Historical Cost

Topics: Balance sheet, Generally Accepted Accounting Principles, Depreciation Pages: 7 (2623 words) Published: January 9, 2013
The historical cost accounting 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. It is usually used in combination with other measurement bases. For example, inventories are usually carried at the lower of cost and net realizable value, on the other hand marketable securities are usually carried at market value, and entities prefer to carry pension liabilities at their present value. The main advantage of using historical cost accounting model is its simplicity and certainty. Most entities know what they have paid for the assets when they purchased them. Similarly they also know what proceeds they received in exchange for their obligations. Historical cost method is a very objective method because usually subjective estimates are not involved. The drawback of historical cost accounting model is that it cannot deal with the effects of changing prices of non-monetary assets. Therefore some entities prefer to use current cost basis instead of historical cost accounting model. The most prominent disadvantage of this method is that book values may be based on badly out of date costs. This becomes more of a problem during periods of high inflation. Therefore, historical cost does not generally reflect current market valuation or fair value of an asset or liability. Historical-cost financial statements do not provide information that is relevant to investors.

Fair value is defined as the amount at which the asset could be bought or sold in a current transaction between willing parties. Fair value is a reliable estimate if the parties involved in the transaction are “knowledgeable” where they are aware of the relevant risks and rewards, utility of the asset, supply and demand of asset, market conditions, and other factors. The transaction should be an arm’s length transaction. Arm’s length transaction means that the parties to the transaction are acting in their own interest. A transaction can be arm’s length transaction if the parties act independently and have no relationship to each other. intangible assets that had never been recognized now had to be separately identified and reported in a business combination. The statement also notes that “judgment is required in estimating the period and amount of expected cash flows,” and that these judgments should be consistent with the objective of measuring fair value. it may be necessary to use the present value of discounted cash flows technique presented in SFAC 7 when a market value cannot be used to establish a reasonable value. The inflation issues and current market valuation are ignored in this method. Thus, it might ‘not provide useful and relevant information for decision making’  Current cost accounting attempts to provide more realistic book values by valuing assets at current replacement cost, rather than the amount actually paid for them. This contrasts with the usual historical cost approach. It is usually calculated by adjusting the historical cost for inflation, in addition to the usual adjustments such as depreciation. The drawback of current cost accounting is it is more complex than historical cost accounting, and attempts to implement it tend to create controversy over what adjustments are appropriate.  The problems that current cost accounting attempt to solve are obviously linked to inflation. Interest in inflation accounting tends to be greatest when inflation is high, and low when inflation is low. Current costs are claimed to have several advantages over the historical cost concept. The current cost represents the amount the firm would have to pay currently to obtain the asset or its services; therefore, it represents the best measure of the value of the inputs being matched against current revenues for predictive purposes. It permits the identification of holding gains and losses, thus reflecting the results of asset management decisions and the impact of the...
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