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

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AF 301

Financial Accounting II

Historical Costing

Name: Shengheng Guan

Student No.: M207952

14 December 2004

 

Table of Contents

  1. INTRODUCTION …………………………………………………………….  3

  1. 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. It uses valuations that rest upon recordable facts about prices paid for assets in the past or amounts agreed to be owing to, or owed by, a business. There are some problems in defining the time of the assets being bought or sold or when they can be agreed to have risen in value, but these can be solved by relying on the actual external transactions. This way of adding up the assets has been commonly used because it is simple, objective and prudent.

However, since 1920s, criticisms of historical cost accounting have been raised by some notable scholars such as Sweeney, MacNeal, Canning and Paton. From the 1950s the level of criticism increased by well-known academics such as Chambers, Sterling, Edwards and Bell. Different new models of accounting were developed and such work continued through to the early 1980s. Although it declined with the levels of inflation dropping throughout the world, the debate carries on.

It has been argued that historical cost accounting information suffers from problems of relevance in times of rising prices because it assumes that money holds a constant purchasing power. As Elliot (1986) states:

An implicit and troublesome assumption in the historical cost model is that the monetary unit is fixed and constant over time. However, there are three components of the modern economy that make this assumption less valid than it was at the time that model was developed.

One component is specific price-level changes, occasioned by such things as technological advances and shifts in consumer preferences; the second component is general price-level changes (inflation); and the third component is the fluctuation in exchange rates for currencies. Thus, the book value of a company, as reported in its financial statements, only coincidentally reflects the current value of assets.

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This quote outlines the main focus of the debate. Historical cost accounting information suffers from problems of relevance in times of rising prices. The current cost of asset could be considerably different from the amount many years ago. The logic behind the additivity has also been questioned. In other words, is it logical to add together assets acquired in different periods when those assets were acquired with different purchasing power?

        

3. THE ALTERNATIVES UNDER CONSIDERATION

3.1 CURRENT PURCHASING POWER ACCOUNTING

Current purchasing power accounting (or as it is also called, general purchasing power accounting; general price level accounting; ...

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