilities, stockholders' equity, revenues, and expenses are recorded.
As applied to most assets, this principle is often called the cost principle. It dictates that purchased or self-
constructed assets are initially recorded at historical cost. Historical cost is the amount paid, or the fair market

value of the liability incurred or other resources surrendered, to acquire an asset and place it in a condition and
position for its intended use. For instance, when the cost of a plant asset (such as a machine) is recorded, its cost
includes the net purchase price plus any costs of reconditioning, testing, transporting, and placing the asset in the
location for its intended use. Accountants prefer the term exchange-price principle to cost principle because it
seems inappropriate to refer to liabilities, stockholders' equity, and such assets as cash and accounts receivable as
being measured in terms of cost.
More recently, the FASB in SFAS 157 has moved definitively towards fair market value accounting, or “mark-to-
market”, which records the value of an asset or liability at its current market value (also known as a “fair value”)
rather than its book value.

SFAS 157 defines “fair value” as “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”.
It is also defined as “an exit price from the perspective of a market participant that holds the asset or owes the
liability”, whether or not the business plans to hold the asset/liability for investment, or sell it.
“The fair value accounting standard SFAS 157 applies to financial assets of all publicly-traded companies in the
US as of 2007 Nov. 15. It also applies to non-financial assets and liabilities that are recognized, or disclosed, at fair
value on a recurring basis. Beginning in 2009, the standard will apply to other non-financial assets. SFAS 157

applies to items for which other accounting pronouncements require or permit fair value measurements except
share-based payment transactions, such as stock option compensation.
“SFAS 157 provides a hierarchy of three levels of input data for determining the fair value of an asset or liability.
This hierarchy ranks the quality and reliability of information used to determine fair values, with level 1 inputs
being the most reliable and level 3 inputs being the least reliable.
• Level 1 is quoted prices for identical items in active, liquid and visible markets such as stock exchanges.
• Level 2 is observable information for similar items in active or inactive markets, such as two similarly
situated buildings in a downtown real estate market.

• Level 3 are unobservable inputs to be used in situations where markets do not exist or are illiquid such as
the present credit crisis. At this point fair market valuation becomes highly subjective.”
Fair value accounting has been a contentious topic since it was introduced, For example, “banks and investment
banks have had to reduce the value of the mortgages and mortgage-backed securities to reflect current prices”.
Those prices declined severely with the collapse of credit markets as mortgage defaults escalated in the financial
crisis of 2008-2009. Despite debate over the proper implementation of fair market value accounting, International

Accounting Principles: A Business Perspective 204 A Global Text