"The principle of historical cost is still used in accounting when there is a large measure of agreement that it is inappropriate." Discuss.

Topics: Generally Accepted Accounting Principles, Balance sheet, Costs Pages: 5 (1213 words) Published: September 29, 2005

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...
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