historical cost accounting

historical cost accounting

The Importance of Historical Cost Accounting in Financial Reporting

1. Introduction to Historical Cost Accounting

Therefore, an objective and verifiable market is an asset that is associated with the positive theory of historical cost accounting and yet has implications for financial accounting policymaking through an accounting records perspective and involves some assumptions about accounting and decision making on the part of financial statement users from the normative approach.

The statement suggests that market price will be used in accounting measurement when market prices are objectively determinable. Objective determinability of market price is an essential component of the relevance enhancing qualitative characteristic of financial reporting.

Historical cost accounting is the practice of recording assets at the historical cost at the time of purchase. In the absence of some other accounting method that determines asset value, historical cost will be used. Therefore, historical cost accounting becomes the default system.

2. Principles and Concepts of Historical Cost Accounting

The accounting principles which guide the process of financial reporting do not have a probiotic role in the success of financial accounting. To some degree, these principles are prescriptive and are the result of political and social negotiations that are underpinned by specific social and cultural norms. The purpose of this chapter is to develop and provide an overview of historical cost accounting and its development. We undertake this task as we are of the view that in any assessment of the utility of financial accounting, historical cost accounting should adhere to the principles of financial accounting, particularly those related to a measurement basis. We believe that a significant challenge exists in addressing this question but also believe that it is important if standard setting in financial accounting is to remain relevant.

The identification, measurement, and reporting of value used to make up a firm’s financial statements are undertaken in the hope that the information contained is of benefit to the user. In large part, the type of information presented depends upon the accounting conventions, principles, and standards used in the historical cost accounting model, which provides the guiding framework. As guidance, the accounting profession, including its professional bodies and standard setters, all proffer a conceptual framework in the hope that sound guidance can be given to the accounting standard setters as they design and develop new or existing accounting standards. Furthermore, accountants, financial analysts, and academics undertake research to provide a critical review of what is wanted and what determines useful financial information in order that those who undertake standard setting can act upon this information. Assuming the noblest of intentions, accounting standard setters utilize the framework and academic research in the hope that the development process of new accounting standards will lead to useful financial information emerging at the other end.

3. Advantages and Limitations of Historical Cost Accounting

The underlying principles of HCA maintain that its advantages are important, given the relative importance that they imply that investors give to the reliability of the financial measurement methods that firms use. Other models’ measurements, costs, and issues would otherwise challenge the benefits of using such amounts in respect of the relevance and the perceived quality of the resulting accounting information to the preparation of financial reports. Indeed, those advocating for the use of other measurement methods generally assume that the subjective costs of using those amounts are acceptable to users in relation to the benefits that they believe those methods provide to investors and other capital providers. However, there is very limited evidence on the opinions of users of financial reports concerning other measurement methods, including fair value accounting. However, the academic, professional, and regulatory debates on fair value focus a considerable amount of attention on the perceived benefits and costs of using such measurements, and speeches and statements of leading U.S. financial regulatory representatives and the International Accounting Standard Board (IASB) imply considerable investor and stakeholder desire to rely on such measurements to monitor firms’ capital values. Here, we only examine the advantages and limitations of using HCA in financial reports.

Historical cost accounting (HCA) is based on the trade-off that, to minimize the subjectivity and potential for bias of measurement and to lower the costs of providing information in financial reports, it is best to prepare financial reports using HCA, which provides information about past transactions at objective and verifiable costs. While no measurement attribute can on its own satisfy all desirable sources of useful information, the relative importance of HCA is, however, questioned by the arguments that accounting should provide information more useful for decision-usefulness purposes than just for decision-specific purposes, which underlies many of its other critiques. The main criticisms of HCA are that, by preparing financial reports using measurements based on historical cost, they do not necessarily provide information that is useful for investors and stakeholders for decision-making purposes. This emphasis on decision-specific usefulness may lead to the provision of information that contains an excessive amount of noise, as investors and stakeholders cannot use the information for alternative purposes.

4. Comparison with Other Accounting Methods

Historical cost is not therefore regarded as a conservative basis of accounting in the sense of a bias having to be introduced after, that is, subsequent to historical events recorded. It is accepted, however, that prudent estimates are required when actual historical events affecting net realizable value only become apparent subsequently. Historical cost numbers do not generally therefore require further manipulation or judgments about which calculative procedure or estimate of a future amount is appropriate or most reliable and the precise point in time at which they should be made. The numbers therefore lack comparability and verifiability advantages currently claimed for replacement cost in constant item value theory and in much of the literature on current cost and present value accounting. However, historical cost has all the theory’s other desirable measurement and disclosure properties. The theory is consistent with the limited use of realizable value adjustments.

Historical costs are unbiased, non-vanishing, complete, simple, stable, easily verified and understood, consistent with money as a measuring tool, and normally in agreement with the actual exchange-transaction principle. They are therefore proposed as being vastly superior to replacement costs, current cost, and present value, and as likely to be accepted by the real world as the basic measurement base in the IASB’s proposed new conceptual framework for, and in all accounting and cost accounting systems. The theory requires that they be used together with balance-sheet or money-amount numbers along with an index converter.

5. Relevance and Application in Modern Business Environment

The importance of historical cost accounting in the business environment can be expressed as the basis on which entities record and report transactions and events in their financial statements. There are different ways in which historical cost accounting is used for financial reporting, including historical cost, realizable value (settlement value), present cost, present realizable value, net realizable value, and physical units. This study specifically emphasizes historical cost. The survey of these methods can be done at several levels, such as challenges from users’ requests for a fairer representation of long-term business assets, a change of emphasis from shareholders to bondholders and creditors, the need to find a way through the current trend of many entities appearing to always be “making” profits in their financial reporting, and proponents’ claim that historical costing violates some qualities of useful information for foreign users, as indicated in the FASB Concept Statement No. 2. These qualities include relevance, faithful representation, verifiability, and neutrality of treatments.