Historical Costing1st August 2020
Historical cost is the preferred method of valuing assets because it can be proven. It is easy for a company to look at the title of a piece of property and see what was paid for it. Other valuation or costing methods like replacement cost or current cost fluctuate with the market and economy. If these methods were used, the company would report the same piece of property at different values every year based on the market. This fluctuation violates the accounting concept or consistency.
The assets and liabilities recorded in the balance sheet with its original acquisition cost, the i.e. amount spent at the time of its acquisition are called as the Historical Cost. In other words, the historical cost is an accounting method in which the assets of the firm are recorded in the books of accounts at the same value at which it was first purchased.
The purpose behind the use of historical cost is to ascertain the total amount spent on purchasing the asset and determining the opportunity cost lost in the past. Also, the amount spent on the purchase of the asset is compared with the changes in profits and expenses incurred as a result of the purchase of such asset.
Historical cost values don’t change from year to year, so the consistency concept is not violated. There are some problems with the historical costing method. For instance, it doesn’t take into consideration time value of money or inflation. The historical cost concept assumes that inflation is not relevant and only values assets based on the purchase price.
Importance of historical cost concept
An important advantage of historical cost concept is that the records kept on the basis of it are considered consistent, comparable, verifiable and reliable.
Any valuation basis other than historical cost may create serious issues for companies. For example, if a company uses current market value or sales value rather than historical cost, each member of accounting department is likely to suggest a different value for each asset of the company.
Further, current market or sales value is not appropriate for entities that prepare their financial statements more than once a year. For example, companies computing net income or preparing balance sheet on monthly basis would have to establish a new sales value for inventory and other assets at the end of each month which is usually inconvenient.
For example, if a company purchases the building worth Rs 15,00,000 in the year 2000, then the value of the building will be recorded in the balance sheet of the year 2000 at Rs 15,00,000. If the company still owns the building in the year 2016, then it will be recorded in the balance sheet of 2016 at the same value, i.e. 15,00,000 irrespective of the current market value of the building (even if the building value has increased to Rs 50,00,000, as per the current standards).
The historical cost method is the most widely used methods of accounting as it is easy for a firm to ascertain what price was paid for the asset. Also, the value of the asset remains same from year to year, thereby complying with the concept of consistency.
But, however, the historical cost method does not take into consideration the current market value of the asset and also ignores the time value of money or inflation. The historical cost is based on the assumption that the inflation is not relevant, and the asset is valued on the basis of its purchase price.
Benefits of Historical Cost Accounting:
- Accounting data under HCA are generally considered free from bias, independently verifiable, and hence more reliable by the investing public, and other external users. Financial statements can easily be verified with the help of relevant documentary and other evidence. Because of the verifiability feature, accounting profession has more preference for traditional accounting
- Historical accounting reduces to a minimum the extent to which the accounts may be affected by the personal judgements of those who prepare them. Being based on actual transactions, it provides data that are less disputable than are found in alternative accounting systems.
- It has been generally found that users, internal and external, have preferences for HCA and financial statements prepared under it. According to Mautz,“if those who make management and investment decisions had not found financial reports based on historical cost useful over the years, changes in accounting would long since have been made”.
Ijiri, a strong supporter of HCA, argues that HCA has played a significant role in the past and will continue to be important in financial reporting in the future. Berkin favours historical cost because of its ability to present actual events without arbitrary adjustments by management. According to him, if corporate income was arbitrarily adjusted to show the impact of inflation, labour would be in an untenable 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:
- In times of inflation, the value of money declines and, therefore, the monetary unit (e.g., rupee in India) which is used as a standard of measurement does not have a constant value and shrinks in value as the prices rise.
The HCA ignores this decline in the value of rupee and keeps adding transactions acquired at different dates with rupees of varying purchasing power. Thus, in historical accounts, the monetary unit (e.g., rupee in India) used to measure incomes and expenditures, assets and liabilities, has a mixture of values depending on the date at which each item was originally brought into 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 does not prove true during inflation because of the change in general purchasing power of the monetary unit. This creates serious problems in measuring and communicating results of a business enterprise.
- Secondly, HCA does not match current revenues with the current costs of operations. Revenues are measured in inflated (current) rupees whereas production costs are a mix of current and historical costs.
Some costs are measured in very old rupees (e.g., depreciation), other tend to be in more recent rupees (e.g., inventories), while still others reflect current rupees (e.g., wages, salary, selling expenses and similar current operating expenses).
In general, whenever there is a time lag between acquisition and utilisation, historical cost may well differ significantly from current cost. Accordingly, HCA tends to report ‘inflated’ or “inventory’ profits and lower costs of consuming stocks and fixed assets during a period of increasing 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 ‘inflated’ profits resulting under HCA are not the real profits but exaggerated and illusory. This causes the depreciation allowance to become inadequate to replace fixed assets and finance growth and expansion.
In periods of inflation, therefore, inflated profits result in substantial fall in the operating capital and in turn, in the operating capability of a business enterprise. This is a major problem and is best illustrated by two examples.