Question

The choice of the measurement model to be used in Financial Statements has always been particularly complex and controversial within the academic community, standard setters and practice. In a recent speech, the Chairman of IASB, emphasized: ‘[…] I was struck by the multitude of measurement techniques that both IFRSs and US GAAP prescribe, from historic cost, through value-in-use, to fair value and many shades in between. In all, our standards employ about 20 variants based on historic cost or current value.’ Hans Hoogervost, Chairman IASB (20 June 2012). It is expected that neither fair value nor historical cost are likely to be both wholly relevant and reliable and that there is often a trade-off between the two. In practice, which measurement method, historical cost or fair value would provide the ‘best’ accounting information?

argues in support of reliability (faithful representation) and historical cost measurement method.

Answer 1

According to Historical Cost concept, an asset is ordinarily recorded in the books of accounts at the price at which it was acquired. This cost becomes the basis for all subsequent accounting for the asset. Since, the acquisition cost relates to the past, it is reffered to as Historical cost.

The justification for the Historical cost concept lies in the following arguments:

• The data under Historical Cost Accounting is generally considered free from bias, independently verifiable, and hence more reliable by the investing public, and other external users. Financial statements can easily be verified with the help of relevant documentary and other evidence. Because of the verifiability feature, this method has more preference among various financialists.
• As it is based on actual transactions, it provides data which is less disputable than the one found in alternative accounting systems.
• It is justified by 'going concern concept', which assumes that the enterprise will continue its activities indefinitely and thus there is no need of using the current values or liquidation values.
• It is the only legally recognised accounting system accepted as a basis for taxation, dividend declaration, defining legal capital, etc
• This method has been proved to be less costly to the society considering the social costs of recording, reporting, auditing and settling disputes.

However, with the forever dynamic economic environment, where prices are constantly rising, HCA suffers from some limitations too, which are as follows:

• During the period of inflation, the figure of net profit disclosed by profit and loss account will be seriously distorted because depreciation based on historical costs will be charged against revenue at current prices.
• The HCA ignores the decline in the value of currency and keeps adding transactions acquired at different dates with currency of varying purchasing power. Thus, in historical accounts, the monetary unit used to measure incomes and expenditures, assets and liabilities, has a mixture of values depending on the date at which each item was originally brought into the accounts.
• HCA does not match current revenues with the current costs of operations. Revenues are measured in inflated (current) currency whereas production costs are a mix of current and historical costs. Accordingly, HCA tends to report ‘inflated’ or “inventory’ profits and lower costs of consuming stocks and fixed assets during a period of increasing prices.