Historical Cost Accounting in Complex Business Environment - Essay Example

? Historical cost accounting is the most common type of accounting, and it certainly retains its uses: Countries with lower inflation, for example, find that it represents meaningfully their real value of assets (McKenzie, 2002, 81). However, many companies are finding that historical cost accounting is increasingly inappropriate for their enterprises (Ahad, 2004, p. 1). Other alternatives such as current cost, replacement cost, purchasing power, net present value or fair value accounting are proposed. While blanket statements like “Historical cost accounting is meaningless in today's complex business environment” are inherently devoid of content, it is certainly true that historical cost accounting is no longer the preferred technique. Historical cost accounting and its alternatives have uses for different firms, markets, management and investment strategy, and auditing approaches, and there is no reason why they cannot both be used even within the same financial report! Historical Cost Accounting Summary Historical cost accounting is the process of accounting based on the historical value of an asset at the time of purchase after taking into account depreciation (Williamson, 2003; National Audit Office, 2009, 88). Historical cost accounting was once a near-universal standard, but now many different standards may threaten coherence (Cao). Disadvantages Historical cost accountings do have serious limits, and they deserve to be addressed. First: Depreciation is arbitrary because it's based on out-of-date values and estimations rather than any real benchmark (Greuning and Koen, 2001, p. 47). The depreciation charges don't end up making a realistic estimation of the actual replacement cost either. However, aside from the advantage of keeping the information all self-contained, historical cost accounting also tends to report information from the firms' perspective: This asset was bought at price X and term Y. Second: Profits will be exaggerated because actual trading will involve replacing assets, which means giving up old assets which are undervalued (Gruening and Koen, 2001, p. 47). However, not all assets are fungible at full price. Historical cost accounting has the advantage that it lets the company recall what the product was worth at any given time. Third: There are possible negative tax implications (Gruening and Koen, 2001, p. 47). Overstating profits by undercharging the depreciation value (e.g. if I buy land twenty years ago, the depreciation isn't on the market value at that time but the value of the land currently as it depreciates or appreciates) and charging cost based on the historical costs of inventories can cause higher tax charges. The value of labor is also not included or developed by historical cost accounting (Stovall, 2001, p. 2-4). Traditional accounting theories, in line with neoclassical economic theory, tend to view everything that is quantifiable as all that makes up an economy (Stovall, 2001, 2-4). Human capital, which is harder to measure and has growth rates which are not easily predictable, do not easily fit into the model and thus are jettisoned. Then again, Stovall (2001, p. 2-4) makes clear that fair value, current purchasing power and net present value accounting do not do this either. The failure to account for inflation, aside from the other problems already discussed, means that the firm may not be protecting its capital base (Gruening and Koen, 2001, 47). It also makes it hard to benchmark performance because different market conditions aren't being accounted for, allowing management to sit on their laurels since it's difficult to see if the company's value is really growing even after controlling for inflation. That having been said, inflation-keyed metrics can lull investors into a false sense of security (Fukui, 2003, p. 2). In fact, it may not be fair to measure executives against inflation of the market in general, given that the market is a cross-section which includes a mixture of high and low risk growths whereas individual firms are not. Another issue with historical cost accounting is that, since real purchasing power varies from year to year, it can be hard to keep track of the actual growth rate of an object (Gruening and Koen, 2001, 47). Historical cost accounting also tends to telescope time, since assets acquired thirty years ago are treated identically to assets acquired a year ago (Ahad, 2004, p. 2). Pretending that a factory purchased in the 1950s is comparably valuable as the benefits of a 2000s-era human resources program does seem to stretch plausibility. The problem is that it is just as senseless to assume that all of these assets are identical based not on history but based on their current market value or other indicator. If the current market value of a factory has declined, that may not represent the true value to the company of the factory. One of the reasons for the attacks upon historical cost accounting is that “in times of inflation, this understates the value of appreciating assets such as land, but overstates profits as it does not record the replacement cost of plant” (McKenzie, 2001, 81). It is true that it is generally bad accounting to ignore inflation entirely. But certainly, not every country has enough inflation for this to be an issue; in any respect, having to manage outside economic factors like inflation is always problematic. Advantages One of the advantages of historical cost accounting is that it recounts a known factor: The historical cost of the item at the time of purchase minus accepted depreciation. But when one begins using replacement cost or purchasing power or other accounting styles, the accounting statement to be realistic has to begin pointing to other elements outside of the accounting of the firm which can increase research and risk. Managers trying to engage in fair value, net present value or current value accounting have to try to guess at what inflation is using whatever indices are available whether it’s comparable goods or a comparison to the consumer index, but these guesses will always have some inaccuracy and thus will always create some error (FAO, 2011). Even “inflation-smart” regimes like replacement cost or fair market value still have to account for variations in inflation that can require securing additional income (FAO, 2011). Current purchasing power regimes look at the general rate of price inflation, measuring the purchasing power of the asset against the modern purchasing power. The problem is that not everything inflates evenly, so the asset might be under-or-over valued. Meanwhile, current cost accounting looks at the specific rate of inflation in the assets relevant to the industry; the problem is that predicting the inflation of individual products can be even more difficult than the general economy due to a higher noise-to-signal ratio. Fukui (2003, p. 2) argues that one advantage of historical cost accounting is that “An accounting earnings figure under clean surplus is a change-of-value proxy under current value accounting as generally expected, but is transformed into a level-of-value proxy under historical cost accounting”. Historical accounting tends to not only create a self-fulfilling prophecy but also tends to lead accountants to divulge more important information. Fukui thus recommends that historical cost accounting can be used by investors to create smart investment strategies. One advantage of this approach is that, while other indices tend to measure the change of value, historical cost accounting tends to be a value-proxy for value itself (Fukui, 2003, p. 2 2). The advantage for an investor is obvious: While seeing how things are improving or changing is useful, seeing what things are actually worth in real terms now tells investors what their investments are actually capable of at this given moment. Similarly, telling investors what things are worth irrespective of inflation allows investors to compare elements in their portfolio (Gruening and Koen, 2001, p. 47). Historical cost accounting has the advantage of being objective and free of potential management bias since it’s based on actual transactions (Ahad, 2004). Accountants can hide malfeasance using other forms of accounting and claim that it was an honest mistake (Ahad, 2004). Historical cost accounting lets assets be compared by the actual recorded transactions: Receipts, invoices and manifests rather than nebulous projections. Historical cost accounting has no uncertainty that requires fluidity in capital or additional loans based on inflation changes (Ahad, 2004, p. 2). More importantly, it allows cash flow statements to be easily zeroed out, and gives a realistic expectation of the balance sheet at any given time. Making predictions of future operational cost is best done based on the actual prior cost combined with realistic expectations of salient market changes. Historical cost accounting allows this to be done most easily because at every step the original transaction costs and the depreciations and cost of sales detracted (Ahad, 2004, p. 2).. While variable debt does obviously hamper historical cost accounting, fixed debt both in accounts receivable and accounts payable is best accounted for by historical cost accounting because it “measures financial instruments at its issuance yield to maturity over its life, regardless of market yield movements” (Ahad, 2004, p. 2). This allows a smooth, predictable return curve to be drawn up. Plantin, Sapra and Shin (2008, p. 85) argue that “For junior assets trading in liquid markets (such as traded stocks), marking-to-market is superior to historical cost in terms of the trade-offs. But for senior, long-lived and illiquid assets and liabilities (such as bank loans and insurance liabilities), the harm caused by distortions can outweigh the bene?ts”. Historical cost accounting is thus superior for those assets. Analysis, Alternatives and Conclusion Fair value accounting looks at what a common market price for the good (assuming the intention to sell within a reasonable timeframe) would be based on costs, utility, the availability and cost of substitutes, current market perception of risk, etc . (Shortridge et al, 2006). “A pre-condition for the application of fair value accounting is that market values are available for the assets or liabilities in question...” (Plantin et al, 2008, p. 86). But many assets and liabilities have either no fair market value or have market values not determined by frictionless markets. Loans, for example, do not trade well in markets and can’t be easily put under the auspices of fair value accounting. Historical cost accounting and fair value accountings are appropriate for different situations (Plantin et al, 2008, p. 86-90). Since different assets depreciate differently and are fungible in different ways, there are different impacts per asset. If “the impairment of a loan is due to increased market risk”, the accounting technique that follows, “stochastic discount rates”, leads to inefficiencies when conducted under historical accounting. But then if “impairment of the loan is due to the deterioration of the credit risk of a specific borrower so that the fair value of such a loan would be derived using a discount rate specific to the borrower”, the inefficiency is eliminated (Plantin, Sapra and Shin, 2008, p. 90). Similarly, current purchasing power accounting uses inflation indices to determine the purchasing power of something based on how it can be traded for some inflation-resistant items that form a consumer price index (IAS 29). Current purchasing power accounting is only recommended for hyper-inflation by the IABS and thus is not generally appropriate as a substitute for historical cost accounting (IAS 29). Net present value accounting looks at investment inflows versus cash outflows (Elliott and Elliott, 2007). It is useful for determining profits but is not designed to price assets and thus is not a replacement for historical cost accounting. One obvious scenario where historical cost accounting and other forms of accounting vary are the likelihood of turn-around or immediate fungibility. A company that has an automobile plant that has highly specialized gear is likely to be unable to sell it easily or at all. If a company finds it difficult, impractical or unnecessary to sell an asset, then the advantages to investors of having the institutional memory of the original price as well as the comparison metric is very high. But for assets with short-to-medium term liquidity, historical cost accounting may not be as appropriate. It is true that mixed accounting approaches have risks of being unable to compare elements of the accounting statements, and wouldn't be appropriate for all industries. But it still would be inappropriate for every industry, no matter how modern, to eliminate historic cost accounting from their repertoire. For most circumstances, historic cost accounting as the industry norm is beneficial because it allows companies to produce financials based exclusively on their own results and successes without pointing to macroeconomic or microeconomic statistics and trends that are incredibly complex and far from uncontroversially verifiable and because it allows investors to see the trends over time in the growth of particular assets. In any respect, historical cost accounting has its uses: In some industries and for some firms, it is appropriate; for others, it is misleading. Increasingly, each of these strategies (historical cost, net present value, fair value and current purchasing power) are being used in present accounting to provide a realistic picture for investors from multiple perspectives. Works Cited Ahad, A. 2004, “Is Market Value the Best Alternative to Historical Cost?”, University of Dhaka, Available at: http://www.scribd.com/doc/17844489/Market-Value-vs-Historical- Cost Cao, Z. “Book Review: W. A. Paton and A. C. Littleton: An Introduction to Corporate Accounting Standards”. Available at: http://www.som.yale.edu/Faculty/sunder/Phdaccountingcontrol/PatonLittletonCao.pdf Christensen, H. and Nikolaev, V. 2009, “Who uses fair value accounting for non-financial assets after IFRS adoption?”, University of Chicago Booth School of Business, Working Paper No. 09-12. Elliott, B. and Elliott, J. 2007, Financial accounting and reporting, Financial Times Prentice Hall. FAO. 2011, “Chapter 6 – Investment decisions”, Corporate Document Repository, Available at: http://www.fao.org/docrep/w4343e/w4343e07.htm Fukui, Y. 2003, “Earning Management with the help of historical cost accounting: Not for managers but for investors”, Aoyama Gukuin University, October, Available at: http://pdfcast.org/pdf/earnings-management-with- the-help-of-historical-cost-accounting-not-for- managers-but-for-investors Great Britain: Parliament: House of Commons: Treasury Committee, National Audit Office. 2009, Banking Crisis: Reforming Corporate Governance and Pay in the City; Ninth Report of Session 2008-09; Report, Together with Formal Minutes, The Stationery Office. Gruening, Hv and Koen, M. 2001, International accounting standards: a practical guide. World Bank Publications. IABS. IAS 29. Ijiri, Y. 1975, Theory of Accounting Measurement, American Accounting Association. Krumwiede, T. 2008, “Why historical cost accounting makes sense”, CBS Money Watch, August. McKenzie, I. 2002, English for business studies, Cambridge University Press: Massachusetts. Sapra, H, Plantin, G, Shin, HS. 2008, “Fair value accounting and financial stability”, Banque de France Financial Stability Review, no. 12, October. Shortridge, RT., Schroeder, A., and Wagoner, E. 2006, “Fair-Value Accounting”, The CPA Journal, April. Available at: http://www.nysscpa.org/cpajournal/2006/406/essentials/p37.htm Stovall, OS. 2001, “ACCOUNTING FOR HUMAN RESOURCES: IMPLICATIONS FOR THEORY AND PRACTICE”, University of North Texas, Available at: http://www.library.unt.edu/theses/open/20013/stovall_olin_scott/dissertation.pdf Williamson, D. 2003, “Brief Notes on Historical Cost Accounting”, Available at: http://www.duncanwil.co.uk/historical.html Read More