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BAO2202-Historical Cost Measurement Method

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  • Course Code: BAO2202
  • University: Victoria University
  • Country: Australia

Question:

You are required to answer the following questions:

1.The Framework for the Preparation and Presentation of Financial Statements identifies enhancing qualitative characteristics as comparability, verifiability, timeliness and understandability.

Discuss how these enhancing qualitative characteristics improve the quality of information for users’ decision making.

2.The Statement of Accounting Concepts 1 (SAC 1) provides details about the identification of dependent users by identifying factors that make an entity a reporting entity.

Critically discuss the primary factors considered relevant in determining whether an entity is a reporting entity (please provide at least three references of research papers published in research journals).

3.The AASB Framework identifies Historical Cost as a measurement base to measure assets and liabilities.

Critically discuss the limitations of Historical Cost as a measurement base in generating decision-useful information for the users of financial statements using the research literature (please provide at least three references of research papers published in research journals).

4.Compare AASB 15 “Revenue from Contracts with Customers” with the superseded accounting standard AASB 18 “Revenue” regarding measurement and recognition of revenue. 

 

Answer:

Historical costing measurement method is the conventional method of measuring the values of various components of financial statements such as income statement and balance sheet. Under this method, transactions and items are recorded at the prices at which such transactions are entered into at their original costs (Taplin,Yuan & Brown, 2014). The assets and liabilities are measured, for the purpose of their incorporation in the financial statements at the cost which they are acquired or entered into. This method of accounting suffers from various limitations which will be discussed below:

It does not consider the changes in the prices:

The entity’s financial statements that are prepared on the basis of historical costing measurement method are just the statements that contain the mere historical facts of the company. It does not take into account the changes in the prices of various assets and liabilities and other items that occurs due to various changes in internal as well as external business environment of the reporting entity. There are various factors that lead to changes in the prices such as inflation, technological up-gradation etc. In order to depict the true state of company’s financial affairs, the financial statements must be prepared on the basis of current market values or fair values of its necessary components (Jaijairam, 2013).

It leads to unrealistic valuation of fixed assets:

The market values of such assets keep on changing depending upon the various economic conditions. Since all the fixed assets of the reporting entity are carried in the statement of financial position at their respective acquisition costs (adjusted for the depreciation accumulated on such assets) and not at their current realisable value, the financial statements do not reveal the true position of company’s financial position.

It also leads to inadequate provision for depreciation:

When assets all the fixed assets of the entity are recorded at their historical costs then the depreciation on such assets is also calculated taking the base of acquisition assets. Depreciation is charged to the assets with the motive of maintaining a fund for the replacement of such assets and if inadequate depreciation is charged to the assets following the historical cost approach, then the firm would have to end up with insufficient funds for the asset replacement (Carroll, Linsmeier & Petroni, 2003).

It often leads to determination of unrealistic profitability:

When the income statements of the entity are prepared on the basis of historical cost measurement method, they do not depict the true profitability position of the business since the revenues of the business are recognised in the profit and loss account at their current values but the expenses of the business are recorded at their original costs at which they were occurred. In the inflationary periods, the profits are over-stated in the income statement of the reporting entity. 

 


It mixes up the capital gain and operating profits of business:

There are high chances of blending of profits earned as a result of capital gains in respect of holding of fixed assets and inventories and the profits that are earned as a result of normal business operations, in case of historical cost accounting. However, it is necessary to segregate the operational profits from the capital profits of the company so as to give clear picture of the true operational performance of the business (Liang & Riedl, 2013).

It fails to achieve fair presentation of financial position:

A balance of an entity comprises of various monetary as well as non-monetary items. Monetary items such as cash, bank loan, accounts receivables, accounts payables etc. are recorded at their current monetary values whereas non-monetary items such as inventories, land and building, plant and machineries etc. are recorded at the prices at which they were originally acquired and such value does not match will the current value. Due to this fact, in the inflationary periods, these assets are often found to be overvalued. Thus, the information contained in balance sheet of the company fails to achieve one of the major qualitative characteristics of the accounting information i.e. its fair representation. When financial statements are not prepared on the basis of fair value, they often lead to incorrect decision making by the users of such statements (AASB, 2015).

All the above discussed limitations of historical costing approach render it a loss of relevance for the purpose of measuring the values of the assets and liabilities and various other items to incorporate them in the financial statements. 

 

References:

AASB, 2015. Conceptual Framework for Financial Reporting. Available at:https://www.aasb.gov.au/admin/file/content105/c9/ACCED264_06-15.pdf Accessed on: 12.09.2018.

Carroll, T.J., Linsmeier, T.J. and Petroni, K.R., 2003. The reliability of fair value versus historical cost information: Evidence from closed-end mutual funds. Journal of Accounting, Auditing & Finance, 18(1), pp.1-24.

Jaijairam, P., 2013. Fair value accounting vs. historical cost accounting. The Review of Business Information Systems (Online), 17(1), p.1.

Liang, L. and Riedl, E.J., 2013. The effect of fair value versus historical cost reporting model on analyst forecast accuracy. The Accounting Review, 89(3), pp.1151-1177.

Taplin, R., Yuan, W. and Brown, A., 2014. The use of fair value and historical cost accounting for investment properties in China. Australasian Accounting, Business and Finance Journal, 8(1), pp.101-113.

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