The historical cost accounting convention
The historical cost accounting convention
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 almost unhelpful when comparing corporate performance.
Alternatives to Historical Cost accounting
Over the years Accounting bodies have introduced number of alternative accounting methods to Historical cost method. 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 (RC) may be defined as the estimated amount that would have to be paid in order to replace the asset as the date of valuation (Page 46,Lewis & Pendrill, 2000). An advantage of replacement cost is that it focuses on the services the asset will provide rather than the precise physical asset. It therefore excludes speculative gains that might be made from selling a building to a purchaser who will redevelop it for an alternative use; equally it allows valuations to reflect the use that the current owner can make of an asset, even if a purchaser would not be able to employ the asset as profitably.
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. Further difficulties inherent in the estimation are noted when the asset in the market is either not identical or obsolete. In these cases usually the replacement costs are much higher. Further more, the replacement costs of an asset will vary depending upon the size of the order, i.e. economies of scale. While there are problems in simply achieving a precise replacement cost, this method also does not provide the various choices and features that HC 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 available 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 reasons 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. Companies like Enron, Worldcom, etc. with the help of their nominated auditors managed to control their share prices by valuing their assets.
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 exists, 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 HC (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 in layman’s terms 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 (objective). For current cost or exit price accounting, changes in prices are recorded but these are not based on actual transactions.
Under historical cost accounting, profit is the difference between sales proceeds and the original cost of the item sold. The purpose of the calculation is to determine the amount available for distribution after the money value of the owners’ original investment has been maintained intact. People understand the notion of profit under historical cost. Critics admit that the historical cost notion of profit is familiar to people, but this does not make it better or proper. Such a view of profit is understood because of the long use of historical cost. Historical costs also allow changes in market prices to be disclosed as supplementary data. If there are people who want current value data, these can be disclosed as supplementary data without having to abandon historical cost accounting. However critics of historical accounting method argue that if the data can be disclosed, it should be included in the financial statements.
Financial statements based on historical cost have been found to be useful. For years, financial statements on a historical cost basis have been used. Empirical evidence indicates that people find the conventional statements useful. Annual financial reports provide the historical facts and figures and organisation use this information from time to time to analyse their performance as compared to past 2-3 years. 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.
So does historical cost accounting method really need replacing ?
Undoubtedly Historical Cost method of performance measurement has some obvious flaws and is certainly not the most reliable method. However this raises the important question of ‘why is it still the standard for measuring corporate performance’? One of the answers to this question is that there is simply not another method efficient and effective enough to replace the traditional Historical cost method. The current available methods such as Value added analysis or Replacement costs have their own advantages but as compared to historical cost accounting they have several flaws, are biased to particular users of information and are subject to manipulation. As compared to Historical cost method other methods are available alternatives to use in different situations or to achieve specific results.
One of the main reasons for the popularity of historical costs is the amount of choices given to reporting entities. The historical cost of a fixed asset purchased when new may be well known, but it will usually be impossible to say what proportion of the original total cost should be regarded as being applicable to that proportion of the asset which remains unused at a point in time valuation (Page 45,Lewis & Pendrill, 2000). This allows the company to define the depreciation rate and it is possible that the asset will be a part of the production operation even after its net book value is zero at a future date. It is also possible for a company to purchase a used asset and determine the remaining life for that asset. Under historical cost, while dealing with stock, the choice remains with the manager to either use ‘average value’ or FIFO, etc. As for finished goods and work in progress, the cost allocation again remains with the management.
Historical costs also allow acquisition of assets through barter or exchange. The assets are acquired as an exchange for the shares in the purchasing company. In these cases an estimate is made about the value of the assets at a amount that would have been realised, had the assets been sold for cash. Sometimes one company buys another exiting company at a value, which is far excess from the physical assets that are acquired. In this transaction the buying company is not only getting acquisition of fixed assets such as land but also of the intangible assets such as patent rights to the brand, customer base and so on. For accounting purposes it is necessary to determine the cost of individual assets and liabilities which have been acquired and this involves an allocation of global price to the individual assets and liabilities which are separately identified in the accounting system. Any balancing figure represents the amount paid for all assets and liabilities and not separately identified in the accounting system and is described as ‘goodwill’ valuation (Page 45,Lewis & Pendrill, 2000).
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 no ‘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? There is always a possibility that switching over to another method may not be happily accepted every where. People are familiar working with the historical costs and that makes it even more difficult for the Accounting bodies to replace it. Historical Cost Accounting has been consistently used in USA for a number of decades. In the UK, the use of historical method is very inconsistent and is applied with moderate modification.
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.