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'Historic cost accounting is the worst possible accounting convention, until one considers the alternatives.'

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Introduction

AF 301 Financial Accounting II Historical Costing Name: Shengheng Guan Student No.: M207952 14 December 2004 Table of Contents 1. INTRODUCTION ...................................................................... 3 2. THE LIMITATIONS OF HISRORICAL COST ACCOUNTING ............. 3 3. THE ALTERNATIVES UNDER CONSIDERATION 3.1 CURRENT PURCHASING POWER ACCOUNTING ......................... 4 'Historic cost accounting is the worst possible accounting convention, until one considers the alternatives.' 1. INTRODUCTION The most commonly encountered accounting convention is the "historical cost accounting". The creation of this accounting convention can be traced to the work of a Franciscan monk by the name of Pacioli in the year 1494. Historical cost accounting sets prices on the basis of original costs, where the cost of assets is measured by their depreciated historic cost. Therefore, no account is taken of changing prices in the economy under historical cost accounting. Over time, numerous other accounting theories have been developed by a number of well respected scholars and historical cost accounting has been criticised on the basis that it has too may shortcomings, with particular emphasis on its failing to provide useful information in times of rising prices. However, many of the proposed methods have been rejected by the accounting profession. In the following section we mainly consider and assess the advantages and limitations of historical cost accounting with respect to some other prescriptive theories of accounting that have been advanced by various people. A final section concludes, summarise the findings and introduce some directions for future research. 2. THE LIMITATIONS OF HISTORICAL COST ACCOUNTING As the traditional method of accounting, historical cost accounting has been used with variations over the past centuries. ...read more.

Middle

However, because the general price index is applied to all assets, this will rarely be the case. Third, various studies have failed to generate support to prove that information gathered under CPPA is relevant for decision making. 3.2 CURRENT COST ACCOUNTING Following the initial acceptance of current purchasing power accounting in 1970s, the accounting profession tended to favour current cost accounting, which is a more recent idea and is more complicated compared with historical cost accounting. It addresses many of the problems associated with historical cost accounting, particularly in times of inflation. Notable advocates of this approach have included Paton, Edwards and Bell. In 1980 the Accounting Standards Committee issued SSAP 16 which required supplementary disclosure of current cost data (SSAP was withdrawn in 1985). The main asset valuation bases used within current cost accounting are replacement cost, net realisable value (i.e. the net present value of the particular asset) and economic value. Depending on the circumstances, a choice have to be made concerning which base to use for valuing a particular asset at its current value. 3.2-1 The replacement cost (RC) model is proposed by Edwards and Bell. They adopt a physical capital maintenance approach to income recognition and assess income and value by reference to entry costs or current replacement costs of materials and other assets utilised within the business entity. In short, it treats holding gains or losses as operating income, which represents the difference of realized revenue and the replacement cost of the asset in question. This approach is considered to be generating a measure of income that represents the maximum amount that can be distributed, while maintaining operating capacity intact. ...read more.

Conclusion

Alternative models of accounting might not be favoured by analysts either. The accounting profession, like some researchers, questioned the relevance of the accounting information adjusted to take account of changing prices particularly in times of lower inflation. As mentioned earlier in this essay, there is some evidence that information might not be relevant to the decision making processes of those parties involved in the capital market. Besides, accounting standard setters are concerned that a dramatic change in the accounting conventions might cause widespread disruption and confusion in the capital market and therefore might not be in the public interest. It has also been speculated that the adoption of a new method of accounting could have consequences for the amount of taxation that the government ultimately collects from businesses. CONCLUTION The purpose of this essay was to assess the historical cost accounting and its alternatives. As we have seen, historical cost accounting has a number of drawbacks particularly in times of rising prices. Its two most widely accepted alternatives, current purchasing power accounting and current cost accounting, set out to solve the problem. Current purchasing power accounting uses historical cost accounting as basis along with the price index. Its main attraction lies in its ease to implement and less costly. Under current cost accounting there are two types of accounting methods: replacement cost accounting and exit price accounting. Replacement cost accounting differentiates operating profit from holding gains and losses and uses the business profit to show how the entity has gained in financial terms from increase in cost of its resources. Exit price accounting The method of accounting predominantly used today is based on historical cost accounting. Hence the accounting profession and reporting entities have tended to maintain the support for this approach. ...read more.

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