|
Accounting concepts and conventions as used in accountancy are the
rules and guidelines by which the accountant lives. The historical cost
accounting convention is an accounting technique that values an asset
for balance sheet purposes at the price paid for the asset at the time
of its acquisition.
The historical cost accounting is the situation in which accountants
record revenue, expenditure and asset acquisition and disposal at
historical cost: that is, the actual amounts of money, or money's
worth, received or paid to complete the transaction.
Historical costs
Historical cost is a generally accepted accounting principle
requiring all financial statement items be based upon original cost.
Historical cost means what it cost the company for the item. It is not
fair market value. This means that if a company purchased a building,
it is recorded on the balance sheet at its historical cost. It is not
recorded at fair market value, which would be what the company could
sell the building for in the open market.
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 recognise the current market value. Historical costs
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 centred 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.
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.
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.
Critics admit that the possibility of manipulation exits, but the
profession can formulate rules on how current values are to be
ascertained. Under historical cost accounting there is no room for
manipulation and the data is supported by evidence such as invoices,
receipts, etc. 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.
The historical cost system provides managers with a significant
range of alternatives in recognising, reporting and measuring economic
information. 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.
Historical costs play an important role here providing this
necessary information. Historical cost 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.
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.
Conclusion
Accounting bodies have not abolished the flawed historical cost
method as they recognise the fact that other methods are flawed as well
and there is not better replacement. Also they cannot ignore the fact
that despite its several limitations historical cost accounting, it has
several advantages and it has now been widely recognised and accepted
by corporations across the globe. Even if accounting bodies develop a
new accounting method or simply pick an existing method to form the
standard of accounting, will it be better than historical cost
accounting? People are familiar working with the historical costs and
that makes it even more difficult for the accounting bodies to replace
it.
A consistent effort is needed from the accounting bodies to develop
a foolproof method, which can effectively take over the traditional
historical method. Until then historical cost accounting will remain
one of the oldest and controversially dominant method for measurement
of corporate performance.
|
(0 vote)