Proponents of historical cost argue that managers need historical cost data in order to evaluate their past decision as they contemplate future commitments.
Whether a past decision was right or wrong must ultimately be ascertained by what happens in the marketplace. Edwards and Bell argue that a proper evaluation of past decision must entail a division of the total profit in a given period between profit from operating activities and profit from gains (or losses) due to holding assets or liabilities while their prices changed. Further, the operating profit and holding gains must be separated into the element that was expected and the element that was a surprise.
Historical cost has usefulness, but it is insufficient for the evaluation of business decision. When asset are acquired, their historical cost is pertinent because it refers to current events. However, once the period of acquisition passes it is no longer current and therefore no longer consequential. Profit in a given year is supposed to represent the net increase in the value of the entity's capital for that year, i.e. activities that transpired in a given year that increased the capital of entity. Capital can be defined in several ways. For example, to be useful for decision making,'capital' may mean the operating capability of the firm (it's the ability to sustain production), or the purchasing power of the firm (its ability to transact in the market).
In terms of historical cost, capital is the original monetary investment in the firm.
This information is useful to decisions that focus on the ability of the entity to maintain production and to compete with others in the industry in the future. If profit is the change in purchasing power, the concept of capital being maintained is financial capital measured in terms of current prices. Again, the information is useful because it provides information regarding changes in the entity future capacity to transact in the market.
The profit reported under historical cost has no such prospective interpretation. Rather it is entirely retrospective. Historical cost accounting adopts a financial capital concept. However, capital is regarded as the nominal dollar investment in the firm rather than the purchasing power of the investment. And after the year of acquisition, historical costs do not correlate with the events of the year. It is a fiction created by accounting procedures to believe that historical costs against current revenues does not allow for the division of the total profit into its operating and holding components.
However, historical cost overstates profit in a time of rising prices because it offsets historical costs against current (inflated) revenues. As such, it could lead to the unwitting reduction of capital where capital is defined in terms of the entity's ability to produce, transact, or otherwise operate into the future. The profit figure under historical cost may deceive management to the extent that dividends paid could exceed annual 'real' profit and erode the capital base.
The historic cost is yesterday's price, inflation increases prices making yesterdays prices unusable as they will understate the cost of inputs and lead to inaccurate and over stated potential profit figures. Historical cost may be more objective that current prices but as mentioned earlier, its relevance for decision making is highly questionable. The fact that numerous exceptions, for e.g. the lower of cost and net realizable value rule for inventories are necessary reveals that it is rationale is flawed. Many reasons are advanced for the use of historical cost, but basically the model stems from conservatism. Sterling remarks, 'Cost is not a fundamental tenet of accounting; instead it is a derivative of the conservatism principle of valuation.'
Basis of historical cost
One of the justifications for the use of historical cost is the going concern assumption. The supposition is that the life of the firm is indefinite, so that normal expectations concerning the non-monetary items will be fulfilled. Inventory can be expected to be sold and non-current assets to be fully used in the business. Therefore, the historical cost of the assets or an allocated portion of it, is the appropriate amount to match with revenues. It is the use of the non-current assets, according to the argument, not their possible sale or repurchase, that is relevant. Sterling, however, question the validity of the assumption:
"The high rate of business failures would make it difficult to build an evidential case for a projection of continuity. No business has ever continued 'indefinitely' into the future. All businesses, except those presently in existence, have ceased operations. Thus, it would seem more reasonable to assume cessation instead of continuity."
So, Sterling wonders why the assumption leads to the historical cost model. The actual justification, he argues is that the firm is locked in , i.e. it has no alternative but to use it non-current assets. Obviously, such a premise is unrealistic.
The criticism that there are many different and acceptable cost allocation systems can be explained within a positive accounting framework which makes the assumption that accounting information is an economic good, subject to demand and supply forces.
Under positive approaches to accounting theory development, diversity of accounting techniques are needed to account for different business situations. For example, where firms are regulated by agencies that allow them to charge prices only on a cost-recovery basis, historical cost could be useful for management accounting price setting and for informing outside users of financial statements about the firm's likely future profits, and also as a means of influencing price regulation agencies regarding the appropriateness of their price-setting formula. The cost allocation techniques used for price setting might involve accelerated cost recognition such as diminishing-balance depreciation over a short period of time because this gives high costs and leads to high prices being set for the firm's products. However, a slower cost allocation might better reflect to outside users the likely life and value of the assets. Moreover, different political and regulatory costs affect each firm, Since firms seek to minimize all costs, they will choose different accounting method.
