An analysis of balance sheets prepared using historical cost accou

Category: Accounting

An analysis of balance sheets prepared using historical cost accou...

Historical cost accounting values the assets and liabilities of a company at the price paid or the liability agreed, at the time of acquisition. These values are written down in the balance sheet at the end of each year and they must equal to the value the company has been financed. Although using this method excludes adjustments for inflation, the cost still needs several adjustments when calculating the book value. The most important of these are depreciation, depletion and impairment. Most companies do not find this method of measurement as a true valuation of their entity's worth, but many factors determine their choice as each method has its advantages and limitations. That's why the IASB Framework says not much about measurement as no agreement can be obtained for the best method that can suit every company. (Weetman, 2006)

As historical cost accounting is based primarily on the original costs incurred in a transaction, it is a relatively objective method. Followers of this accounting principle point to its reliability and objectivity because the monetary amount of the transaction is known. (Weetman, 2006) For this reason also is difficult for the companies to falsely manipulate all the readers, and especially those who check their accounts and financial statements, in their favour. It is difficult for them to change the values that are to be recorded in the balance sheet showing what they want to show as assets are valued at their cost of purchase or creation.

It is an easy method for each company to apply and verification of all the values presented is really straightforward as all the documents, which include all the exact

information about each transaction, already exist in their hands. This indicates again that there is no room for manipulation here as invoices and receipts are evidential for every transaction so there is no doubt about balance sheet amounts. Another advantage of using historical costs is that it helps the managers to forecast the future operational costs of their companies based on their past data. This role of providing all this information is of much importance, as not only the figures are there, they are also very reliable.

However, it is argued that the results of using historical cost accounting can be misleading. Book values may be based on badly out of date costs. This is occurring in times of high inflation since money is not a stable unit of measurement. The assets are understated and this is because when high inflation arises the result is the fall in the purchasing value of money, hence the assets should be revaluated and the value recorded appreciated and adjusted to the high inflation. So some adoptions and changes will need to take place in order for the values to be true and fair. If these changes do not occur the valuation of the entity's worth shown in the balance sheet will not represent the worth of the company in terms of current value. For example, if a company bought some property, the amount recorded in the balance sheet is at its historical cost. However this is not the price the company would offer to sell this property in the open market. As a result this value will not be representative to the market as it does not represent the market value of the property.

Secondly, companies maintaining their capital, are only concerned with the nominal amount of the capital invested rather its purchasing power. This arise as a problem as capital maintenance is only done when the financial amount of their net assets

at the end of the financial period is equal to, or exceeds, the financial amount of net assets at the beginning of that period. (Oxford Dictionary, 2005)

Responding to the statement above, if using historical cost accounting preparing the balance sheet shows a true valuation of the entity's worth, other things being treated the same, my answer is no. In my opinion, showing the money as a cost value and not showing the purchasing power of the money does not seem very logic. Still, a company using an alternative method showing the purchasing power of money when it values its assets, its balance sheet does not necessarily show the value of it. Some assets may be given an unrealistic value when revaluated and some intangible assets, such as goodwill, may be omitted altogether from the balance sheet. This is the reason why I previously referred to other things being treated in the same way, because showing a fair value of your entity's worth depends on many factors and we cannot be aware what each company's 'games' are. However intangible assets missing from the balance sheet might not be a problem, only if their value is recorded in the Profit and Loss account of the company.

In addition, effects of inflation may not be the same for all companies in the market and historical cost accounts are not so helpful when it comes to compare their corporate performance. Critics are saying that this amount in the balance sheet does not

represent the real value of the company. If all companies' balance sheets would show their real value it would also be easier for comparison between them and the market.

Over time the limitations of applying historical costs have been spotted and even though historical cost accounting is flawed, it is the basic model. Accountants are not

willing to price and value the assets at current market value and accounting bodies have been made reluctant to use current market values as they have a direct effect on the share

prices. No other accounting method is providing such exact information like historical cost accounting. Alternative methods, such as current cost accounting, record changes in their prices which are not based on actual transactions. (http://www.echeat.com/essay.php) They also open the door for manipulation of the numbers shown in the balance sheet, where this is not the case with historical cost accounting. This is why it is said to be the most reliable method, and despite of all its weaknesses it has been recognised and accepted throughout the whole world. The accounting bodies recognised that the other methods are flawed as well but they also know that there is no better substitute. In fact, accountants think that inflation accounting is a waste of time and are working through management and taxation to see how they are able to record the transactions without worrying about inflation. (http://www.duncanwil.co.uk/historical)

However the Financial Accounting Standard Board (FASB) is marching towards fair value accounting and away from historical cost accounting. Those opposed, believe that it provides unreliable information in the financial statements of a company and those

in favour claim that it provides more timely and relevant information despite the increased use of estimates.(http://www.allbusiness.com/professional-services/accounting-tax-auditing)

Concluding, 'providing a true value of your entity's worth', has a lot of meanings. The word 'true' does not change its meaning but the accounting principles which contribute to this true value change with the circumstances. Each company may apply its own method of measurement after extracting information and making the suitable research on the subject. However historical cost accounting is the best model and it is the most commonly used as it is the only one which provides definite values.