It is a system of accounting which is based on the principle that assets should be valued at historical cost or historical cost is the original monetary value of an economic item. Historical cost is based on the stable measuring unit assumption. In some circumstances, assets and liabilities may be shown at their historical cost, as if there had been no change in value since the date of acquisition. The balance sheet value of the item may therefore differ from the “true” value. It is relaxed to some extent by such practices as the valuation of stock at the lower of cost and net realizable value and, revaluation of fixed assets. The advantages of historical-cost accounting are that it is relatively objective, easy to apply, difficult to falsely manipulate, and suitable for audit verification. In times of high inflation, however, the results of historical-cost accounting can be misleading as profit can be overstated, assets understated in terms of current values, and capital maintenance is only concerned with the nominal amount of the capital invested rather than its purchasing power. Because of these defects it is argued that historical-cost accounting is of little use for decision making, but attempts to replace it with such other methods as current-cost accounting have failed. Conventionally financial accounts are based on historic cost; that is, assets are valued in the balance sheet at their cost of acquisition. Expenses are also charged against revenues in the determination of profit based upon the historic cost of the assets used up in generating the revenues.
This system was developed long ago during decades of relatively stable price levels and continued to be used before the consequences of inflation on the preparation of financial accounts were recognised. The principle advantage claimed for historical cost accounting (HCA) (and incidently until the development of CPP and CCA accounting was simply referred to as accounting, it only being recently that the traditional form of accounting has been distinguished by calling it HCA) is that it enables the preparation of accounts on an objective basis. However, it will suggest that in considering techniques for allowing for inflation the accounting profession should not be eager to let objectivity be the overriding consideration when formulating ground rules for the preparation of financial statements, since even the existing system of HCA frequently proves to be wanting as far as the possibility of achieving pure objectivity is concerned. Current cost measurements may provide useful information about assets that are held by a business as well as those that are used or sold. If the current cost that is the specific price of an asset has increased, it may be because the asset can be used to earn more than previously therefore people are willing to pay more. Thus, increase in the current cost of assets held by a company may provide a clue to the increases in the cash flow and earnings that the assets will be able to generate in the future. It is likely to be a better basis for assessing future cash flow than historical cost information but it must be interpreted with an appreciation of the economics of the industry in which the business concerned operates. Purchasing Power of Money Under inflation (or deflation) the value of money, its general purchasing power, is the reciprocal or the general level of prices. If all prices rise at the same rate, the holder of a given set of goods would gain by the rise in price and lose by the fall in the value of the money unit in which prices are expressed; the gain and the loss would be offsetting. But nothing would offset the loss in the purchasing power of money in respect of net monetary items (cash and receivables less payables), which are commonly exchangeable at their nominal amounts. In the more general case, the prices of non-monetary assets do not vary uniformly, nor consistently with changes in the value of money; and the asset compositions of firms, as between monetary and non-monetary assets, vary.
These variations have differential impacts on firms. Further, a change in the price of any good may be in part due to a change in the relativities of the prices of goods, and in part due to a change in the general purchasing power of money. To what extent those changes affect severally any price is unknown, even to buyers and sellers; and they, in any case, deal on the basis of prices as they stand from time to time whatever their causes.
But periodical income calculation was different matter. To know what person could consume or firms could distribute in a period without impairing their financial capitals would be a guide to prudent behavior. According to Sweeney advanced “stabilized accounting”for that purpose (various papers, and in 1936, Stabilised Accounting). Stabilised accounting dealt with income calculation by reference to the maintenance of real capital, dated general purchasing power, deriving the stabilized accounts from customary HCA accounts by use of a general price index. Such schemes would later be called Current Purchasing Power or CPP accounting. HCA does not yield a balance sheet representing the money’s worth of non-monetary assets. Where depreciation charges are based on calculations and inventory charges are based on any such rule as valuation at the lower of cost and market, neither those charges nor the resulting asset balances are price indicative of money’s worth. Only to dated selling prices and dated amounts of net monetary assets may a price index be applied, if the object is to discover a present purchasing power equivalent of an opening stock of general purchasing power equivalent of an opening stock of general purchasing power, and then a gain or loss on the change in the value of money. Another main criticism of historical accounting method is its obvious flaws in times of inflation.
The validity of historic accounting rests on the assumption that the currency in which transactions are recorded remains stable, i.e. its purchasing power remains the same over a period of time. Another main point with regards to inflation is rise in prices for an asset. An asset purchased at a point in time may be expensive in future. The traditional accounting principles record all assets at an original cost and continue to use these historic figures throughout the asset’s life, while economists make a more intelligible assumption that money has a time-value attached to it. (Thompson, 2010, pp.1)
Changes in Prices of Inventories and Property, Plant and Equipment Held Changes in the current costs of inventories, property, plant and equipment while they are held awaiting use or sale are often called holding gains or holding losses. They arise under the current cost approach. For example; Current cost operating income of $0.80, the company would have a nominal holding gain of $0.20 because the current cost of the inventory item increased from $1.00 to $1.20 while the company held it. Of the $0.20 holding gain, it may be said the $0.10 corresponds to or represents the effect of general inflation of 10% and the remaining of $0.10 represent a holding gain net of inflation, some times referred to as a “real” holding gain or a constant dollar holding gain. Holding gains (or losses) may be either realized-meaning that the asset has been sold or used or they would be unrealized which mean that the asset is still held by the company.
Realized holding gains are included in operating income in the basic (historical cost) financial statements but they are not shown separately. These gains include what are often called inventory profits. Unrealized holding gains are not reflected or included in the traditional income statement. Further, the realized holding gains that are included are those realized in the current period, without regard to whether they result from price changes in the current period. Under current cost accounting in Statement 33, realized and unrealized holding gains and losses that result from changes in the current period in prices of inventory and property, plant and equipment are reported as increases and decreases in current cost amounts. Holding gains or losses are generally excluded from operating income. Gain or Loss in Purchasing Power on Net monetary Items This component may be described in various ways, such as gain from decline in purchasing power of net amounts owed or loss from decline in purchasing power of net monetary assets held. In this book we will refer to it simply as the monetary gain or loss; it is a measure of the effect of holding monetary assets or liabilities. Monetary assets include cash and claims to receive a fixed amount of money (such as receivables). Holders of monetary assets experience a loss of purchasing power due to inflation because the amount of goods and services that can be bought with a fixed sum is reduced by inflation.
Monetary liabilities are obligations to pay fixed amounts of money in the future. A borrower experiences a gain from inflation because the fixed amount of money required to repay the loan diminishes in purchasing power. A brief example illustrates this point. Suppose that a company holds cash of $1.00 throughout a year while the CPI increases by 10% so that dollar will buy less at year-end than it would have bought on January 1. A 10 percent increase in the CPI will indicates that it would take $1.10 at year end to match the purchasing power of the original $1.00. Therefore, the company lost $0.10 worth of purchasing power measured in end of year dollar. Companies that have more monetary assets than liabilities will show a net loss of purchasing power when there is inflation. If deflation occurred- if the general level of prices fell- they would have a gain. A majority of nonfinancial companies (that is, excluding banks, insurance companies, etc) have more monetary liabilities than assets. However, Historical cost accounts, in general, simply show the acquisition cost or the depreciated historical cost of a company’s assets and not their current value, let alone the value of the company as a whole.
Therefore, historical cost accounting do not provide an absolute measure of success of the company. In times of inflation such companies show a net gain in purchasing power, reflecting the fact that they will be able to repay with dollars of reduced purchasing power. In addition effects of inflation may not be the same for all the companies in the market and historical cost accounts become almost unhelpful when comparing corporate performance. Causes of Price Level Changes It is useful to ask whether price level changes come solely from inflationary or deflationary effects. And the answer would be ‘no’ and it is found that price level changes are made up from three major components. These are: scarcity ,i.e. supply and demand factors; changes in technology and cost factors. From the combination of the effects of these three factors will come the total price level change in which it is virtually impossible to isolate completely any effects of the other factors from inflationary or deflationary component.
Because any of these factors may be working on price levels even in times of general price stability there will still be changes in relative prices. For example, The retail price index might remain stable, yet there may have been an increase in the price of services, an area where production is generally labour intensive, which was compensated for by decrease in the price of consumer durables, produced using capital intensive methods of production. Thus it becomes important that any system developed to adjust accounts for changes in price levels must be able to cope with the possibility of prices in different factor and product groupings changing at different rates. In taxation also can be impact or affect the historical cost accounting, for example, the company tax charge is based on it’s the accounting profit, the higher the amount and that will be paid in tax. The historical cost accounting does not constitute a suitable basis for the computation of the taxation obligation of business. However, the use of historical cost accounting as the basis for taxation it means that in period of rising prices the proportion of the increase in company’s wealth which is taken by taxation might be very much larger than that which is implied by the nominal rate of taxation.
For example, the rapid of inflation of the mid-1970 made government and others very much aware of the inadequacy of historical cost accounting for the purpose of taxation. Edwards & Bell proposed the separation of gains (or losses) into operating and holding gains. Holding gains, said to be capital gains, are the differences between selling prices while goods are held. Current operating profit is the difference between the prices at which goods are sold and their current costs at the time of sale, aggregates of both of which were said to be expressed in average of the year dollars (currency). The distinction was made necessary by the determination to distinguish current operating profit, realisable cost savings, realise cost savings and capital gains and to calculate realised profit and business profit, two concepts of money profit. Also which given the occurrence of inflation, price level changes were considered to play a subsidiary role.
Inflation gave rise to fictional gains or losses which had to be eliminated to obtain real realised profit and real business profit. They also rejected HCA and CPP, in favour of recording particular price changes as they occur (Edwards & Bell, 1961, p.17). They considered firms as adaptive entities in an uncertain world, adjusting their operations and arrangements to shifts in the price-indications of changes in internal and external conditions. The options for discovering the consequences of past decision/event (Historical cost) they considered to be the exit prices and the entry prices (current costs) of assets at the terminal dates of successive periods. The use of exit prices would said “realizable profit” and the use of entry prices would be a “business profit”.
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