Weaknesses Of Historical Cost Accounting

Historical cost accounts do not measure the loss of value of monetary assets as a result of inflation. So in case of high inflation, the assets could be mispricing and provoke disturbances in the analysts. The validity of historical-cost accounting is based on the assumption that the currency in which transactions are recorded remains stable, that is to say its purchasing power remains the same over a period of time.

Over the past several years, there has been a growing controversy over the accounting issues of fair values and historical cost. The basis of this controversy revolves around which one of these principles is the most accurate. There are many different viewpoints on this issue. Many accounting professionals believe that fair value is just as accurate as the historical cost principle, while others believe that the historical cost is more reliable. The facts about each of these valuation methods will be researched and explained throughout this research document, as well as the different viewpoint about which method is the most accurate and reliable.

Cost accounting is a type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step of production as well as fixed costs such as depreciation of capital equipment. Cost accounting will first measure and record these costs individually, then compare input results to output or actual results to aid company management in measuring financial performance (Cost Accounting, n.d.).

Historical cost is the most common adopted measurement basis in the IASB; FASB suggests that market selling price (Fair Value) is more accurate description of how much assets and liabilities are currently reflected in financial reporting (SFAC 5, 2008). In other words, it was about the historical cost versus fair value. Historical cost gives priority to existing shareholders and regard stewardship as an important function of financial reporting (Whittington, 2008). Historical cost records actual transaction with supporting documents so the financial report is less subject to manipulation by management (Shortridge et al., 2006). The information is relevant to forecasting future cash flows within entity specific perspective rather than direct valuation of future cash flows. Historical cost accounting may lack relevance as during period of inflation (Pozen, 2009). The fact that relevant information has predictive value strengthens its decision making power over reliability principle (KAYA,

An organization using historical cost has some advantages which is simple and verifiable method for an organization. When an audit exam the company financial information, a company can prove that it is validity and reliability based on the document. For example, an organization can show the document such as invoices to an audit to prove the amount that record in financial statement is true and accurate when an audit question that amount. Besides, historical cost accounting very helpful in making decisions. Manager of an organization will make decisions based on the past purchase price. For instance, manager will decide to increases or decreases the amount of stock based on the past purchase price to maximize the profit. ( Historical Cost Principle | Examples | My Accounting Course.

In the past, historical cost measures were mainly used for reporting as they are reliable. However, historical cost is only relevant upon acquiring the asset and becomes irrelevant as time passes. On the other hand, fair value-based reporting, which accounts for changes in fair values, can produce balance sheet figures that provide a better reflection of the company’s value. This is also why accounting bodies are moving towards fair value accounting (FVA).

For example, a tract of land which was purchased 50 years ago for $10,000 may be worth $1 million today, but it will be recorded on the balance sheet at its historical cost of $10,000. The historical cost principle is used because of its reliability and freedom from bias when compared to the fair market value principle.

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

Compare with revaluation method, history cost method will decline the comparability of the market. As we all know, from the 21 century, network, communication, and transportation were enhanced very quickly, so globalization of markets has a huge scale and international trade is highly common for all the country. Therefore accounting is more important for a cooperative or competitive partner. Meeks and Swann (2009) believe that the various accounting report will hinder the progress of international trade. When the company will use history cost to record the fixed assets, the initial value and regular deprecation are written in the financial statement. Accounting to Ying and Kan (1996), due to the development of technology, scarcity of labor and price changes, the historical cost method cannot reflect the real assets. However, the revalued method is used fair value which can show the real price of assets, and Lihong, Yun, Yunying (2010) state that if the fair value used in the accounting, the profit will more approach the profit of economy. What is more, as reported by Ionascu (2012); Mane (2013) that uses fair value in revaluation method is unreliability and it violates the principle of prudence. Thus revaluation method can exhibition the fair value of property, plant, and equipment.

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When we look at a benefit of the fair value accounting method we see that a firm will behave differently, and will take this method into consideration when they are purchasing this asset. The decisions tend to be less risky if they know that they will have to devalue the asset in the future. Bad decisions would be something that they would have to identify publicly with future marking to market. Companies would no longer have a motivation to sell assets for the benefit of recognizing an accounting gain. Historically a major financial event or crisis prompts reconsideration of accounting rules governing reported asset valuations. The credit crisis in 2008 generated reconsideration. In the 1980’s the savings and loan crisis prompted accounting rules move away from historical cost accounting. Had there been a fair value accounting system in place in the 1980’s the savings and loan crisis would have not taken years to realize. The banks had made long term mortgage loans and borrowed short term. When the interest

Fair value accounting utilising market value as a benchmark to value company’s assets has drawn a lot of controversy.

By providing a background of Measurements in general and these methods specifically, this Report afterwards

Continued use of current (fair) values is consistent with FASB’s and the IASB’s conceptual preference for the primacy of the balance sheet over the income statement. Fair value represents measurements related to the present. Historical cost represents measurements relating to the past. Current GAAP requirements for fair value measurement of select assets and liabilities hark back to the banking and Savings & Loan crisis of the 1980s. At that time, many financial institutions were paying higher interest on deposits than they were earning on long-term fixed-rate mortgage loans. The historical cost model, the prevailing measurement attribute under GAAP at that time, masked the problem by recognizing losses gradually through negative net interest income. The current value of the institutions’ assets was less than the current value of the liabilities, effectively making the institutions insolvent. The historical cost model obscured the problem due to the requirement of carrying assets at inflated cost figures. Therefore, transparency was greatly diminished. Existing fair value and mark-to-market requirements were developed over several decades to address specific market events or conditions as noted above. These standards were the result of an extensive due process, and their

In other words, it means the information provided by the company can actually affect the decision making of information users and satisfied the needs of information users. Compared with other accounting methods, fair value accounting can get a more accurate disclosure of a company’s cash flow, and better reflect the company’s operation ability, solvency and financial risk assumed. So that the users of financial report can be better informed of the entity’s financial position and operating performance, to help them to make the right decision. As fair value accounting provides information about current market conditions, it is the most relevant measure for assets and liabilities. For one thing, fair value accounting measure can obtain intangible assets in to financial reports, such as intellectual property rights, human recourses and goodwill etc. make the information of financial report more complete to reflect the financial position, profitability and the ability to face risk. For another, fair value represents the present value of future cash flows, so investors just need the fair value of assets or liabilities and estimates the market interest rate, they could calculated the expect value of assets or liabilities in a certain point in future. Moreover, fair value accounting is a market-based accounting, so it more relevant to the decision making.