Historical Cost Accounting | Cost Accounting - B Com PDF Download

The favored approach for assessing asset value is historical cost due to its verifiability. Examining the purchase price of a property through its title is a straightforward process for a company. In contrast, alternative valuation methods such as replacement cost or current cost are subject to market and economic fluctuations. If these methods were employed, the company would annually report varying values for the same property, reflecting market changes. Such fluctuations would undermine the accounting principle of consistency.

Historical Cost refers to the original acquisition cost at the time of obtaining assets and liabilities, as recorded in the balance sheet. Essentially, it is an accounting approach where a firm's assets are documented in the financial records at their initial purchase value.

The primary aim of using historical cost is to determine the total expenditure incurred in acquiring the asset and to assess the opportunity cost lost in the past. Additionally, it involves comparing the amount spent on the asset with the changes in profits and expenses resulting from its acquisition.

One advantage of historical cost is its consistency, as these values remain constant from year to year. However, this method has drawbacks, such as its failure to consider the time value of money or inflation. The historical cost concept assumes that inflation is irrelevant and values assets solely based on their purchase prices.

Importance of historical cost concept

The historical cost concept offers a crucial advantage as it ensures that the records maintained are consistent, comparable, verifiable, and reliable.

Using any valuation method other than historical cost can lead to significant problems for companies. If, for instance, a company opts for current market value or sales value instead of historical cost, members of the accounting department may propose varying values for each asset.

Moreover, relying on current market or sales value can be impractical for entities preparing financial statements more frequently than annually. For example, companies that calculate net income or compile balance sheets on a monthly basis would need to establish new sales values for inventory and other assets each month, which can be inconvenient.

To illustrate, if a company acquires a building worth Rs 15,00,000 in the year 2000, the balance sheet for that year will record the building's value as Rs 15,00,000. If the company still owns the building in 2016, the balance sheet for that year will reflect the same value, i.e., Rs 15,00,000, regardless of the current market value of the building (even if it has increased to Rs 50,00,000, based on current standards).

The historical cost method is widely adopted in accounting because it allows firms to easily determine the price paid for an asset, and the asset's value remains consistent from year to year, aligning with the concept of consistency.

However, it's important to note that the historical cost method overlooks the current market value of the asset and does not account for the time value of money or inflation. This method operates under the assumption that inflation is not relevant, and the asset is valued solely based on its purchase price.

Benefits of Historical Cost Accounting

• Under the Historical Cost Accounting (HCA) method, accounting data is widely regarded as unbiased, independently verifiable, and therefore more reliable for investors and other external users. The use of relevant documents and other evidence makes it easy to verify financial statements. Due to its verifiability, the accounting profession tends to favor traditional accounting methods.
• HCA minimizes the impact of personal judgments from those who prepare the accounts, as it is grounded in actual transactions. This results in data that is less prone to disputes compared to alternative accounting systems.
• Both internal and external users have shown a general preference for HCA, as financial statements prepared under this method are found to be useful. As noted by Mautz, "if financial reports based on historical cost were not valuable to those making management and investment decisions over the years, accounting changes would have been implemented long ago."

Ijiri, a staunch advocate for Historical Cost Accounting (HCA), contends that HCA has been pivotal in the past and will maintain its significance in future financial reporting. Berkin supports historical cost due to its capacity to depict actual events without managerial interventions or arbitrary adjustments. He argues that if corporate income were arbitrarily altered to reflect inflation's impact, it would place labor in an unsustainable bargaining position.

• Historical accounting is also defended on the ground that it is only the legally recognised accounting system accepted as a basis for taxation, dividend declaration, defining legal capital, etc.
• Historical cost valuation is, among all valuation methods currently proposed, the method that is least costly to society considering the social costs of recording, reporting, auditing and settling disputes.

Limitations of Historical Cost Accounting

In an economic environment, where prices are constantly rising, as has been the case in most countries of the world, HCA suffers from some limitations.

The drawbacks of HCA are listed as follows

• During inflationary periods, the purchasing power of money decreases, resulting in a decline in the value of the monetary unit (such as the rupee in India) used as a standard of measurement. As prices increase, the constant value of the monetary unit diminishes.

The Historical Cost Accounting (HCA) method overlooks the devaluation of the rupee, as it accumulates transactions obtained at different times with rupees of varying purchasing power. Consequently, in historical accounts, the monetary unit (such as the rupee in India) used for measuring incomes, expenditures, assets, and liabilities encompasses a blend of values determined by the date each item was initially included in the accounts.

The HCA is based on the assumption of stable monetary unit which assumes that:

(i) There is no inflation, or
(ii) The rate of inflation can be ignored.

This assumption becomes invalid in times of inflation due to the altered general purchasing power of the monetary unit. This gives rise to significant challenges in quantifying and conveying the outcomes of a business enterprise.

• Moreover, Historical Cost Accounting (HCA) fails to align current revenues with the contemporary costs of operations. While revenues are assessed in inflated (current) rupees, production costs encompass a combination of current and historical costs.

Certain costs, such as depreciation, are quantified in outdated rupees, while others, like inventories, are often represented in more recent rupees. Meanwhile, expenses like wages, salary, selling expenses, and other current operating costs reflect the current rupee value.

In instances where there is a time gap between acquisition and utilization, historical cost can substantially deviate from current cost. Consequently, Historical Cost Accounting (HCA) tends to depict 'inflated' or 'inventory' profits and reduced costs associated with consuming stocks and fixed assets during periods of rising prices.

‘Overstated’ profits become harmful in the following respects

(a) Over-distribution of dividends.
(b) Settlement of wage claims on terms which companies could not afford.
(c) Excessive taxation on the corporate sector in general and inequitable distribution of tax burden between companies.
(d) Under-pricing of sales.
(e) Investors being misled as to the performance of companies.

The profits labeled as 'inflated' under Historical Cost Accounting (HCA) are not authentic gains but rather overstated and deceptive. This situation leads to an insufficient depreciation allowance, making it challenging to fund the replacement of fixed assets and support growth and expansion.