Importance of Historical Cost Accounting

How is historical accounting better than alternatives?

Tina S
Tina S
Nov 5, 2009
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Historical Cost Accounting
is a traditional valuation method as it reflects only on the past cost of the asset, however in the contemporary business environment companies must remain flexible and transparent.

This belief has lead to the creation of several other valuation methods, due to word constraints I have focused primarily on Fair Value Accounting as an alternative to Historical Cost Accounting.

Although Fair value accounting is a theoretically superior valuation methodology, there are several severe problems in its current application, due to lax regulations and ineffective methods of determining current values of non-current assets. These problems within Fair Value Accounting have ensured that most companies conservatively remain using Historical Cost Accounting.

The historical cost system provides managers with a reliable, objective data that solely identifies changes in the organisations performance. Upon this base changes in performance can then be compared in reporting and measuring economic information.

No other method of accounting can provide exact information at a glance on the change in trends in the company's workings like the historical costs method.

Current valuations of non-current assts can also be disclosed as supplementary data without affecting financial statements.

What Does Historical Cost Mean?

A measure of value used in accounting in which the price of an asset on the balance sheet is based on its nominal or original cost when acquired by the company. The historical-cost method is used for assets in the U.S. under generally accepted accounting principals (GAAP).

Based on the historical-cost principle, under U.S. GAAP, most assets held on the balance sheet are to be recorded at the historical cost even if they have significantly changed in value over time.

For example,
say the main headquarters of a company, which includes the land and building, was bought for $100,000 in 1925, and its expected market value today is $20 million. The asset is still recorded on the balance sheet at $100,000.

Not all assets are held at historical cost. For example, marketable securities are held at market value on the balance sheet.


Criticisms of the historical costs method :

Historical cost method, over a period of time has been subject to many criticisms, especially as it considers the acquisition cost of an asset and does not recognize the current market value.

A historical cost is only interested in cost allocations and not in the value of an asset. While it tells the user the acquisition cost of an asset and its depreciation in the following years, it ignores the possibility that the current market value of that asset may be higher or lower than it suggests.

    * Another main criticism of historical accounting method is its obvious flaws in times of inflation. The validity of historic accounting rests on the assumption that the currency in which transactions are recorded remains stable, i.e. its purchasing power remains the same over a period of time.

    * Another main point with regards to inflation is rise in prices for an asset. An asset purchased at a point in time may be expensive in future.

The traditional accounting principles record all assets at an original cost and continue to use these historic figures throughout the asset's life, while economists make a more intelligible assumption that money has a time-value attached to it. The economist's approach is broadly embraced in the corporate finance model whose objective is centered on value creation for the shareholders.

In addition effects of inflation may not be the same for all the companies in the market and historical cost accounts become almost unhelpful when comparing corporate performance.

Alternatives to historical cost accounting :

Over the years accounting bodies have introduced a number of alternative accounting methods to historical cost accounting.

Opportunity costs are commonly used in economics and do not have much relevance here, however accounting bodies and academic commentators have forwarded new methods of accounting using the current asset value, as opposed to the conventional acquisition cost.

Replacement costs could be used as a possible alternative to historical cost method. In crude terms replacement costs may be defined as the estimated amount that would have to be paid in order to replace the asset as the date of valuation. An advantage of replacement cost is that it focuses on the services the asset will provide rather than the precise physical asset.

However, there is an immediate flaw noted in its definition, where the costs have to be estimated. Estimation has to be carried out after reviewing the asset, the market and if an identical asset is still being traded in the market.

While there are problems in simply achieving a precise replacement cost, this method also does not provide the various choices and features that historical cost accounting has to offer.

More accounting systems such as current cost accounting, exit price method, etc. are possible alternatives to historical cost accounting but these are also subject to manipulation to set a norm for measuring corporate performance.

How is historical accounting better than alternatives?

Quite clearly the several limitations and flaws of the traditional historical costs method have been highlighted and picked upon from time to time.

Still historical costs are the standard form of accounting due to its unique features and conventions that make it better than most available alternatives.

Ø    One of the main resources why historic accounting even though flawed forms the basis of our traditional accounting model is because accountants are reluctant to price the assets at current market value. Over the years number of cases relating to accounting malpractice and creative accounting have been exposed that have made accounting bodies reluctant from using current values which directly effect the share prices.

Ø    Accountants have to guard the integrity of their data against internal modifications. The use of current cost or exit price opens the door to manipulation of these numbers. The alternative measures for measuring and reporting assets provide management with considerable discretion and opportunities to influence the value of assets reported.

Ø    Critics admit that the possibility of manipulation exits, but the profession can formulate rules on how current values are to be ascertained.

Ø    Under historical cost accounting there is no room for manipulation and the data is supported by evidence such as invoices, receipts, etc.

Ø    Any other basis for recording transactions would be subjective, i.e. the amount in which the transaction will be recorded would be dependant on individual point of view and is bound to differ with different people.

Ø    The historical cost system provides managers with a significant range of alternatives in recognizing, reporting and measuring economic information.

Ø    One of the advantages of using historical costs it helps the managers to forecast future operational costs based on past data. The basic function of historical accounting is to tell a user "the cost of a thing". Without knowing the original costs future projections are almost hampered.

Ø    Historical costs play an important role here providing this necessary information. It is based on recording actual transactions. Not only is there a record of actual transactions, but also the figures are reliable. For current cost or exit price accounting, changes in prices are recorded but these are not based on actual transactions.

Ø    Financial statements based on historical cost have been found to be useful. Empirical evidence indicates that people find the conventional statements useful. No other method of accounting can provide exact information at a glance on the change in trends in the company's working like the historical costs method.








Keywords: opportunity cost,valuation current assets,GAAP,criticisms historical cost accounting,traditional accounting principles,replacement cost,historical accounting better than alternatives

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