3Historical Cost Model The model has been around since the 1400’s Until after WWII, inflation was not really part of our economic environmentThe essence of the model is that all transactions are recorded at their acquisition or original cost
4Historical Cost Model (Cont’d) Form of payment is irrelevantAssumes aggregation of monetary units from different periods acceptableAcquisition cost of depreciable assets is allocated over asset’s effective service lifeHistorical cost depreciation is matched against current dollar revenue creating an illusory net income component
6Historical cost is relevant in making economic decisions Decisions making concerning future commitments => need data on past transactions as the basis for judgingHistory cost is relevant for decision makingAffecting evaluation and selection of decision rules=> historical cost is directly related to past decisions=> determine the quality of the past decision=> serve as a basis for the forecast2. Providing input to the “satisficing” notion=> decision makers do not seek to optimizes but to satisfice=> consider how much earned rather than how much can earn
7Historical cost is relevant in making economic decisions 3. Imposing on the decision maker by their environment=> employed many different contextse.g. taxable income , cost-plus contracts
8Historical cost is based on actual, not merely possible transactions Record of the actual transactions=>supporting documents are provided=>determining how effectively management has met its responsibilities=>increasing the accountability-primary objective under stewardship functionCurrent cost or exit price accountingBasis of year end market prices without reference to actual transactions
9Throughout history, financial statements based on historical cost have been found to be useful Financial reports based on historical cost useful for over the yearsModern industrial and managerial accounting practices based on trial and error for many years=> not useful => changed
10The best understanding concept of profit is the excess of selling price over historical cost Profit is accepted as a measure of successful performanceProfit requires sufficient use of time , place and form be added to the materials, products or services purchased above the costHistorical cost is the basis idea of profitE.g. decision on whether continue a product line or not depends on the favorable spread between revenue and cost
11Accountants must guard the integrity of their data against internal modification Historical cost is less subjective to manipulation than current cost or selling price.Littleton => these are still wholly outside the prior decisions and the recorded experience of the enterprise
12Accountants must guard the integrity of their data against internal modification Mautz => whom would you trust to value the assets of any major company, how are current values to be determined, how would an accountant ascertain that the values are a fair presentation, can an accountant withstand the pressure by managers to accept optimistically valued assets?
13How useful is income information based on current cost or exist price Is it useful to show as income an increase in the value of an asset that the firm has no intention of selling?If the price of an asset at the end of the year is lower than it was during the year, this encourages criticism of management by shareholders for not having disposal of the asset earlier.
14How useful is income information based on current cost or exist price Current cost and exist price accounting induce a short-term view of profits.In many cases, management may believe that disposing of assets is not the more profitable alternative – reasons for holding an asset other than realizing an immediate profit.
15Changes in market prices can be disclosed as supplementary data Historical cost does not differ materially from current cost.Supplementary data on current prices are a practical and sufficient way of dealing with such information without having to shift from historical cost to a current cost basis.Adopted by the Australian Accounting Standard setters in 1976.Supplementary statement in addition to their conventional financial statement
16Changes in market prices can be disclosed as supplementary data Based on studies of the relationship between accounting data and the market reaction to the data, the efficient markets hypothesis in semistrong form states that security prices always reflect publicly available information.Implying that the method of disclosing any information including current values, whether shown in the text of the financial statements, as a footnote, or as supplementary data, makes no difference to the market.
17There is insufficient evidence to justify rejection of historical cost accounting Most of the research studies indicate that current cost data do not provide any more information than historical cost dataTraditional accountants argue that there is no persuasive empirical evidence that indicates that current cost or exist price accounting information is more useful than historical cost information
19Objective of accounting Provide useful information for economic decision making is taken to mean providing information to the stewardship function of management.Historical cost accounting reveals that the primary role of accounting is to meet the decision-making needs of usersForward-looking decision-usefulness approach
20Objective of accounting Information on the stewardship function does not necessarily restrict accountability to the original amounts invested directly or indirectly by equityholders.Investors are interested in knowing about the increases or decreases in the value of their investments as represented by the net assets of the company
21Objective of accounting Historical cost system fails in its underlying function of providing objective information.It is far from objective and is open to manipulationMonograph 10 questions the validity of the historical cost information and attacks a basic tenet of the system, which is that historical cost information ensures the maintenance of an entity’s capital base.
22Information for decision making Historical cost=> management needs historical cost data in order to evaluate their past decisions as they contemplate future commitmentsPast decision was right or wrong must ultimately be ascertained by what happens in the marketplaceHistorical cost has usefulness, but it is insufficient for the evaluation of business decisions.
23Information for decision making Historical cost accounting adopts a financial capital concept.However, capital regarded as the nominal dollar investment in the firm rather than the purchasing power of the investment. After the year of acquisition, historical costs do not correlate with the events of the year.
24Information for decision making (Cont’d) Historical cost overstated income in a time of rising prices because it offsets historical cost against current inflated revenue.Highly questionable for the relevance of historical cost for decision making.
25Basis of historical cost Historical cost is under the ‘going concern’ assumptionSterling => questions the validity of the assumptionThe high rate of business failure would make it difficult to build an evidential case for a projection of continuity. No business has ever continued ‘indefinitely’ into the future.
26Historical cost under attack Balance sheets contain outdated cost prices or valuations => hardly to say to be true and fairA lot of departuresAll non-financial assets of GTEs be measured using ‘deprival value” conceptsLiabilities be measured using present valueDepartures provide more relevant information than historical cost
27Notions of investor needs Historical cost cause either a distortion or concealment of important company disclosures=> goal of conventional accounting are ill-conceivedBecause accountant:Have naïve, simplistic view of investor and their needsAccept old-fashioned, fundamentalist viewShare market analysis and corporate analysis are differentMarket analysis mainly of trying to ascertain what other investor are thinkingCorporate analysis not really concerned about corporate facts but about the psychology of the market
28MatchingGoing concern assumption does not underlie the use of historical costMatching concept-when revenues are earned, the expenses incurred in earning those revenues are matched (offset) against the revenues to calculate incomeConventional accounting puts emphasis on deciding whether a cost should be deducted form revenues in the current period or be deferred to future periods=>responsible for deferred charges and that are not assets and deferred credits that are nor liabilities
29Matching Decisions are based on the matching principle => in most cases the matching of costs and revenues is a practical impossibilitye.g. cost allocation- not capable of being verified or refuted because there is no way to select one method over another except arbitrarily
31Definition of current cost accounting a cost calculated to take into consideration current circumstances of cost and performance levelsadjusting to constant purchasing power by using the average inflation rate in the current year
32Business Profits composes into 2 parts Current operating profit: realizable cost savingsCurrent operating profit:excess of the current value of the output sold over the current cost of the related inputs Realizable cost saving:increase in the current cost of the assets held by the firm in the current periodboth realized and unrealized cost changes.
33Business Profits realizable cost savings = holding gains/losses Holdings gains:a saving attributable to the fact that the input was acquired in advance of usethis savings is attributable to holding activities.
34Why we need to measure separately? Holding assets and liabilities enhance the firm’s market positionmanagers and others want to know if these holding activities are successfulUnder the conventional accounting gains are only recorded when the assets are disposed impossible to show it unless assets are bought and sold mislead the investor to determine which firm is more efficient
35Assumption of the CCAWithout the measurement of the holding gains/losses confuse the evaluation of management decision hinders the allocation of resources in the economy CCA suggest that separation of holding gains and operation profits gives credit to the appropriate managers
36Financial Capital Concept vs. Physical Capital Concept CCA provides more useful information than conventional accountingsupports can be divided into 2 campsthose who believe in the financial capital conceptthose who believe in physical capital conceptDifference: “whether or not holding gains or losses are included in income”
37Financial Capitalfirm invests financial resources with the expectations that the investment will create a higher level of cash inflowrecovery of the amount of financial resources invested is a return of capitalcash flows in excess of the amount financial resources invested are a return on capitalholding gains cost savings and the increases in future cash flow of the assets
38Physical capitalphysical units denoting the firm’s operating capabilityemphasize on the need to know the firm’s operating capability has been maintained continue in businessesthe holding gains capital maintenance adjustment
39Argument Against CCA Realization principle it violates the traditional realization principlebecause the changes in market price of the assets in use is irrelevantfixed asset is not more valuable to a firm simply because its current cost has risenasset value lies in its service potential, not its market value
40Argument Against CCA (Cont’d) Subjectivityanother problem is the subjectivity of determining the amount of the increase in costif there is no reliable secondhand market, current cost must be the new asset expected to replace the old oneadjustment has to be made between the actual asset and the replacementit is difficult to calculate
41Argument Against CCA (Cont’d) Subjectivityanother problem is the subjectivity of determining the amount of the increase in costif there is no reliable secondhand market, current cost must be the new asset expected to replace the old oneadjustment has to be made between the actual asset and the replacementit is difficult to calculate
42Argument Against CCA (Cont’d) viewpoint of exit pricecost implies opportunity cost or sacrifice of the next best alternativecurrent sacrifice faced by a company is to sell the asset rather than use itbut not to purchase the item because company has already owned itso current cost, which is the price to purchase, is irrelevant
43Argument Against CCA (Cont’d) Allocation problemallocation of current cost is arbitrary and lack in real-world counterpartsbacklog depreciation is charged to income or to a capital accountcause difference in amount of income reported
44Argument Against CCA (Cont’d) Technological changesimproved assets will more than likely replace existing assetsso current operating profits would be poor predicators of future profitsinvestors would be misled by the current operating profit as a basis for predicting future cash flows
45Argument Against CCA (Cont’d) Sum up:current cost information is irrelevant to most investment decisionsit does not focus on the firm’s ability to command financial resources in the firm’s quest to adapt itself to the environment
46Argument For CCA Recognition principle current cost accounting violates the conventional principle of recognizing a holding gain only for unrealized holding gains from a financial capital viewunrealized holding gains represent actual economic phenomena occurring in the current periodtherefore should be recognized if there is sufficient objective evidence to support the price changes
47Argument For CCA (Cont’d) Recognition principle (cont’d)market price of fixed assets are not relevanthowever, whether the firm intends to use or sell a fixed asset is not pertinentthe change in the price of the asset is relevantdetermination of periodic income should be based on what actually happened in the current period, not on what might occur
48Argument For CCA (Cont’d) Subjectivitycurrent cost accounting lacks objectivity?current cost is not based on actual transactions in which the firm is a participanthowever, objectivity is relativeeven under conventional accounting, some figures are more objectivetherefore, the question is whether current costs meet a certain minimum level of objectivity that the accounting profession is willing to accept
49Argument For CCA (Cont’d) Subjectivity (cont’d)market prices are relatively easy to obtainthe objectivity of their current costs would be acceptableE.g current cost of fixed assets can be obtained from secondhand dealersNo market prices are availableappraisals, calculations of reproduction costs and use of index numbers
50Argument For CCA (Cont’d) Viewpoint of exit priceValue at exit price is unusual because the firm is normally a buyerutilizing exit prices when liquidation is not contemplated is misleadinge.g. a customized asset used by the company is of great value, but when a firm is under liquidation, the value of the asset is greatly reduced as it is customized for the company’s own use
51Argument For CCA (Cont’d) Viewpoint of exit price (cont’d)however, the company decides to keep and use its assets rather than sell the assetbecause the management of the company believes its value in use is greater than its exit value
52Argument For CCA (Cont’d) Allocation problemallocation problem exists in most accounting method, even the conventional historical cost accounting also has the allocation problem
53Argument For CCA (Cont’d) Technological changescurrent operating profit = indication to make a positive long-term contribution to the economyit also indicates that the production process in use by the firm is effectiveif profit > interest earned on the net assets at current costthe existing production process is worth continuing
54Argument For CCA (Cont’d) Technological changes (cont’d)current operating profit is primarily representative of the long-term profit capability of the firm under the existing production process, assuming that existing conditions remain relatively the samethe technological changes are not taken into accountWhen a new machine changes the cost of production, the price of the old must adjustthe price of the old asset reflects the technological change
55Conclusioncurrent cost accounting performs significantly better than historical cost incomebecause historical cost accounting fail to adjust for inflationNo doubt, CCA data provide useful information to managers
56Conclusion (Cont’d)Question: whether benefits exceed the cost of gathering the information?On a cost-benefit basishistorical cost information are almost provided in the capital marketsObjectivity:information obtained from genuine transaction that have occurredInformation is capable of being verifiedConclusion: Historical Cost Accounting is better