Historical cost accounting

A balance sheet prepared using historical cost accounting provides a true valuation of the entity's worth. Discuss.

Historical cost accounting can be defined in many different ways. It can be described as a method of accounting based on the original cost of assets and liabilities with no adjustment for changes in price. "The assets are valued at the price paid at the time of acquisition for use in the formation of balance sheets" (Weetman 2006:384). The value of the asset or liability is measured by the actual amount of money used to complete the transaction.

Historical cost accounting is widely used by many UK companies and is under the generally accepted accounting principles known as GAAP. "These state that assets must be shown in the balance sheet as their historical cost adjusted for depreciation." (Brealey, Myers, Marcus, 2009: 59)

There are many limitations to this method of accounting that many analysts have come across over time particularly concerning its relation to balance sheets and other financial statements. The concept of historical cost convention does not provide a true representation of a company's assets as they are valued at their original cost, only the allocation cost is recognised not its true value. The model is built on a number of assumptions and a number of influencing factors are disregarded. External factors such as changes in inflation, exchange rates and price elasticity of demand will affect the value of an asset or liability therefore contrasts with values in historical cost accounts. An increase in inflation rates will cause a loss in the real value of money therefore a balance sheet containing historical values will prove to be incorrect and hence an inaccurate measure of an entity's worth.

Values presented on the balance sheet are seen as book values or the cost of the asset at the time of acquisition and therefore does not represent the current or market value. Its market value is the cost at which a company could sell their assets in current markets today.

As a result of this a distortion in the value of assets is created as the value of money changes. The time frame between the acquisition of an asset and the use of an asset to create revenue for an entity also creates a distortion particularly in the measurement of income. Therefore, a large difference can be seen in the acquisition cost and current cost of fixed assets such as stocks when costs are matched against revenue. ...............................

A disadvantage associated with historical cost accounting is the issue of purchasing power. Purchasing power is the number of goods or services that can be bought with one particular unit of currency.

The balance sheet portrays assets and liabilities at the cost at which they were bought however they may have been bought at different periods of times with different levels of purchasing power. If no common level of purchasing power is assumed and hence no common denominator, asset values that are added together in the balance sheet will produce an incorrect total asset value. As a result of this, interpretation problems may be caused when assessing a company's valuation of assets particularly when considering external factors such as inflation and the exchange rate.

Another main disadvantage is the change in the level of inflation over time. Inflation is an important factor that affects the values resulting from historical cost accounting; as general prices rises historical values will hold no resemblance to current values and hence an overstatement is made when measuring income. In relation to the balance sheet, an overstatement in income will result in an over optimistic profit level, this will also be reflected in the profit and loss accounts. The validity of historical costs can be questioned here as the assumption that currency will remain stable and hence purchasing power, creates uncertainty in the values shown on the balance sheet.

The effects of inflation vary between different business organisations and therefore figures in historical accounts create a difficulty when comparing assets values with competition. Inflation therefore creates a limit to the usefulness of historical cost accounting when measuring and comparing current profit levels and real asset values.

Furthermore, historic costing may lead to incorrect depreciation charges for a company's assets. Depreciation is "the systematic allocation of the depreciable amount of an asset over its useful life, the depreciable amount is cost less residual value" (Weetman, 2006:G3). Historic costing assumes an assets life expectancy beforehand at the time of purchase however, this may have changed since then due to many factors such as wear and tear, maintenance, and external factors hence depreciations charges would be different as would the true value of the entity. Incorrect depreciation charges will also affect the profit and loss accounts and balance sheet as the carrying value of the asset may change with time.

There are many alternative methods to historical cost accounting that have been saught out to reduce the number of flaws in the system such as replacement cost accounting and current asset accounting. However none have proved to be as reliable as historical cost accounting and therefore it continues to be used by many accounting bodies and is approved of by the IASB.

Considering these criticisms discussed above, there is one particular advantage to historical cost accounting which causes a general adherence by many UK companies to continue using these methods. It is a reliable and verifiable; the monetary value of the transaction is known and therefore in relation to cash flow statements the outflow and inflow of cash is known. Definite values of asset and liabilities are presented and therefore provide a greater level of certainty for the business. The data is not subjective and hence eliminates data interpretation and levels of inaccuracy. Data can be extrapolated and future values predicted, however as inflation and depreciation are considered these values become distorted and the true valuation of transactions becomes hard to measure.

There are many alternative methods to historical cost accounting that have been saught out to reduce the number of flaws in the system such as replacement cost accounting and current asset accounting. However none have proved to be as reliable as historical cost accounting and therefore it continues to be used by many accounting bodies and is approved of by the IASB.

In conclusion a balance sheet prepared using historical cost accounting does not provide a true valuation of an entity. The balance sheet is a financial statement describing a business's financial position at that point in time. A true valuation of an entity's worth suggests evaluating its real value at the time of measurement, hence using current values rather than book values. Recognising current values as oppose to book values will provide a more accurate representation of the entity's true worth. Consequently balance sheets prepared using historical cost accounting does not provide a true account of the current financial status of the entity thereby not fulfilling the role of a balance sheet. Factors such as inflation and depreciation also support the argument that historical costing does not represent the real value of an entity. These factors

Full list of References
  • Pauline Weetman, (2006) Financial Accounting, An Introduction, Fourth Edition
  • Accounting Theory and Practice, Sixth Edition, M W E Glautier and B Underdown (1997)
  • Fundamentals of Corporate Finance Brealey/ Myers / Marcus Sixth Edition (2009)

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