Discuss the Criticism of Historical Cost Accounting When It Is Applied in Times of Rising Costs.

Question 2 –April 2009

a) Discuss the criticism of historical cost accounting when it is applied in times of rising costs.

Historical cost is an accounting principle whereby it requires that all financial statement items be based on its original cost. Historical cost means what it cost the company for the item. It is not fair market value. This means that if a company purchased a building, it is recorded on the balance sheet at its historical cost. It is not recorded at fair market value, which would be what the company could sell the building for in the open market.

However, there are many criticism of historical accounting method. One of the criticisms is its obvious flaws in times of inflation. The validity of historic accounting rests on the assumption that the price in which transactions are recorded remains stable, i.e. its purchasing power remains the same over a period of time.

Another main point with regards to inflation is rise in prices for an asset. An asset purchased at a point in time may be expensive in future. The traditional accounting principles record all assets at an original cost and continue to use these historic figures throughout the asset's life, while economists make a more intelligible assumption that money has a time-value attached to it. The economist's approach is broadly embraced in the corporate finance model whose objective is centred on value creation for the shareholders. In addition effects of inflation may not be the same for all the companies in the market and historical cost accounts become almost unhelpful when comparing corporate performance.

On top of that, historical cost overstates profit in a time of rising price because it offsets historical costs against current revenues. (eg; Undervalued asset leads tu As such, it could lead to the unwitting reduction of capital where capital is defined in terms of the entity’s ability to produce, transact or otherwise operate into the future. The profit figure under...