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Advantages and Disadvantages of Historical Cost Accounting Essay

Historical cost accounting has been a controversial method that experienced many criticisms over a period of time, especially since it considers the acquisition cost of an asset and does not recognize the current market value. Merits and demerits of this method are as follows.

The most obvious advantage of HC accounting is objectivity. It is a predominantly objective system, which records the original cost of an item when it was purchased. Under historical cost accounting there is no room for manipulation and “the data is supported by independent documentary evidence, such as invoice, statement, cheque counterfoil, receipt or voucher.”(Elliott and Elliott:43) Any other method for recording transactions would be less objectives since the amount being recorded would depend on individual point of view and is various from different people.

Secondly, being compared with most other methods, historical cost is an easier and cheaper way of valuation. In respect that the original cost is one that already existed and could not be amended, which is easy to determine and can be verified. Therefore, it requires less estimation for accountants to record the data and easier for auditor to inspect them subsequently. In addition,” as a basis of fact, it is verifiable and to that extent is beyond dispute”. (Alexander and Nobes :180)

Another significant advantage of it is reliability, which is one of the key characteristics of financial reporting, as examined in the IASB’s Framework. As a past value, for most assets historical cost is more reliably determined than other current valuation such as fair value. This measurement can ensure that there are not excess benefits to users. (Alexander and Nobes:181)

Unfortunately, as every coin has two sides, HC accounting also can not avoid having drawbacks. The main disadvantage exists in the subsequent days after acquisition. “The continued reporting of historical cost based values does not reflect any changes in market value. “ Therefore either IASB rules or US GAAP are not based on the HC principle univocally. Actually, the measurement model used by these standards, like IFRS, is a mixture of historical costs, market values, net realizable values and discounted present values. (Walton and Aerts:76)

Moreover, although HC accounting method is reliable, the problem mentioned above lead to another disadvantage—lack of relevance, which is also a vital characteristic of financial reporting for decisions makers. As we know, making decisions normally requires estimation of the future, particularly the prediction of cash flows. (Alexander and Nobes:181). However HC method is based on the past values, and therefore can not provide the most relevant information for the future. It may not be the best guide to the future performance, financial status and investment potential. (Alexander, Britton and Jorissen:867)

In addition, although this method is predominantly objective, it can be broke by some special situations, owing to alternative definitions of revenue and costs and the need for estimates. Revenue and cost could be determined according to a choice of criteria. For instance, “although inventories are valued at the lower of cost or net realizable value, the cost will differ depending upon the definition adopted, like first-in-first-out or last-in-first-out cost.”

Assets are often subjected to revaluation. In an economy of changing price levels, the historical cost system has been compromised by a perceived need to restate the carrying value of those assets that comprise a large proportion of a company’s capital employed such as land and buildings.(Elliott and Elliott:44)

B. Elliott and J. Elliott, 2009, Financial Accounting and Reporting ,13rd edition, FT Prentice Hall , Essex D. Alexander, A. Britton and A. Jorissen, 2007, International Financial Reporting and Analysis, 3rd edition , Thompson Learning , London. P. Walton and W. Aerts, 2006, Global Financial Accounting and Reporting: Principles and Analysis, Thomson Learning, London D. Alexander and C. Nobes, 2004, Financial Accounting: An International Introduction, 2nd edition, FT Prentice Hall , Essex

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