“The use of the Historical Cost convention and the accrual concept for stewardship and for decision making”
Topic 1: The Historical Cost Convention
The historical cost convention is unarguably one of the most debated topics in the theoretical base of accounting. Some are of the opinion that it should be done away with, while others believe that it plays a vital role in presenting an accurate picture of the business concern. The Historical cost convention has different uses and dimensions for stewardship and for decision making purposes. Meaning of the HISTORICAL COST CONVENTION:
“The historical cost principle requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities.” The historical cost convention means that an asset must be shown in the books of accounts at its cost of acquisition, or its “purchase price”. It is this purchase price which is referred to as the “historical” cost.
An extension of this discussion will lead to interesting questions. The asset must be shown in the books at the purchase price. It is not to be shown at the market value. This is done to ensure a “true and fair” picture of the financial position of the firm. It is commonly noted that the asset which is purchased by the company will increase/decrease in value over time, because of market forces. In such a case, the correct representation of the asset will lie only in showing them at their original, historical cost. Showing the asset at its market value will portray the asset at a value which may be inflated or deflated, as the market forces may be. This will defeat the purpose of financial accounting, which involves giving a “true and fair” view of accounts. Example
An area of land was purchased by X and Co. for $50,000 in 2000. Today, as on 11th October 2006, the value of that property stands at $80,000.
In such a case, as per the historical cost principle, the value of this land will be $50,000 in the books. Showing it at the inflated price of $80,000 will be against the accounting principle of prudence, and it will inflate the profits of the firm, which may influence prospective outsiders. The Use of the Historical Cost convention for Stewardship:
We know that Assets less Liabilities equals equity. So, greater the assets, greater the equity. However, since investors, creditors and other outsiders need to know the accurate information, which can be provided only with an accurate stewardship, there has to be a method that makes the selection of asset-value uniform. And that method is the historical cost principle.
Not only does the historical cost convention make the value of assets uniform and unambiguous ' as the cost of acquisition is shown as the asset value ' it makes the whole process of number crunching an easier one.
Evaluating the assets at their market value allows a lot of ambiguity to creep in. Since market value is always subject to volatility, the value of assets would always be subjective. The historical cost principle, in such a situation, evaluates the assets at the cost of their acquisition, making the value objective and uniform. In such a case, the historical cost convention is particularly useful for stewardship. As discussed earlier, the historical cost convention requires the asset to be valued at its acquisition cost only. This means that only the money which we have actually spent is to be shown in the books. An inflated value of the assets goes against the principle of prudence. Stewardship, which plays the important role of communication of information to outsiders, involves presenting the financial position of the firm as accurately as possible, and of course, keeping in mind all norms. The historical cost convention enables this function to be done with vital ease. Upon employing the historical cost principle, the books of accounts present an impartial view of the financial...