Advantages and disadvantages of historical cost accounting, alternatives to historical cost accounting
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 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...