Historical cost is the measure of the total value used in accounting where the price of a certain asset on the balance sheet is based on its original cost when being acquired by the company. The concept of historical cost states that both the assets and liabilities of a company should be presented in the accounting records at their historical cost. Jones (1999) suggests that some people argue that historical cost is no longer relevant in accounting while others still maintain it is actually important as it gives too much subjectivity into accounting. This presentation is going to look at both the advantages and disadvantages of historical cost and some of the reasons why Forensic Specialists Accreditation Board chose not to use historical cost in many of its accounting standards.
Advantages of historical cost in accounting
Benston (2006) argues that although historical cost accounting is viewed as a traditional method of valuation and in this case it reflects mostly on the past cost of the assets, it still maintains a flexible and transparent business environment in most companies. This is because the method provides managers with constants and reliable data that identify changes in the performance of the organizations. They can also use these records to compare reports and measure economic growth. With this kind of system, there is no room for manipulation and the required data is well supported by physical evidence of receipts and invoices. Historical cost accounting provides the empirical evidence that people find useful as no other method of accounting can provide the exact information at a glance with all the changes in trends in the company.
Disadvantages of historical cost accounting
This method of accounting has over the years been faced with a lot of criticisms mainly because it considers the initial cost of assets but fails to recognize the current market value. The use of these outdated figures is not realistic and cannot predict the future flow of cash related with those assets. Overstatement of figures is very common with historical cost accounting and often brings complications especially when profit calculation is dependent on the figures acquired that may not reflect shareholders’ purchasing power. Some of these misleading figures may create a wrong impression of the financial trends of the company as well as the abilities of the company which may be overvalued or undervalued. In historical cost accounting, losses and gains on the account holding inventories are in most cases mixed up with the operating gain and losses. These mix ups should be segregated from the operating gain/loss to determine the real operating performance.
Recently, the Financial Accounting Standards Board (FASB) has moved from historical cost in many of its accounting standards to fair value accounting mainly to enhance comparability and international standards according to FASB (1984). This is as a result of so much disagreement and uncertainty when it comes to double-entry bookkeeping where accountants had concerns with the valuation of financial statement components. FASB claims that fair value measurement has improved financial reporting caused by measuring related assets and liabilities differently hence it is more consistent with their long-term objectives compared to historical cost accounting.
It is clear that from the early 70s, most business organizations started adopting newer methods of accounting such as fair value model to avoid financial crisis caused by historical cost method thus it should not be continually used in accounting.
References
Benston, G. J. 2006. Fair-value accounting: A cautionary tale from Enron. Journal of Accounting and Public Policy 25 (4): 465-484.
FASB. 1984. Statement of Financial Accounting Concepts No. 5: Recognition and Measurement in Financial Statements of Business Enterprises. Norwalk, CT: Financial Accounting Standards Board.
Jones, J. C. 1988. Financial instruments: Historical cost v. fair value. The CPA Journal 58 (8): 56-63.
