HISTORICAL COST
...ise the available information and the periodic information should be comparable to other periods. Does historical cost therefore meet these needs for decision making? Many argue that it does, however there are a few factors which indicate that it may not. Firstly, when we look at the historical cost method of accounting, it’s key feature is that assets and liabilities are recorded at their original transaction values. Gains and losses in capital are only recognised when they are ‘realised’ by an organisation. This means that if the dollar value changes or inflation occurs, the current market value of an asset is not recognized. But rather when the asset is sold for a profit or loss, the distinction between a profit or loss is not based on the current market value, but rather the historical or original cost of the asset. This in turn causes assets that were purchased in a previous period, and sold in a current period to be recorded at a profit based on a historical purchase price. If the cost of an asset was less in a previous period, the profit margin is increased when the asset is sold. This indicates that a gain from a previous period was understated as the asset was realized in that period. If bad debts, or losses exist, management has the ability to sell assets purchased in a previous period at a profit that is recognised in the current period, to offset these bad debts. This can nullify the loss of the current period and goes against the principal of timeliness of financial reporting. “….a perceived ability of management to manipulate the reported performance” (Ian Wright, 1998) This in turn may cause capital erosion. The historical cost method vies to maintain money capital intact, after income is made. If an inventory asset is purchased in one period and sold at a profit, the original capital outlay is recovered. As price inflation occurs on the inventory items (assets) that need to be replaced, the capital outlay required to replace these will rise. As the income from the previous period took into account only the cost of goods sold in that period, more capital must be outlaid to acquire the same amount of inventory in the new period for a higher cost. This is capital erosion. This problem leads to the view that investors are not interested in what you paid for it (historical cost), they’re interested in what its worth (M. Barth, 2003) in regards to any asset in a set period. “No banker has ever made a collateralised loan to a customer based on the customer’s historical cost of the collateral; the Banker insists on knowing the market value of the collateral No investor in any asset ever made an investment based on the seller‘s cost of the asset” (W.P. Schuetze, 1992) As you can see the question over which value to use then arises, what an asset is worth currently versus what an asset cost to buy. Or fair value versus Historical cost. The financial information supplied by historical cost has to be relevant and timely to those who use this information as a basis for making important economic decisions. Fair value accounting is the new rival of historical cost accounting. “Fair value is measured based on a quoted price, if one is available, in an active market. If a market price is not available, fair value is measured based on the information and techniques that provide the best available estimate of such price. A financial instrument’s market price reflects the market’s assessment of (1) the present value of the future cash flows embodied in it (based on current interest rates) and (2) the risk that the amount or timing of cash flows will differ from expectations.” (P.N Hague and D.W Willis, 1999) This indicates that fair value cost-accounting does in fact remove much of the previously noted problems experienced by the historical cost method. There are in current practice elements of fair value accounting used, however there is a degree of support for its general usage and the eradication of historical cost. However a 1992 survey indicated a division exists between preparers and users of financial reports in relation to the debate over historical cost versus fair value. The results were as follows: Users prefer fair value disclosures on financial reports, preparers feel these will not be useful. This was found on the premise that reports are reliable, comparable, and timely, which preparers say will be difficult due to the subjectiveness of the information. Users desire precise fair cost estimates, financial reporters feel that reports will be less accurate du...