Historical Cost vs Current Cost
Nowadays, high inflation is an inevitable problem in many countries. High inflation occurred owing to the demand level of goods and services are over the supply level of goods and services. It is lead to price changes taking place. Since year of 1980, several different accounting approaches were introduced to overcome these problems that reflected by inflation. However, the historical cost accounting still widely and continuously to be used by most companies in their accounting.
Conversely, reporting current cost in accounting are recommended rather than historical cost as it is the fair value reported in the current year would be beneficial to the firm and the shareholders of the company. 2. 0 Historical Cost Accounting and Benefits of Current Cost 2. 1 Introduction to Historical Cost, Disadvantages and Advantages of Historical Cost The historical cost accounting is conventional adopted method and it still used in our studies and working place today.
Historical basis approach stated all the financial items “are presented on the balance sheet at their value at the time of acquisition (generally represented by the original purchase cost)” ([email protected], 2001) [Online]. The inflation issues and current market valuation are ignored in this method. Thus, it might ‘not provide useful and relevant information for decision making’ (Han, et al, 1994, p. 243).
From the above example, we can realize that the historical cost does not provide accuracy cost owing to ignorance of inflation. Even though the company X Ltd has implement the depreciation on those assets, but it just depreciated based on the cost of acquisition; not the recognized current market price of those assets. Besides that, it might bring other disadvantages to us. The historical cost does not consider current purchasing power would be change as it is assumes the currencies of the transactions are remained same.
In actual, it might be more expensive than previous time due to inflation. Other than that, it also “does not measure the loss of value of monetary assets as a result of inflation” (Wikipedia. 2009) [Online]. Therefore, the profit in the income statement might be overstated. On the other hand, historical cost has its advantages as it is simple and easier to use because the costs are recorded based on factual with supported evidence such as invoice and receipts. Such costs are be recognised, thus, it can prevent the manipulation of costs by creative accounting.
In addition, historical cost system provides important information to recognize that a series of management practices, reporting and measurement of economic information. Therefore, it can help the managers to estimate the future cost with the reference of those past cost incurred. 2. 2 Benefits of Providing Current Cost Over the years, there are various alternative accounting methods to treat the problems of historical cost accounting. For examples, the replacement cost in the current market, the adjusted historical cost based on the real retail price index, net realisable value, and so on.
There are several benefits by providing these current costs. “An advantage of replacement cost is that it focuses on the services the asset will provide rather than the precise physical asset” (Thompsom,2007) [Online]. Replacement cost defined “as the estimated amount that would have to be paid in order to replace the asset as the date of valuation” (Thompsom,2007) [Online]. The estimation of replacement cost is derived after reviewing the asset in the current market and also can be recognised by trading amount of a same asset in the current market.
Furthermore, net reliasable value is the “estimated amount that would be received from the sale of the asset less the estimated costs on its disposal” (Wood and Sangster, 2008, p. 442). Generally, net reliasable value is use to identify the assets which are damaged, obsolesce, out-dated and so on. Hence, the value derived from this method should be applied to the financial reports and make these reports more relevant and practicable in the present market. Apart from this, adjusted historical cost accounting that also known as current purchasing power accounting is using to determine the today’s cost of the assets.
Normally, this method reflects the historical cost become current cost by using the retail price index in the current year. The main feature of this method is the consideration of the ‘changes of purchasing power of money over the period from acquisition to the present balance date’ (Wood and Sangster, 2008, p. 440). In overall, providing current costs are relatively better than historical cost as it is updated and more relevant amount that closer with the actual value in the market. Therefore, the current cost would be more useful and helpful in the decision making. 3. Alternatives to Historical Cost Accounting As above mentioned, there are several accounting approaches to remedy the effects caused by inflation. The main categories of the alternative to historical cost accounting are current purchasing power (CPP) accounting and current cost accounting (CCA). Now, the author will deeply explain the features and contrast of these two methods and how they change the historical cost to current cost. 3. 1 Current Purchasing Power (CPP) Accounting CPP accounting which also known as adjusted historical cost accounting that uses the approach of general purchasing power maintenance.
General purchasing power maintenance is use the approach that “measures the capital of a business in terms of its purchasing power (using the Retail Prices Index as a guide) and regards profit as the amount by which the general purchasing power of the business has increased during an accounting period” (Melville, 1999, p. 351). Essentially, this method only modified the amount based on the original historical cost by utilizing price index to reflect the changes in current purchasing power of currency since the transaction took place.
These adjustments do mean that assets have been revalued as it is just adjust from its historical cost. The following is the formula to restate the historical cost with retail price index: “Historical cost x [pic] ” (Arnold, et al, 1994, p. 398) Furthermore, CPP accounting only adjusts the non-monetary assets such as plant, machinery, building, inventory and so on. The monetary assets and liabilities would not be adjusted as they stated in currency of year-end purchasing power. “Monetary assets comprise cash or legal amounts receivables under contract such as trade debtors” (Han, et al, 1994, p. 47).
On the other hand, monetary liabilities contain current liabilities like trade creditors and bills payable; and non-current liabilities (long-term liabilities) such as debentures, mortgage on land and buildings. Those monetary assets and liabilities are taken into consideration in the calculating the purchasing power gain and loss. In the inflation (price rising) periods, a debtor stands to gain (purchasing power gain) while a creditor stands to lose as the contractual amount of the debt has less the purchasing power at the time of payment made and received.
The following balance sheets (extract) are using to illustrate how CPP accounting adjusts the historical cost: Additional Information: The general price indexes for the related year are as follows: January 200190October 2009120 July 2002100December 2009130 Illustration 2 is the restatement of illustration 1 by using Current Purchasing Power (CPP) accounting: 3. 2 Current Cost Accounting (CCA) and Contrast with CPP Accounting This is another approach that tries to remedy the limitation of historical cost accounting in times of inflation. Current cost accounting (CCA) adopts the approach that known as specific purchasing power maintenance. This approach measures the capital of a business in terms of its purchasing power with regard to the specific item” (Melville, 1999, p. 351). The increase in the specific purchasing power of the business over the accounting period would be treated as profit.
The basic rule of CCA is assets should be shown at their current cost or current in the balance sheet in the current year. Current cost or current values are those accounting method that valuing an asset by reference to its current price. Those methods that use in CCA are ‘replacement cost, net realizable value, value to the firm (deprival value), (Arnold, et al, 1994, p. 30) and economic value. In contrast, CPP method just needs the retail price index to adjust the historical cost. Those current cost methods that mentioned at above can be obtained from various sources such as “suppliers’ price lists, professional valuers or the entity own costs of production” (Arnold, et al, 1994, p. 398). When a restatement made to a historical cost accounting, there might involve a complex adjustment as the assets’ current values are derived from various resources and every asset’s current cost determination might not be same.
In brief, the adjustment in CPP model is easier than CCA model as it is directly adjust the amount with retail price index only. In way to prepare a current cost accounting financial report, there are numbers of adjustment that must be made against the historical cost. Adjustment that needed are relating to “non-current assets, depreciation, inventory, cost of sales, monetary working capital and gearing” (Wood and Sangster, 2008, p. 458). There are also no adjustments would be made to the monetary assets that has been mentioned in current purchasing power (CPP).
Other that than, current cost reserve would occur in CCA due to the adjustments made. This reserve is required by matching concept, if we directly alter the amount at the balance sheet; the balance would not tally. The next illustration is the restatement of illustration 1 by using Current Cost Accounting (CCA) with the following additional information: At the year end of 31 December 2009: 1. The building has been revalued by a professional valuer at cost of RM300,000. 2. With reference to manufacturer’s price list, the price of such machine has a cost of 130,000. . The stock in Ice Q ltd has a net realizable value of RM48,000.
To sum up, the cost provided in CCA model is more relevance and useful to the business as it is the most likely fair value in contrast with CPP model because CPP is adjust the historical cost value and it assume the historical cost was accurate. 4. 0 Conclusion In fact, conventional financial accounting which often referred to historical cost accounting still using by many entities in today even though there was many limitations was occurred during inflation times.
In this on method, profits are generally overstated; gains and losses on monetary item are not disclosed; holding gains on inventory are not identified and misleading of accounting ratios. Therefore, there was two accounting method of current purchasing power (CPP) accounting and current cost accounting (CCA) were introduced to adjust the historical cost; make the financial statement more relevance and be helpful in decision making in the firm.