The Benefits and Criticisms of Historical Cost Accounting

Introduction

Accounting is a measuring and communicating of fiscal information about economic activities to interested individuals.[ 1 ]The primary function of accounting is to supply an effectual measuring and coverage system which is besides accounting information system for determination devising.

The corporate signifier of a big concern has created separation of concern ownership and control. ‘Outsiders ‘ of an organisation, normally, do n’t possess first-hand cognition of the daily running and status of the concern, which makes them dependant, to some extent, on accounting studies for information.

Management is considered to be a company insider, who has entree to the of import information about a company that can impact its stock monetary values or might act upon investor ‘s determinations. This creates ‘conflict of involvement ‘ as company insiders are in a place to work a professional or official capacity in some manner for their personal or corporate benefit.

‘International Accounting Standards Committee ( IASC ) position that investors need information on hazard and return ; employees are interested in their stableness and profitableness; loaners are concerned with loans and involvement to be paid when due ; providers and other bargainers want to cognize whether owed sum will be paid or non ; and clients are interested in continuation of the endeavor.

‘Information is needed by assorted users to be able to make up one’s mind when to purchase, keep or sell equity of investing ; or to entree the stewardship or answerability of direction. Creditors and providers use information to measure security for the sum Lent to the endeavor.

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However, non all users of information have involvement or assurance in the information provided by the direction. Due to separation of ownership and control ; and directions ‘ ability of working foreigners for their ain benefits, many investors have no involvement or assurance in analysing a company ‘s fiscal statements. Alternatively, they rely on market analysis by other specializers about the psychological science of the market and its consequence on portion monetary values.

This study is focused on the historical cost accounting adopted by most of the states and why, even though has many jobs associated with it, have authoritiess accepted this system even with handiness of alternate accounting systems. This study inside informations the benefits and unfavorable judgment of historical cost accounting along with options to historical cost accounting and their unfavorable judgments.

Historical Cost Accounting

The historical cost accounting values an plus for balance sheet intents at the monetary value paid for the plus at the clip of its acquisition. The historical cost accounting is the state of affairs in which comptrollers record gross, outgo and plus acquisition and disposal at historical cost: that is, the existent sums of money, or money’s worth, received or paid to finish the transaction.

Historical cost is based on existent dealing instead than prognosiss. There are back uping records for all the figures provided in the fiscal statements. It is besides relevant in doing economic determinations, as past informations minutess are needed for doing future determinations. Another defence of historical cost is that ‘historical cost ‘ has been used throughout history as fiscal statements which use historical cost are found to be utile.

Net income is the extra of selling monetary value over historical cost. Net income is a really good recognized construct of step of public presentation. It is the difference between gross and cost that determines on determination to go on a merchandise line or division. Historical Cost Accounting is really much based on this construct of net income and loss.

Others, in defence of Historical Cost Accounting argue that historical cost is less capable to use of informations than other signifiers of accounting such as Current Cost. The usage of current cost or issue monetary value opens the door to use of these Numberss. In other words, how are current costs to be determined and how can comptrollers find which value is true and just? More importantly comptrollers must guard the unity of their informations against internal alteration.

Criticisms of Historical Cost Accounting

Overtime, unfavorable judgment of historical cost accounting have been raised by figure of noteworthy bookmans, peculiarly in relation to its inability to supply utile information in times of lifting monetary values.[ 3 ]Historical Cost Accounting record all assets at an original cost and go on to utilize these historic figures throughout the plus ‘s life, while time-value of money is wholly ignored.

Across clip these unfavorable judgments appear to hold been accepted to a certain grade by accounting regulators. In recent old ages assorted accounting criterions have been released that require the application of just values when mensurating assets. For illustration AASB 116 gives fiscal statement preparers a pick between the cost theoretical account and the just value theoretical account in measuring of belongings, works, and equipment. Fiscal Instruments ( AASB 139 ) , investing belongingss ( AASB 114 ), and biological assets ( AASB141 ) are required to be valued at just value as opposed to historical cost.

Chambers in 1966 argued that the historical cost accounting information suffers from jobs of irrelevancy in times of lifting monetary values. It is besides questioned whether it is utile to be informed about something that cost a peculiar sum many old ages ago whereas its current value might be well different. It has been argued that there is a existent job of additivity.[ 4 ]The affair at issue is whether it is logical to added together assets acquired at different periods when those assets were acquired with sums of different buying power.

Options to Historical Cost Accounting

Current Cost Accounting

Current Cost Accounting ( CCA ) attempts to supply more realistic book values by valuing assets at current market purchasing monetary values. It takes into history time-value of money and rising prices. It is more complex than the traditional accounting, and it has created contention about what accommodations are appropriate.

Unlike Historical Cost Accounting, there is no demand for stock list cost flow premises such as last-in-first-out and leaden norm. The concern net income in CCA shows how the entity has gained in fiscal footings the addition in cost of its resources, which is ignored by historical cost accounting. Distinguishing runing net income from keeping additions and losingss has claimed to heighten the utility of information being provided by CCA. Keeping additions are different from merchandising income as they are due to market-wide motions which are beyond the control of the direction.[ 5 ]Therefore, CCA does n’t honor directors for net incomes from keeping additions and losingss which is n’t an existent net income and besides gives utile information to investors.

Supporters of CCA are convinced that it provides more utile information than conventional accounting but still they do non hold on all issues. There is one group who believe in the fiscal capital construct in which the retention additions is included in the net income and the other group is those who believe in the physical capital construct. Under physical capital construct, keeping additions and losingss are non included in the net income and are supported by the theory of optimum resource use that uses current costs as a step of input chance cost.

Criticism of Current Cost Accounting

Measurement mistakes may hold reduced the utility of current-cost and replacement-cost informations. Replacement-cost ratings of works and equipment frequently include the cost of technological progresss and frequently these progresss would cut down operating costs below the degree reported by historical cost. As a consequence, when replacement-cost depreciation is substituted for historical-cost depreciation, the cost of making concern includes the high capital cost of the advanced engineering every bit good as the high operating costs of the older engineering in usage, which creates measurement mistakes.[ 6 ]

The protagonists of Historical Cost Accounting knock CCA because it violates the traditional gross acknowledgment rule by acknowledging additions in the value of the assets, both current and non-current, before they are sold. This is irrelevant as alterations in market monetary value don’t intend anything until the assets are sold. A non-current plus is n’t more valuable to a concern merely because its current cost has increased.

Another job is the subjectiveness of finding the sum of the addition in cost. There are some non-current assets that do n’t hold a second-hand market because it was specifically built or made for that concern merely. So the footing of finding the current cost must be the new plus expected to replace the old one.

CCA besides involves a mathematical job of additivity. This is because the figures generated from CCA are n’t of the same nature because it involves a assortment of measurement theoretical accounts.

Exit Price Accounting

Exit Price Accounting ( EPA ) besides known as Continuously Contemporary Accounting ( CoCoA ) has been proposed by research workers such as McNeal, Sterling, and particularly Raymond Chambers. It ‘s an accounting theory that prescribes that assets should be valued at issue monetary values and that fiscal statements should work to inform about an organisation ‘s capacity to accommodate.[ 7 ]Chambers described the entity ‘s capacity to accommodate as the hard currency that could be obtained if the entity sold its assets. Chambers believed that economic endurance of the entity depends on the sum of hard currency it can command and the balance sheet is important to these determinations.

Chambers used the term ‘current hard currency equivalents ‘ to mention to the sum that was expected to be generated through the orderly sale of assets. He believe that the information about current hard currency equivalent were cardinal to effectual determination devising.

Chambers stated that ‘the accounting regulations used were so different in consequence that comparing between companies was frequently rather misdirecting. ‘[ 8 ]One of the chief statements for EPA is that it provides utile information to the users. They believe that EPA reports all net incomes and losingss and values as determined in competitory markets and provides a true and just fiscal statement that serves the intent of the stockholders.

Other statements that support EPA is the additivity map. EPA values all elements in the balance sheet and income statement at their issue monetary values, which, hence, provides one consistent regulation that could be applied by all or any company. It involves mentions to real-world illustrations because untestable averments are n’t made such as depreciation.

Criticism of Exit Price Accounting

Harmonizing to Chambers theoretical account of CoCoA, if assets ca n’t be sold individually, they are deemed to hold perfectly no value for the intent of finding organisation ‘s fiscal place. This is considered to be excessively utmost by many accounting practicians and research workers. Assetss such as good will and work-in-progress have no merchandising value therefore will be hold no value at all in the fiscal statements.

Other unfavorable judgments of CoCoA are that it does n’t see the value in usage. An plus that is held instead than sold out must be worth more to its proprietor than its issue monetary value, otherwise, it would be sold. In instance of specialised resources such as a blast furnace has positive value in usage, but can non be sold individually, for the intent of CoCoA has no value.[ 9 ]Even though advocates of EPA argue for the additivity of issue monetary values, the construct of current hard currency equivalent does n’t acknowledge the possibility of selling assets as one bundle. Some assets sold as a bundle are worth more than when sold separately in the market. This construct has been ignored in the issue monetary value accounting.

CoCoA has besides been criticized on the footing that issue monetary values are determined by the monetary value that could be achieved in an orderly sale.[ 10 ]The gross revenues might be at different times and wo n’t needfully reflect values at balance day of the month. Therefore, the fiscal statements based on these values might non be utile for supervising the company ‘s direction.

Positive Accounting Theory and Efficient Markets Hypothesis

Milton Friedman was the 1 who strongly supported and backed the positive theories in economic sciences. He stated that the ultimate end of a positive scientific discipline is the development of a theory or hypothesis that yields valid and meaningful anticipations about phenomena non yet observed. Watts and Zimmerman besides stated that the aim of positive accounting theory is to explicate and foretell accounting pattern which was consistent with the positions of Friedman.

The beginning of positive accounting theory is the Efficient Markets Hypothesis ( EMH ) . The EMH is based on the premise that capital markets react in an efficient and indifferent mode to publically available information. The chief strengths of Positive Accounting Theories over Normative Accounting Theories are the facts that hypothesis are framed in such a manner that they are capable of disproof by empirical research. Besides, these theories aim to supply an apprehension of how the universe works instead than saying how the universe should work. Furthermore, PAT tries to understand the relationship and connexion between assorted accounting information, directors, houses, and markets ; and besides analyze these relationships within an economic model.

There are several premises made in development of positive accounting theory. The first is that the house is a link of contracts. In relation to PAT, because there is a demand to be efficient, the house will desire to minimise costs associated with contracts. Contract costs involve accounting variables as contracts can be stipulated in footings of accounting information such as net income, and fiscal ratios.[ 11 ]The house will take the accounting policies that best acknowledge the demand for minimisation of contract costs. PAT recognizes that altering fortunes require directors to hold flexibleness in taking accounting policies which brings frontward the job of ‘opportunistic behaviour ‘ . This occurs when the actions of direction are to better their ain personal involvements.

The other premise is that the directors are rational economic determination shapers and will move to maximise their ain net income and non the net income of the company. Under PAT, houses want to maximise their chances for endurance, so they organize themselves expeditiously.

Criticisms of Positive Accounting Theories

One of the chief unfavorable judgments of PAT is that it doesn’t supply prescription for accounting and therefore doesn’t supply any agencies of bettering accounting pattern.[ 12 ]This, hence consequences in disaffection of practising comptrollers. It is argued that merely explicate and foretelling accounting pattern is non plenty. There is no counsel on what people should make, as there is a general absence of prescription.

The other unfavorable judgments of PAT relate to the cardinal that all action is driven by a desire to maximise wealth. Many research workers find this statement really negative in nature. They believe that PAT promotes a morally belly-up position of the universe. The construct of ‘positive theory ‘ is drawn from an disused doctrine of scientific discipline and is in any instance a misnomer, because the theories of empirical scientific discipline make no positive statement of “what is ”.[ 13 ]And besides of class, Watts and Zimmerman do state, “We do non postulate that all issues are settled, but instead encourage others to prosecute, rectify, and widen our analysis. ”

Decision

Quite clearly the several restrictions and defects of the traditional historical costs method have been highlighted and picked upon from clip to clip. Still historical costs are the standard signifier of accounting due to its alone characteristics and conventions that make it better than most available alternatives. Historical cost accounting has and is still been widely recognized and accepted by corporations across the universe.

There hasn’t been any development of better options to Historical Cost Accounting. The alternate accounting such as current cost accounting and issue monetary value accounting carry more jobs in them than historical cost accounting. For examples states like Unites States and United Kingdom have tried to follow current cost accounting system but subsequently withdrew as there were many complexnesss in utilizing current cost accounting. Even if accounting organic structures merely pick an bing method to organize the criterion of accounting, it will decidedly non be better than historical cost accounting.

However, in my sentiment, the current usage of historical cost accounting by many houses have been a lending factor in dissembling the true and just value of their assets. As investors are the primary users of fiscal statements, precedence must be given to the demands and wants of the stockholders. Empirical groundss show that investors want both measurings i.e. historical cost and current cost accounting.[ 14 ]I believe a procedure should be created where historical cost and current cost operate side-by-side, which will heighten relevancy, dependability, and comparison. Rather than debating between different attacks, focal point should be given to implement an accounting system which reports all assets and liabilities at their true value without extinguishing the benefits of historical cost accounting.