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The principle of historical cost Essay

Synopsis.

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.

What are Historical costs?

Historical cost is a generally accepted accounting principle requiring all goods or assets used in production to be valued by the expenditures actually incurred to acquire those goods or assets, however far back in the past those expenditures took place (System of National Accounts, 1993). Valuing assets upon their original cost ensures valuations are objective, reliable and may be verified through invoices and documentation. Furthermore, accumulative depreciation ensures that the cost of the asset is spread throughout its productive lifetime. This method smooths out speculative fluctuations within Financial Statements to reflect comparable changes in company performance. The American Accounting Association (AAA 1936, p188) supported this view;

“…accounting is thus not essentially a process of valuation, but the allocation of historical costs and revenues to current and succeeding fiscal periods.”

Criticisms of Historical cost Accounting

Historical cost method, over a period of time has been subject to many criticisms, especially as it tells the user the acquisition cost of an asset and its deprecation in the following years, but ignores the possibility that the current market value of that asset may be higher or lower than it suggests. This occurs due to the various factors, other than the state of the good, that influence price. Rees (2004, p 21) expresses the need for fair value accounting within the Real Estate industry as land and houses tend to only increase in value over time.

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. However, inflationary pressures erode the purchasing power of money, therefore asset valuations should increase relative to inflation to reflect these changes. 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 historic cost accounting.

AASB 1010 Accounting for Revaluation of Non-Current Assets allows a good deal of scope because it doesn’t specify acceptable means of valuing assets, any need for reporting on the basis of the valuation or frequency of valuations. The Sydney Morning Herald (1990, p 24) reported on this situation, comments of Mr C. Breach:

“In Australia there are no commonly accepted standards and how properties are valued depends on the instructions of those asking for the valuation”

The lack of regulation has lead to various other valuation methods being used throughout the industry and thus enabling valuations to be manipulated by owners.

Fair Value Accounting.

Although various other valuation methods exist ‘Fair Value Accounting’ is the most popular alternative. The Fair Value of an asset is the amount at which that asset could be bought or sold in a current transaction between willing parties, other than in liquidation (GAAP 2004). This is important for businesses as, by using this valuation method, financial statements reflect the current value of company assets and thus true state of company solvency. Increased transparency and effective increase in asset valuations may encourage investors.

Appropriate valuation of assets without verifiable data can be difficult and subjective. This is especially the case when there is no market for the asset and valuation must be wholly speculative, often leading to unintentional over-valuations of assets.

Furthermore, management using Fair Value Accounting may intentionally over-value assets to improve the financial position of the company, as asset appreciation is recorded as revenue. Watts’ (2003, 2) points out that Enron’s ability to manipulate ‘fair values’ and WorldCom’s capitalisation of unverifiable unused capacity, were factors in those particular accounting scandals.

Comparison between Historical Cost Accounting and Fair Value Accounting.

Quite clearly historical cost accounting has several limitations and flaws that can have notable influences on businesses and are often criticised. Still historical costs are the standard form of accounting due to its unique features and conventions that make it better than all currently available alternatives.

If markets were liquid and transparent for all assets and liabilities, fair value accounting clearly would be reliable information useful in the decision making process. However, because many assets and liabilities do not have an active market, the inputs and methods for estimating their fair value are more subjective and, therefore, the valuations less reliable. Management bias, whether intentional or unintentional, may result in inappropriate fair value measurements and misstatements of earnings and equity capital.

Many recent cases of ‘accounting malpractice’ and ‘creative accounting’ have made accounting bodies reluctant from using current values that directly effect share value. Use of alternative valuation methods, such as Fair value pricing and Replacement Costing, opens the door to manipulation of numbers as it must, in part, be speculative and thus subjective. Under Historical cost accounting there is no room for manipulation and the data is supported by evidence such as invoices, receipts, etc.

The increased risk associated with Fair Value Accounting due to the high tendency of malpractice can also be detrimental to investor confidence in certain cultures, despite the method providing greater transparency. L. Nichols’ (2002, p 3) study highlights this belief as German bankers general lend more to companies using Fair Value Accounting, whereas US bankers, in a proportional more corrupt market, lend more to companies using historical cost accounting.

The high level of speculation required for valuation of assets will also increase company’s volatility to economic conditions. As Wilson explains,

“Financial reporting will be about predicting the future as opposed to reporting the past,”

(International Accounting Bulletin 2004).

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.

Conclusion.

The accounting industry should be very careful before moving toward a more comprehensive fair value approach, where all financial assets and liabilities are recorded on the balance sheet at fair value and changes in fair value are recorded in earnings, whether realized or not. However, the many potential gains of Fair Value Accounting should be noted, especially in industries such as Real Estate where non-current assets can produce revenue.

Historical cost accounting is not the most effective valuation method possibly for businesses, and theoretically Fair Vale Accounting would improve company transparency, flexibility and efficiency. However, the various problems of the current methodology diminish its current popularity. Until Australian Accounting Standards can ensure that regulations are being enforced to guarantee fair value estimates are reliable, verifiable, and auditable, the risk of malpractice shall continue to weaken investor confidence.


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