Historical Cost

Lectured by Dr. Siriluck SutthachaiAccounting Department

Faculty of Management ScienceKhon Kaen University

Khon Kaen, Thailand

Historical Cost

The amount actually paid for an item is more concrete and objective than an amount that one would have paid.

Acquisition cost represents more of a reality to a particular firm than market price.

The financial statements represent the result of past performance.

Defence of Historical Cost Relevant in making economic decision. Based on actual, not merely possible,

transactions. Throughout history; financial statements

based on historical cost have been found to be useful.

The best understood concept of profit is the excess of selling price over historical cost.

Accountants must guard the integrity of their data against internal modification.

Defence of Historical Cost

How useful is income information based on current cost or exist price?

Changes in market prices can be disclosed as supplementary data.

There is insufficient evidence to justify rejection of historical cost accounting.

Criticism of historical cost Objective of accounting and Information

for decision making. Basis of historical cost—the ‘going

concern’ assumption. Matching—fraught with estimates and

assumptions such that its application can be described only as arbitrary.

Notions of investor needs—the distortion or concealment of company disclosures.

Current-Value Accounting

Current-Value Accounting For accounting information to be decision

useful, it must measure the actual events of a particular period as accurately as possible.

Under the current cost accounting concept, accounting information serves two purposes: The evaluation by managers of their past

decisions in order to make the best possible decisions for the future.

The evaluation of managers by shareholders, creditors and others.

Current-Value AccountingConcepts of business profit:

Current operating profit: the excess of the current value of the output sold over the current cost of the related input.

Realisable cost savings: the increase in the current cost of the assets held by the firm in the current period (holding gains/losses).

Current-Value Accounting

Current value can be calculated on the basis of:

Capitalization, or the present-value method;

Current entry price;

Current exist price; or

Combination of values derived from these three methods.

Current-Value AccountingCapitalization, or the present-value method The net amount of the discounted expected cash

flows pertaining to the asset, group of assets, or total assets during their useful lives.

Four variables must be known:

The expected cash flows

The timing of those expected cash flows

The number of years of the asset’s remaining life

The appropriate discount rate

Current-Value Accounting

The capitalized-value method is deemed useful for such long-term operating decisions as capital budgeting and product development.

The capitalized values of long-term receivables and long-term payables are also used in financial statements.

Current-Value AccountingLimitations:

The subjective nature of the expectations used for its computation

The lack of adequate adjustment for the risk preferences of all users

The ignorance of the contribution of factirs other than physical assets to the cash flows

The difficulty of allocating total cash flows to separate factors that comprised the contribution

The fact that the marginal present values of physical assets used jointly in operations cannot be added together to obtain the value of the firm.

Current-Value Accounting

Current Entry Price The amount of cash or other consideration that would

be required to obtain the same asset or its equivalent.

Replacement cost-used: the amount of cash or other consideration that would be needed to obtain an equivalent asset on the second-hand market having the same remaining useful life.

Reproduction cost: the amount of cash or other consideration that would be needed to obtain an identical asset to the existing asset.

Current-Value Accounting

Current Entry Price The valuation of assets and liabilities at current entry

prices gives rise to holding gains and losses

The realized holding gains and losses that correspond to the items sold or to the liabilities discharged;

The non-realized holding gains and losses that correspond to the items still held or to the liabilities owed at the end of the reporting period.

Current-Value Accounting

Current Entry Price The holding gains and losses may be classified

as:

Income when capital maintanance is viewed solely in money terms.

Capital adjustments, bacause they measure the additional elements of income that must be retained to maintain the existing productive capacity.

Current-Value AccountingCurrent Entry Price The advantages of the separation of current

operating profit and holding gains (or losses): Useful in evaluating the past performance of managers.

Useful in making business decisions.

Current operating profit corresponds to the income that contribute to the maintainance of physical productive capacity.

Provide important information that can be used to analyze and compare interperiod and intercompany performance gains.

Current-Value Accounting

Criticisms of current-entry price

The price is based on an asuumption that current-entry-price data is easily obtained.

Recognising current value as a basis of valuation but does not account for changes in the general price level.

What is meant by ‘current entry price’? Is an asset held for use or sale to be replaced by an equivalent, identical, or new asset?

Current-Value AccountingCurrent Exit Price The amount of cash for which an asset might

be sold or a liability might be refinanced.

The price is generally agreed to correspond to:

To the selling price under conditions of orderly rather than forced liquidation; and

To the selling price at the time of measurement.

Current-Value Accounting

Current Exit Price

All assets and liabilities are revalued at their net realizable values

Net realizable values are generally obtained from market quotations adjusted for estimated selling costs and therefore correspond to the quoted sales prices on the demand market.

Current-Value AccountingWhenever net realizable values cannot be

estimated directly from the demand market, two alternatives may be considered:

The use of specific sales price indices, computed either by external sources or internally by the firm; and

The use of appraisals by external appraisers or by management.

Current-Value AccountingAdvantages of current exit price:

Measures of the economic concept of opportunity costs.

Provides relevant and necessary information on which to evaluate the financial adaptability and liquidity of the firm.

Provides a better guide for the evaluation of managers in their stewardship function.

Eliminate the need for arbitrary cost allocation on the basis of the estimated useful life of the asset.

Current-Value AccountingDisadvantages of current exit price:

Relevant only for assets that are expected to be sold for a determined market price.

Not relevant for assets that the firm expects to use.

The valuation of certain assets and liabilities at the current exit price has not yet been adequately resolved.

Abandonment of the realization principle at the point of sale.

Does not take into account changes in the general price level.