Question

Why is the analysis of historical accounting information relevant when we do valuations?

Answer 1

Historical Cost Accounting is a traditional valuation method as it reflects only on the past cost of the asset, however in the contemporary business environment companies must remain flexible and transparent.

This belief has lead to the creation of several other valuation methods, due to word constraints I have focused primarily on Fair Value Accounting as an alternative to Historical Cost Accounting.

Although Fair value accounting is a theoretically superior valuation methodology, there are several severe problems in its current application, due to lax regulations and ineffective methods of determining current values of non-current assets. These problems within Fair Value Accounting have ensured that most companies conservatively remain using Historical Cost Accounting.

The historical cost system provides managers with a reliable, objective data that solely identifies changes in the organisations performance. Upon this base changes in performance can then be compared in reporting and measuring economic information.

No other method of accounting can provide exact information at a glance on the change in trends in the company's workings like the historical costs method.

Current valuations of non-current assts can also be disclosed as supplementary data without affecting financial statements.

Advantages

1. Cost is known and can be checked to an invoice

2. Enhances comparability

3. Leads to stable, non-volatile pricing

There are several merits or advantages of historical cost accounting concept. Firstly, it is easy to use and simple to apply as it is not required to reference to market values. Therefore, users no need to do market research to get the current price or market value of the financial items as the historical cost is not subjected to any future changes. They can just record down the original cost of the financial items in financial reports. Thus, the financial reports can certainly be prepared more speedily and easily than using other bases of measurement, which are current replacement cost, current market value and net realizable value, so it can contributes to cost savings and time savings.

Secondly, Historical cost accounting concept is easy to understand. In consequence of the simplicity of historical cost, users can easily understood and interpret financial reports well even though they do not have any financial background. Thirdly, Historical cost accounting concept is objective, verifiable and reliable. Since the historical cost is record based upon original amount paid, hence the original cost of the assets can confirmed through an original invoice or receipt.

Moreover, historical cost accounting concept also enables biz to keep track of their assets. Because the financial items are recorded in financial reporting based on the original cost of the items, therefore the users can compare the current cost and the original cost of the assets.

However, historical cost accounting concept also has shortcomings or disadvantages. Firstly, historical cost accounting concept is fixed, which means it is recorded based on the original cost in the invoice or receipt. Thus, it does not take inflation or changing prices into the account. During the inflation period, the price of the assets is different from changing a lots, it reflects large difference between original price and current price, so it does not seem sensible to record the value of assets by using the historical cost accounting concept when facing changing price.

Secondly, historical cost accounting concept does not show the true value of company’s assets. It recorded all the assets at the price at the date they are acquired. It is unrealistic fixed assets values, which mean the balance sheet value of the financial assets are differ from the true value.