Historical cost accounting is meaningless in todays complex business Essay

Historical cost accounting is meaningless in todays complex business environment - Essay Example Historical cost accounting and its alternatives have uses for different firms, markets, management and investment strategy, and auditing approaches, and there is no reason why they cannot both be used even within the same financial report! Historical Cost Accounting Summary Historical cost accounting is the process of accounting based on the historical value of an asset at the time of purchase after taking into account depreciation (Williamson, 2003; National Audit Office, 2009, 88). Historical cost accounting was once a near-universal standard, but now many different standards may threaten coherence (Cao). Disadvantages Historical cost accountings do have serious limits, and they deserve to be addressed. First: Depreciation is arbitrary because it's based on out-of-date values and estimations rather than any real benchmark (Greuning and Koen, 2001, p. 47). The depreciation charges don't end up making a realistic estimation of the actual replacement cost either. However, aside from t he advantage of keeping the information all self-contained, historical cost accounting also tends to report information from the firms' perspective: This asset was bought at price X and term Y. Second: Profits will be exaggerated because actual trading will involve replacing assets, which means giving up old assets which are undervalued (Gruening and Koen, 2001, p. 47). However, not all assets are fungible at full price. Historical cost accounting has the advantage that it lets the company recall what the product was worth at any given time. Third: There are possible negative tax implications (Gruening and Koen, 2001, p. 47). Overstating profits by undercharging the depreciation value (e.g. if I buy land twenty years ago, the depreciation isn't on the market value at that time but the value of the land currently as it depreciates or appreciates) and charging cost based on the historical costs of inventories can cause higher tax charges. The value of labor is also not included or dev eloped by historical cost accounting (Stovall, 2001, p. 2-4). Traditional accounting theories, in line with neoclassical economic theory, tend to view everything that is quantifiable as all that makes up an economy (Stovall, 2001, 2-4). Human capital, which is harder to measure and has growth rates which are not easily predictable, do not easily fit into the model and thus are jettisoned. Then again, Stovall (2001, p. 2-4) makes clear that fair value, current purchasing power and net present value accounting do not do this either. The failure to account for inflation, aside from the other problems already discussed, means that the firm may not be protecting its capital base (Gruening and Koen, 2001, 47). It also makes it hard to benchmark performance because different market conditions aren't being accounted for, allowing management to sit on their laurels since it's difficult to see if the company's value is really growing even after controlling for inflation. That having been said , inflation-keyed metrics can lull investors into a false sense of security (Fukui, 2003, p. 2). In fact, it may not be fair to measure executives against inflation of the market in general, given that the market is a cross-section which includes a mixture of high and low risk growths whereas individual firms are not. Another issue