Prepared by Arabella Volkov
University of Southern Queensland
References
• Text – Chapter 6
Historical cost
Learning Objectives
At the conclusion of this lecture, you
should have an appreciation of:
– the historical cost model and its
application
– the reasons for the dominance of
the historical cost model and the
arguments against the model
Learning Objectives
At the conclusion of this lecture, you
should have an appreciation of:
– historical cost valuation issues and
the equity perspective adopted
– the alternative models discussed in
other chapters as they relate to the
historical cost system
– criticisms of historical cost accounting
Basic Concepts
Objectives of accounting
• Separation of ownership and control
– leads to: information asymmetry
• Stewardship role of accounting
• Determination of profit versus net
worth (?)
Basic Concepts
Paton and Littleton:
Corporation reports should rest upon
the assumption that a fiduciary
management is reporting to
absentee investors who have no
Independent means of learning how
their representatives are discharging
their stewardship
Basic Concepts
Profit
• Measures the performance of managers
regarding the use of entity resources
• Income statement is most important
financial statement
• Balance sheet serves as link between
income statements
• Framework defines expenses and income
in terms of changes in value of assets and
liabilities
Basic Concepts
Paton and Littleton:
Accounting exists primarily as a means of
computing a residuum, a balance, the
difference between costs (as efforts)
and revenues (as accomplishments) for
individual enterprises. This difference
reflects managerial effectiveness and is
of particular significance to those who
furnish the capital and take the ultimate
responsibility
Basic Concepts
Costs attach theory
• Economic theory versus accounting theory
• Opportunity cost (displacement cost) vs.
embodied cost
• Theory is fundamental to cost accounting
Basic Concepts
Flow of costs
• Accountants keep track of flow of
costs
– Which costs have expired (expense)
– Unexpired costs (assets)
– Matching principle
Defence of Historical Cost
1. Relevant in making economic
decisions
2. Based on actual not possible
transactions
3. Historically this model has been
found to be useful
Defence of Historical Cost
4. Concept of profit as the excess of
selling price over historical cost is
understood
5. Historical cost is less subject to
manipulation and therefore helps
prevent manipulation of accounting
numbers
Defence of Historical Cost
6. Is income information based on
current cost or exit price useful?
7. Changes in market prices can be
disclosed as supplementary data
8. There’s insufficient evidence to
justify rejection of historical cost
accounting
Defence of Historical Cost
Evidence on usefulness of accounting data
• First direction
– Determine whether sufficient
information is disclosed
• Second direction
– Determine the effect on decision
making
• Third direction
– Examine the correlation between share
prices & accounting data
Defence of Historical Cost
Evidence on predictive value
• Using past earnings used to predict
future profit
• Profit as a random walk
• Using quarterly and segment data
used to predict annual profit
• Useful in predicting annual profit
Defence of Historical Cost
Evidence on predictive value
• Using financial ratios to predict
financial distress
– Accounting information appears to be a
good predictor of financial distress
• Using past profits to predict future
cash flows
– Historical cost profits appear to be useful
in predicting future cash flows
How Objective is Historical
Cost?
• Application of historical cost model
involves:
– Estimation
– Choice of methods (e.g. inventory
valuation)
– Other subjective judgments
How Objective is Historical
Cost?
• Many items may be included in the cost of
an asset
• Outlay necessary to bring asset to
existing condition and location
Example:
• IAS 2/AASB 102 ‘Inventories’ – Para. 10
(a) the cost of purchase
(b) the cost of conversion
(c) other costs
How Objective is Historical
Cost?
Example:
• IAS 36/AASB 136 ‘impairment of assets’
Para. 6
– ‘recoverable amount’ of asset
– Need to estimate future cash flows and
subsequent sale price
– Estimates required to determine discounted
future cash flows from non-current asset
Criticisms of Historical Cost
Accounting
• Objective of accounting
– Does the model fulfill the stewardship
role?
• Information for decision making
– The model may lack relevance for
decision making
• Basis of historical cost
– Going concern assumption
Criticisms of Historical Cost
Accounting
• Matching of revenues to expenses
• Notions of investor needs
– Distortion of or concealment of important
company disclosures
• Historical cost under attack
– Increasing use of other valuation models
Summary
• Advantages and disadvantages
of the historical cost system
• The objective of accounting
• Relevance v. reliability
Key Terms and
Concepts
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Historical cost model
Costs attach theory
Historical cost valuation
Alternative models
Historical cost accounting
Where to get more
information
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Other courses
Accounting handbook
List books
Articles
Electronic sources