The historical cost accounting convention.

Topics: Balance sheet, Generally Accepted Accounting Principles, Costs Pages: 7 (2266 words) Published: April 15, 2003

Realised-profit, matching-based, historical cost accruals accounting (HCA) has for over fifty years been repeatedly challenged as being an inadequate basis for the measurement of "income" which reports increments in the value of businesses. Such challenges continue unabated and are made by both accounting standards regulators and by academic commentators. Despite its obvious deficiencies for measuring valuation based income, and subject to concept of prudence, internationally HCA remains the dominant basis for reporting and share prices appear to be influenced by reported earnings.

This paper will go through few criticisms of our standard accounting model, look at possible alternatives and finally will provide a detailed explanation of why Historical Cost accounting is still the conventionally used method.

What are 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.

The role of 'Stewardship'

It is a widely held view that the prime objective of the preparation and publication of regular financial reporting is - so far as public limited companies are concerned - to provide a vehicle whereby the directors can account to the owners of the company on their stewardship of the resources entrusted to their charge (Page 57,Lewis & Pendrill, 2000). Historical Cost accounting adequately helps the Directors to report to the Shareholders of how well their funds or company's resources have been used. A typical historical cost balance sheet will list the company's assets and liabilities held by outsiders. It does not recognise and include the intangible assets such as skills and knowledge of employees, company's markets share and so on. It therefore provides the shareholder with monetary efficiency of the company but the Director's stewardship does not end there. The Directors have to use the potential of their employees to the fullest, ensure high market share and other related duties that they have to fulfil for the Shareholders. Hence it has been argued that Historical Cost is only efficient in a narrowly defined stewardship.

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 deprecation 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...
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