Question

What is the main advantage/disadvantage associated with the historical cost concept?

Answer 1

Historical Cost Accounting, also known as conventional accounting, requires that all financial statement items to be based upon original cost, thus the transactions appearing in both the balance sheet and the profit and loss account in monetary amounts which displays the historical costs. Historical cost refers to what it cost the company for the item, and not the fair market value.

ADVANTAGES:

-- The chief advantage of using historical cost on the balance sheet for plant and equipment, property, and other assets is that historical cost can be verified. The cost at the time of purchase is supported with documents such as invoices, contracts, payments, transfer taxes.

-- The historical cost of plant and equipment (excluding land) is also used for the computation of depreciation amount reported on the income statement.

-- The accounting data under historical cost are often considered free from bias, independently verifiable, and thus increases the reliability by the investing public, and other external users. The reason is that it is based on actual transactions; it gives data that are less disputable in comparison to the alternative accounting systems

-- Historical accounting is also accepted on the ground that it is only accounting system that is accepted legally recognised as a basis for taxation, dividend declaration, defining legal capital, etc.

-- The method is least costly to society in consideration to the social costs in terms of recording, reporting, auditing and settling various disputes

DISADVANTAGES:

-- Changes in the value of money that leads to change in general level of price are not taken into consideration, thus does not provide true and fair picture of the state of affairs of the organization

-- Under historical cost accounting, fixed assets are presented and recorded at the price at which they are acquired; and any market value change is ignored thus provides an unrealistic fixed assets values

-- Income statement prepared under historical cost accounting does not provide true profit

--The depreciation provision made under historical cost accounting is on the original cost which will not be sufficient for the replacement of assets.

-- During period of inflation, non-monetary items are understated; as a result balance sheet does not present a fair value financial position.