Historical Cost Accounting: Criticisms and Alternatives

Historical Cost Accounting: Criticisms and Alternatives Introduction Accounting is a measurement and communication of financial information about economic activities to interested persons.  [1]  The primary role of accounting is to provide an effective measurement and reporting system which is also accounting information system for decision making. The corporate form of a large business has created separation of business ownership and control. Outsiders of an organization, usually, dont possess first-hand knowledge of the day-to-day running and condition of the business, which makes them dependant, to some extent, on accounting reports for information. Management is considered to be a company insider, who has access to the important information about a company that can affect its stock prices or might influence investors decisions. This creates conflict of interest as company insiders are in a position to exploit a professional or official capacity in some way for their personal or corporate benefit. International Accounting Standards Committee (IASC) view that investors need information on risk and return; employees are interested in their stability and profitability; lenders are concerned with loans and interest to be paid when due; suppliers and other traders want to know whether owed amount will be paid or not; and customers are interested in continuance of the enterprise.  [2]  Information is needed by various users to be able to decide when to buy, hold or sell equity of investment; or to access the stewardship or accountability of management. Creditors and suppliers use information to assess security for the amount lent to the enterprise. However, not all users of information have interest or confidence in the information provided by the management. Due to separation of ownership and control; and managements ability of exploiting outsiders for their own benefits, many investors have no interest or confidence in analyzing a companys financial statements. Instead, they rely on market analysis by other specialists about the psychology of the market and its effect on share prices. This report is focused on the historical cost accounting adopted by most of the countries and why, even though has many problems associated with it, have governments accepted this system even with availability of alternative accounting systems. This report details the benefits and criticism of historical cost accounting along with alternatives to historical cost accounting and their criticisms. 2. Historical Cost Accounting The historical cost accounting values an asset for balance sheet purposes at the price paid for the asset at the time of its acquisition.  The historical cost accounting is the situation in which accountants record revenue, expenditure and asset acquisition and disposal at historical cost: that is, the actual amounts of money, or moneys worth, received or paid to complete the transaction.   Historical cost is based on actual transaction rather than forecasts. There are supporting records for all the figures provided in the financial statements. It is also relevant in making economic decisions, as past data transactions are needed for making future decisions. Another defense of historical cost is that historical cost has been used throughout history as financial statements which use historical cost are found to be useful. Profit is the excess of selling price over historical cost. Profit is a very well accepted concept of measure of performance. It is the difference between revenue and cost that determines on decision to continue a product line or division. Historical Cost Accounting is very much based on this concept of profit and loss. Others, in defense of Historical Cost Accounting argue that historical cost is less subject to manipulation of data than other forms of accounting such as Current Cost. The use of current cost or exit price opens the door to manipulation of these numbers. In other words, how are current costs to be determined and how can accountants determine which value is true and fair? More importantly accountants must guard the integrity of their data against internal modification. Criticisms of Historical Cost Accounting Overtime, criticisms of historical cost accounting have been raised by number of notable scholars, particularly in relation to its inability to provide useful information in times of rising prices.  [3]  Historical Cost Accounting record all assets at an original cost and continue to use these historic figures throughout the assets life, while time-value of money is completely ignored. Across time these criticisms appear to have been accepted to a certain degree by accounting regulators. In recent years various accounting standards have been released that require the application of fair values when measuring assets. For example AASB 116 gives financial statement preparers a choice between the cost model and the fair value model in measurement of property, plant, and equipment. Financial Instruments (AASB 139), investment properties (AASB 114), and biological assets (AASB141) are required to be valued at fair value as opposed to historical cost. Chambers in 1966 argued that the historical cost accounting information suffers from problems of irrelevance in times of rising prices. It is also questioned whether it is useful to be informed about something that cost a particular amount many years ago whereas its current value might be considerably different. It has been argued that there is a real problem of additivity.  [4]  The matter at issue is whether it is logical to added together assets acquired at different periods when those assets were acquired with amounts of different purchasing power. Alternatives to Historical Cost Accounting Current Cost Accounting Current Cost Accounting (CCA) attempts to provide more realistic book values by valuing assets at current market buying prices. It takes into account time-value of money and inflation. It is more complex than the traditional accounting, and it has created controversy about what adjustments are appropriate. Unlike Historical Cost Accounting, there is no need for inventory cost flow assumptions such as last-in-first-out and weighted average. The business profit in CCA shows how the entity has gained in financial terms the increase in cost of its resources, which is ignored by historical cost accounting. Differentiating operating profit from holding gains and losses has claimed to enhance the usefulness of information being provided by CCA. Holding gains are different from trading income as they are due to market-wide movements which are beyond the control of the management.  [5]  Therefore, CCA doesnt rewards managers for profits from holding gains and losses which isnt an actual profit and also gives useful information to investors. Supporters of CCA are convinced that it provides more useful information than conventional accounting but still they do not agree on all issues. There is one group who believe in the financial capital concept in which the holding gains is included in the profit and the other group is those who believe in the physical capital concept. Under physical capital concept, holding gains and losses are not included in the profit and are supported by the theory of optimal resource usage that uses current costs as a measure of input opportunity cost. Criticisms of Current Cost Accounting Measurement errors may have reduced the usefulness of current-cost and replacement-cost data. Replacement-cost valuations of plant and equipment often include the cost of technological advances and often these advances would reduce operating costs below the level reported by historical cost. As a result, when replacement-cost depreciation is substituted for historical-cost depreciation, the cost of doing business includes the high capital cost of the advanced technology as well as the high operating costs of the older technology in use, which creates measurement errors.  [6]   The supporters of Historical Cost Accounting criticize CCA because it violates the traditional revenue recognition principle by recognizing increases in the value of the assets, both current and non-current, before they are sold. This is irrelevant as changes in market price dont mean anything until the assets are sold. A non-current asset isnt more valuable to a business just because its current cost has increased. Another problem is the subjectivity of determining the amount of the increase in cost. There are some non-current assets that dont have a second-hand market because it was specifically built or made for that business only. So the basis of determining the current cost must be the new asset expected to replace the old one. CCA also involves a mathematical problem of additivity. This is because the figures generated from CCA arent of the same nature because it involves a variety of measurement models. Exit Price Accounting Exit Price Accounting (EPA) also known as Continuously Contemporary Accounting (CoCoA) has been proposed by researchers such as McNeal, Sterling, and especially Raymond Chambers. Its an accounting theory that prescribes that assets should be valued at exit prices and that financial statements should function to inform about an organizations capacity to adapt.  [7]  Chambers described the entitys capacity to adapt as the cash that could be obtained if the entity sold its assets. Chambers believed that economic survival of the entity depends on the amount of cash it can command and the balance sheet is crucial to these decisions. Chambers used the term current cash equivalents to refer to the amount that was expected to be generated through the orderly sale of assets. He believe that the information about current cash equivalent were fundamental to effective decision making. Chambers stated that the accounting rules used were so different in effect that comparison between companies was often quite misleading.  [8]  One of the main arguments for EPA is that it provides useful information to the users. They believe that EPA reports all profits and losses and values as determined in competitive markets and provides a true and fair financial statement that serves the purpose of the shareholders. Other arguments that support EPA is the additivity function. EPA values all elements in the balance sheet and income statement at their exit prices, which, therefore, provides one consistent rule that could be applied by all or any company. It involves references to real-world examples because untestable assertions arent made such as depreciation. Criticism of Exit Price Accounting According to Chambers model of CoCoA, if assets cant be sold separately, they are deemed to have absolutely no value for the purpose of determining organizations financial position. This is considered to be too extreme by many accounting practitioners and researchers. Assets such as goodwill and work-in-progress have no selling value therefore will be have no value at all in the financial statements. Other criticisms of CoCoA are that it doesnt consider the value in use. An asset that is held rather than sold out must be worth more to its owner than its exit price, otherwise, it would be sold. In case of specialized resources such as a blast furnace has positive value in use, but cannot be sold separately, for the purpose of CoCoA has no value.  [9]  Even though proponents of EPA argue for the additivity of exit prices, the concept of current cash equivalent doesnt recognize the possibility of selling assets as one package. Some assets sold as a package are worth more than when sold individually in the market. This concept has been ignored in the exit price accounting. CoCoA has also been criticized on the basis that exit prices are determined by the price that could be achieved in an orderly sale.  [10]  The sales might be at different times and wont necessarily reflect values at balance date. Therefore, the financial statements based on these values might not be useful for monitoring the companys management. Positive Accounting Theory and Efficient Markets Hypothesis Milton Friedman was the one who strongly supported and backed the positive theories in economics. He stated that the ultimate goal of a positive science is the development of a theory or hypothesis that yields valid and meaningful predictions about phenomena not yet observed. Watts and Zimmerman also stated that the objective of positive accounting theory is to explain and predict accounting practice which was consistent with the views of Friedman. The beginning of positive accounting theory is the Efficient Markets Hypothesis (EMH). The EMH is based on the assumption that capital markets react in an efficient and unbiased manner to publicly available information. The main strengths of Positive Accounting Theories over Normative Accounting Theories are the facts that hypothesis are framed in such a way that they are capable of falsification by empirical research. Also, these theories aim to provide an understanding of how the world works rather than stating how the world should work. Moreover, PAT tries to understand the relationship and connection between various accounting information, managers, firms, and markets; and also analyze these relationships within an economic framework. There are several assumptions made in development of positive accounting theory. The first is that the firm is a nexus of contracts. In relation to PAT, because there is a need to be efficient, the firm will want to minimize costs associated with contracts. Contract costs involve accounting variables as contracts can be stipulated in terms of accounting information such as net income, and financial ratios.  [11]  The firm will choose the accounting policies that best acknowledge the need for minimization of contract costs. PAT recognizes that changing circumstances require managers to have flexibility in choosing accounting policies which brings forward the problem of opportunistic behavior. This occurs when the actions of management are to better their own personal interests. The other assumption is that the managers are rational economic decision makers and will act to maximize their own profit and not the profit of the company. Under PAT, firms want to maximize their prospects for survival, so they organize themselves efficiently. Criticisms of Positive Accounting Theories One of the main criticisms of PAT is that it doesnt provide prescription for accounting and therefore doesnt provide any means of improving accounting practice.  [12]  This, therefore results in alienation of practicing accountants. It is argued that simply explain and predicting accounting practice is not enough. There is no guidance on what people should do, as there is a general absence of prescription. The other criticisms of PAT relate to the fundamental that all action is driven by a desire to maximize wealth. Many researchers find this statement very negative in nature. They believe that PAT promotes a morally bankrupt view of the world. The concept of positive theory is drawn from an obsolete philosophy of science and is in any case a misnomer, because the theories of empirical science make no positive statement of what is.  [13]  And also of course, Watts and Zimmerman do say, We do not contend that all issues are settled, but rather encourage others to pursue, correct, and extend our analysis. Conclusion Quite clearly the several limitations and flaws of the traditional historical costs method have been highlighted and picked upon from time to time. Still historical costs are the standard form of accounting due to its unique features and conventions that make it better than most available alternatives. Historical cost accounting has and is still been widely recognized and accepted by corporations across the world. There hasnt been any development of better alternatives to Historical Cost Accounting. The alternative accounting such as current cost accounting and exit price accounting carry more problems in them than historical cost accounting. For examples countries like Unites States and United Kingdom have tried to adopt current cost accounting system but later withdrew as there were many complexities in using current cost accounting. Even if accounting bodies simply pick an existing method to form the standard of accounting, it will definitely not be better than historical cost accounting. However, in my opinion, the current use of historical cost accounting by many firms have been a contributing factor in masking the true and fair value of their assets. As investors are the primary users of financial statements, priority must be given to the needs and wants of the shareholders. Empirical evidences show that investors want both measurements i.e. historical cost and current cost accounting.  [14]  I believe a process should be created where historical cost and current cost operate side-by-side, which will enhance relevance, reliability, and comparability. Rather than debating between different approaches, focus should be given to implement an accounting system which reports all assets and liabilities at their true value without eliminating the benefits of historical cost accounting.