Nowadays, high inflation is an inevitable problem in many countries. High inflation occurred owing to the demand level of goods and services are over the supply level of goods and services. It is lead to price changes taking place. Since year of 1980, several different accounting approaches were introduced to overcome these problems that reflected by inflation.
However, the historical cost accounting still widely and continuously to be used by most companies in their accounting. Conversely, reporting current cost in accounting are recommended rather than historical cost as it is the fair value reported in the current year would be beneficial to the firm and the shareholders of the company.
2.0 Historical Cost Accounting and Benefits of Current Cost
2.1 Introduction to Historical Cost, Disadvantages and Advantages of Historical Cost
The historical cost accounting is conventional adopted method and it still used in our studies and working place today. Historical basis approach stated all the financial items “are presented on the balance sheet at their value at the time of acquisition (generally represented by the original purchase cost)” (Knowledge@Wharton, 2001) [Online]. The inflation issues and current market valuation are ignored in this method. Thus, it might ‘not provide useful and relevant information for decision making’ (Han, et al, 1994, p.243). Notwithstanding the adjustments for inflation is not taking account in this method, but there are several accounting adjustments to affect the carrying value; such as “depreciation, depletion and impairment” (Graeme Pietersz, 2009) [Online]. Assets of
X Ltd | | | |Accumulated | |Net Book | |Fair | |(at 31.12.2009) | |Cost | |Depreciation | |Value | |Value | | | |(RM) | |(RM) | |(RM) | |(RM) | |Building A | |100,000.00 | |- | |100,000.00 | |120,000.00 | |Plant & Machine | |70,000.00 | |38,000.00 | |32,000.00 | |40,000.00 | |Furniture | |20,000.00 | |10,000.00 | |10,000.00 | |12,000.00 | |Inventory | |15,000.00 | |- | |15,000.00 | |18,000.00 | | | |205,000.00 | |48,000.00 | |157,000.00 | |190,000.00 | | | | | | | | | | | |Here we are using an example to illustrate the difference of historical cost and current cost when taking over another company’s assets with following table:
When we take over the assets of X Ltd; these assets’ historical cost after depreciation is RM 157,000 which has a difference of RM33,000 compared to the fair value of RM190,000. The difference of RM3,000 in inventory is consider as holding gain for X Ltd if the company continue keeping it because the cost of such inventory is increase at the end of the accounting year.
From the above example, we can realize that the historical cost does not provide accuracy cost owing to ignorance of inflation. Even though the company X Ltd has implement the depreciation on those assets, but it just depreciated based on the cost of acquisition; not the recognized current market price of those assets. Besides that, it might bring other disadvantages to us. The historical cost does not consider current purchasing power would be change as it is assumes the currencies of the transactions are remained same. In actual, it might be more expensive than previous time due to inflation. Other than that, it also “does not measure the loss of value of monetary assets as a result of inflation” (Wikipedia. 2009) [Online]. Therefore, the profit in the income statement might be overstated.
On the other hand, historical cost has its advantages as it is simple and easier to use because the costs are recorded based on factual with supported evidence such as invoice and receipts. Such costs are be recognised, thus, it can prevent the manipulation of costs by creative accounting.
In addition, historical cost system provides important information to recognize that a series of management practices, reporting and measurement of economic information. Therefore, it can help the managers to estimate...