Question

You are the accountant of White Hotel Berhad, a corporation that engages in the hotel businesses. The corporation is having a high value of buildings and has been using historical cost to measure it. The directors of White Hotel Berhad wanted to continue using the historical cost measurement since they feel that the valuation exercise is costly to the corporation. Prepare a note explaining 4 drawbacks of using the historical cost measurement for buildings.

Answer 1

Solution:

Meaning of Historical Cost Measurement Method:

The Historical Cost Measurement is a method in which fixed assets of a business are recorded at the Cost at which the assets were purchased. In other words, an asset is reported in Balance Sheet at Original Cost of the Asset. This Method is used for measuring fixed assets under US Generally Accepted Accounting Principles. In the given case, White Hotel Berhad which is engaged in Hotel Businesses has been accounting its buildings at Historical Cost of Measurement.

Drawbacks of using Historical Cost Measurement are as follows:

1. Non-Disclosure of Current Worth of Buildings:

If Historical Cost Method is used to measure Buildings then it represents the Original Cost at which the Buildings were acquired by the Corporation. It is possible that over the years, the Cost of Building has appreciated or depreciated due to various factors such as inflation or market demand for buildings. In such scenario, the Original Cost fails to represent the correct market value of buildings. Thus, by adopting Historical Cost Measurement, White Hotel Berhad would not be representing the Current Worth of Buildings held by it.

2. Lack of Timely Reporting of Changes in Value of Buildings:

Due to Historical Cost Measurement, the changes in value of Buildings is not reviewed timely by the Corporation. Due to this, the Financial Statements of the Corporation do not report significant change in value. Thus, the Financial Statements fail to represent true and fair value of buildings.

3. No Recording of Gain or Loss in Real Value:

As per Historical Cost Measurement, the value of assets are not required to be increased or decreased due to inflation or deflation in value of assets. Due to this, there is no recording of gain on inflation in value of buildings as well as no recording of loss due to deflation in value of buildings. Thus, White Hotel Berhad is failing to record gain or loss in real value of buildings which may be purchased many years ago.

4. Depreciation Provision insufficient to meet Replacement Cost:

Under Historical Cost Measurement, depreciation is charged on the original historical cost of building. Depreciation is nothing but a method to account for generation of funds for replacement of an asset when the asset can no longer be useful due to wear and tear over a period of time. Since, the replacement cost of building exceeds its original cost of purchase, the depreciation provision on original cost is quite insufficient to meet the current replacement cost.