Limitations of Historical Cost Accounting - Essay Example

Names of your group members Course code+name Professor’s name University name Date of submission Table of Contents 1.0.Introduction 2 2.0.Limitations of Historical Cost Accounting 3 3.0.Current Cost Accounting 5 3.1.Advantages 6 3.2.Disadvantages 6 4.0.Exit-price Accounting (EPA) 7 4.1.Advantages 7 4.2.Disadvantages 8 5.0.Current Purchase Power Accounting (CPPA) 9 5.1.Advantages 9 5.2.Disadvantages 10 6.0.Conclusion 10 7.0.References 11 1.0. Introduction The use of Historical cost accounting has gained momentum and has proven to attract a level of attention rarely witnessed in the annals of accounting practice. Historical cost accounting (HCA) refers to generally agreed principle that requires all the financial statement items to be based on their original cost (Nobes, 2008). As an accounting convention, historical cost accounting technique value assets for purposes of balance sheet for the price the asset was acquired. In addition, HCA is an accounting concept stating that all assets available in a financial statement need to be reported depending on their original cost. Here, accountants record expenditure, revenue and asset acquisition and disposal at the actual amount or the historical cost. In a different context, historical cost (HC) refers to the original monetary value of any economic item. As such, it is based on the stability of the measuring unit assumption. Even though HCA has been criticized for it inaccuracy, most accounting systems still use it in their various accounting operations. The point to note in that regard is that historical cost of an economic item does not always give a true reflection of the current market valuation. 2.0. Limitations of Historical Cost Accounting HCA gives no indication of current prices and values of the assets in any business. It only allocates cost but does not regard the value of the asset. Even though it gives the depreciation value and the acquisition cost of an asset, it does not take into account the fluctuations that may arise to the current market value of particular assets as it may suggest (Schipper and Francis, 2006). HCA gives no records on opportunity costs of the use of older assets, specifically property whose value is recorded based on its cost several years ago. It is common that an item purchased at a particular time may appreciate and become expensive in future. According to Zyla (2010), the historical accounting system records the value of assets at an original cost and continues assuming the historic figures remain throughout the asset’s life, even though money also enjoys a time value attached to it. This posits the system as unreliable since the value of assets keeps on appreciating with time. The unrealistic fixed assets value in historical cost accounting ignores the changes that may arise from the market value. HCA on inflation and the loss of value of monetary assets: This method is a very flawed system since it does not take into account the inflation. It assumes that the currency under which the transactions were carried on remains stable over a long period of time. It assumes the purchasing power of items remains unaltered for a long time as it obeys the historical cost recorded on the balance sheets. Moreover, HCA may not be helpful in comparing the performance of different corporations since inflation is not static; it varies from a particular company to another. HCA financial statements are merely statements of historical facts since they do not clearly give the state of affairs in a particular organization. Since changes in the value of money due to changes in the prices are not taken into account it becomes almost impossible to trace the development levels of various organizations. According to Nobes (2008) fluctuation in exchange rates also makes it difficult to assume that money would hold the purchasing power. Specific price level changes such as shifts in technological advances and consumer preferences cannot also allow money to hold the purchasing power. Mixing up Operating and Holding gain: In order to regain the true operating performance; there is need to separate loss to gain on accounts of the holding inventories. This is not the case in HCA since the operating losses or gain and holding inventories may be mixed up in many cases (Weetman, 2011). In some cases there is poor segregation between holding gain and operating losses and gains. Failure to give fair and correct value of financial position: In HCA, the balance always contains both the monetary and non-monetary items. The constitutes of the monetary items like debtors, loans, creditors and cash are presented at their current value while on the contrary, the non-monetary items like inventory and land are presented at their historical costing. As such, the balance does not give a true value of assets at different times. Exaggerated profits: All statements resulting from the HCA do not give exactly the profit a given organization has generated. The problem is expounded due to the fact that expenses are recorded and not on the current cost but the historical cost while revenues are recorded on the current value (Schipper and Francis, 2006). This would imply that during inflation profits are overstated and understated during good economic times. Distribution of profits would result to erosion of operating capacity. Poor mechanisms to provide for depreciation: Depreciation is vital in generating funds to replace the old fixed assets when their time is due. Failure to charge depreciation on the price of acquiring given assets but on the historical cost makes it insufficient for replacing the assets. 3.0. Current Cost Accounting It refers to an accounting method that is used to value assets, raw materials and even stock at their current replacement market cost rather than the historical cost (Schipper and Francis, 2006). 3.1. Advantages Differentiating holding gains and losses from operating profit can facilitate the usefulness of information given. CCA therefore is not interested in rewarding people in management for holding losses and profits which might not be real profit (Weetman, 2011). This information can be used by different investors to plan for the future. There is better comparability of different entities’ performance. It compares the financial capital and physical capital entities. In the physical capital concept, the profits do not include both the holding gains and losses as in the optimal resource usage where opportunity cost is measured using current costs (Nobes, 2008). On the other hand, in financial capital, profits include the holding gains. 3.2. Disadvantages CCA does not follow the traditional revenue recognition principle. This is because CCA does recognize the possibility of increase in the value of both non-current and current assets before they are sold out. This does not give a clear prospect in business since price changes might not mean that would be the sellout price for a particular asset. Moreover, increasing the cost the current assets might matter so much in any given business so it becomes irrelevant in this sense (Schipper and Francis, 2006). Subjectivity: It is not an easy task to determine the increase in cost since non-current assets are meant for particular businesses only. These groups of current assets do not have second hand market as they are meant for particular businesses only. CCA accrues a lot of measurement errors that often reduces the usefulness of the replacement cost and current cost data. This makes it very difficult to ascertain the replacement costs. According to Zyla (2010), during valuations of the costs of equipment and plants, technological advances cost is included which reduces the operating cost to a marginally low level of historical cost. This results to high operating cost and high capital cost of the technological advances. The higher operation cost on the older technology to that of the capital cost of acquiring a new technology causes the measurement error. In addition, replacement costs of assets also vary from a firm to another and some firms might opt to retain their assets instead of replacing them. It is therefore arbitrary to allocate the replacement cost through depreciation. Additivity: CCA in some cases involves a problem of mathematical addition. This is even complicated owing to the fact that different measurement models used in current cost accounting generate figure of the different nature. Due to this addition problem, CCA present an obstacle of comprehension to those with little or no background in accounting (Zyla, 2010). 4.0. Exit-price Accounting (EPA) Exit-price Accounting refers to an accounting theory that proposes that assets need to be valued at the exit prices and that the financial statements should always inform about an organizations capability to function and adapt (Weetman, 2011). It is also referred to as Continuously Contemporary Accounting (CoCoA) 4.1. Advantages It gives reliable and relevant information on the depreciation which is useful to the users. In these regard it provides a true financial statements containing reports of all losses and profits. Ability to measure the economic value and opportunity costs. The amounts of cash that a given entity can control as well as the balance sheet are vital to its economic survival. EPA also provides all the necessary information needed; the basis on which a firm’s financial liquidity and adaptability is evaluated. This is done by considering the total exit value of assets. In conclusion, EPA tend to remove the need for arbitrary cost allocation in terms of the estimated important life of the asset.This is because losses and gains on assets depend on changes in the exit prices, therefore there is need to allocate prices to assets. 4.2. Disadvantages Exit-price accounting does not give an elaborate interpretation of economic value. Both current and historical costs use entry prices which must ensure any firm continues with the production process. As a matter of contestation, exit pricing is only concerned with changes in prices of liabilities and assets but not the firm’s performance (Allen and Carletti, 2006). This will only allow the firm to concentrate on the short-term and liquidity decision making since the emphasis regards price changes to operations. In addition to this point, EPA can only be applicable to assets that are expected to be sold for a quoted market price. The valuation of particular liabilities and assets at the current exit price has been efficiently resolved. Moreover, the current price is seen as the correct valuation of an asset and as such old prices are viewed as history therefore not important to current situations. EPA has abandonment of the notion of realization principle at the selling point: This is due to the fact that it does not recognise revenue at a point of sales but at the production and purchase points. 5.0. Current Purchase Power Accounting (CPPA) It refers to an accounting method that is used to quantify the inflation effects on the money value (Weetman, 2011). This involves the conversion of historical costs to current prices using consumer price index (CPI). It is also referred to as general purchasing power accounting. It has two forms namely; general price level accounting and constant dollar accounting. 5.1. Advantages This first advantage is that it makes a comparative study with other methods easy by adopting the use of a common purchasing power as the unit of measurement. Secondly, due to its capability to hold monetary items, it ensures the calculation of losses and gains in general price level of purchasing power. These monetary items do not change in value from inflation results. Also related to the second point is that provides a path that allows organizations to formulate their policies and plans. This has been necessitated due to the reliability of the financial information it provides. It ensures there is a level playground by using the similar units of measurement. This is because CPPA takes into account the price changes due to factors such as inflation and differences in exchange rates. CPPA ensures that the purchasing power of capital which is generated from the shareholders is kept intact. Additionally, it is an important step to the shareholders since it allows them to plan for the organization. 5.2. Disadvantages The use of general price index rather than the constant dollar index is still not satisfactory since it only takes into account the consumer goods. This creates a problem since businesses are ever interested in the prices of producer goods. CPPA uses statistical index number as their basis of accounting. This index can only be used in a group of corporations but not an individual firm. Other disadvantages are that first, CPPA presents a problem of choosing the suitable and best price index. Secondly, it does not give a true variation in the market prices since it only considers changes in the general purchasing power and ignores the changes in individual items value. 6.0. Conclusion However much the historical accounting method may be flawed, accounting bodies still believe that there cannot be any perfect replacement to this since all other accounting methods are flawed as well. Conversely, apart from the limitations of this method it has several advantages that are still recognized by different corporations around the world. As matter to completely replace the historical cost accounting method, a persistent effort is required to develop a perfect accounting system which is foolproof to take over from the historical cost. Until this is done, historical cost will remain though controversial, an appropriate method to measure the performance of different corporations around the world. In as much as the recent accounting standards strife to embrace fair values as the basis of accounting measurements, most assets are still quantified on a historical basis. For instance the exit-price accounting (EPA) and current cost accounting (CCA) have posed many problems to different corporations compared to historical cost accounting. United Kingdom and United States in particular adopted current cost accounting but changed due to complexities. Instead of debating too much on the pros and cons of different alternatives to historical cost accounting, an accounting system needs to be implemented which record the true value of both liabilities and assets without taking away the benefits of historical cost accounting. 7.0. References Allen, F. and Carletti, E. (2006). Mark-to-Market Accounting and Liquidity Pricing, Center for Financial Studies, Working Paper No. 2006/17. Nobes, C. (2008. Introduction to financial accounting. Berkshire House: George Allen & Unwin. Schipper, C. and Francis, J. (2006). Financial Accounting: An Introduction to Concepts, Methods, and Uses. Natorp Boulevard Mason, OH: South-Western Cengage Learning. Weetman, P. (2011). Financial and management accounting: An introduction 4th Ed. London: Financial Times Prentice Hall Zyla, M. (2010). Fair value measurements: Practical guidance and implementation. Hoboken, New Jersey: John Wiley & Sons Read More