PDF Current cost accounting versus historical cost accounting a critical review

The four enhancing qualitative characteristics are timeliness, understandability, verifiability and comparability. The purpose of this article is to outline and explain the key principles in Chapters 1 – 7 of the Conceptual Framework. Suppose Turner Construction Company owns a building that it purchased for $1 million five years ago. Furthermore, the company estimates that the useful life of the building is 20 years, meaning that it depreciates the facility by $50,000 per year ($ 1 million / 20 years). The user acquisition funnel is a framework that marketers and product managers use to understand…

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• Replacement Cost Accounting (RCA) Technique is an improvement over Current Purchasing Power Technique (CPP).
• They worry that frequent revaluation can lead to significant swings in reported profits, which may confuse investors.
• Now, let’s assume that the real estate market experiences a downturn, and the value of the property decreases to $900,000.
• Replacement cost and realisable value are suitable when resources are disposed of or replaced at frequent intervals.
• It later got recognition as an accounting method under the Statement of Standard Accounting Practice (SSAP 16).

On the balance sheet, annual depreciation is accumulated over time and recorded below an asset’s historical cost. Historical cost is the amount that is originally paid to acquire the asset and may be different from the current market value of the asset. Let us assume, for example, that a herbal medicine company purchases a piece of land for growing herbs on it, paying $25,000 in cash.

However, the volatility of current values can also introduce uncertainty and risk, as the value of assets may change rapidly in response to market conditions. However, critics argue that the historical cost principle may lead to a distorted view of a company’s true worth, especially in times of inflation or when the market value of assets has significantly changed. They contend that this method fails to provide relevant information for decision-making purposes, as it does not reflect the current economic realities.

• This subjectivity may lead to inconsistencies and reduce comparability across financial periods or between companies, complicating decision-making for stakeholders.
• The company purchases 1,000 units of raw material for $10 per unit, meaning the historical cost of the raw material inventory is $10,000.
• Value in use (or fulfilment value) is defined as an entity-specific value, and is the present value of the cash flows that an entity expects to derive from the continuing use of an asset and its ultimate disposal.

Challenges in Balancing Historical Costs and Current Values

(2) The replaced new assets are not of the same type and quality as old assets because of new developments and improved qualities. The computation of monetary gain or loss can be followed with the help of the following illustrations. The fair value is determined in good faith by the fund’s board who are required to establish fair value methodologies and oversee pricing services. If data is not readily available or if the investment is not a security, the Act requires the fund to use the investment’s fair value. Fair value is the price an investor pays for a stock and may be considered the present value of the stock when its intrinsic value and its growth potential are considered. In investing, fair value is the price that investors are willing to pay to generate their desired price growth and rate of return.

Understanding Historical Costs and Current Values

Cash flow statements are indirectly influenced by CCA due to changes in operating income. While cash flow itself remains unchanged, stakeholders may interpret cash flow metrics differently, considering the impact of adjustments on profitability and operational efficiency. (b) the change in the entity’s assets and liabilities as a result of that transaction or other event. Different IFRS Accounting Standards apply different criterion; for example, some apply probable, some virtually certain and some reasonably possible.

This valuation concept requires the knowledge or estimation of three basic factors—the amount or amounts to be received, the discount factor and the time periods involved. Under the CCA technique, cost of sales are to be calculated on the basis of cost of replacing the goods at the time they are sold. As for sales are concerned, it is current revenue and out of the costs, all operating expenses are current costs. But in case of inventories, certain adjustments will have to be made, known as cost of sales adjustment. The same is true is in deflation also, as current revenues are not matched with current costs.

Verifying the accuracy of data on replacement cost or realisable value is not possible because the data cannot be compared with actual results. (iv) The discounted value of the differential cash flows of all of the separate assets of the firm cannot be added together to obtain the value of the firm. This is partly due to the joint-ness of the contributions of the separate assets, but it is also due to the fact that some assets, such as intangibles, cannot be separately identified. Current cost has become an important valuation basis in accounting, particularly as a means of presenting information regarding the effect of inflation on an enterprise. At times a company finds that over the years it has introduced many variants of a product in the product line. In this process the product lines become unduly complicated and long with too many variants, shapes or sizes.

Contingent Liability

Thus, net realisable values and current cash equivalents may be relevant for many predictions. But when the expected future benefits are highly uncertain, the use of input valuations may offer a reasonable substitute in some situations. Therefore, cost is the exchange price of goods and services at the time they are acquired. When the consideration given in the exchange consists of non-monetary assets, the exchange price is determined by the current fair value of assets given up in the exchange. Cost is thus the economic sacrifice expressed in monetary terms required to obtain a specific asset or a group of assets.

Nevertheless, while both methods of accounting affect financial statements, the impact of fair value accounting on the balance sheet and income statement is extreme due to the potential volatility of the method. Fair value accounting is deemed superior when compared to historical cost accounting because it reflects the current situation in the market whereas the later is based on the past. In addition, in relative terms, fair value accounting provides users with more current financial information and visibility. The debate between historical cost and current value accounting methods is a longstanding one, with each approach offering its own unique insights into asset valuation. Historical cost accounting, which records the price of an asset at the time of its purchase, provides a clear and consistent basis for financial reporting.

Consolidated Financial Statements

Sometimes, a company finds one end of its line selling well and the other end selling poorly. Then the company may try to boost demand for the short sellers especially if they are produced in a factory that is idled by lack of demand. Companies that emphasise high profitability will carry shorter lines consisting of carefully chosen items.

In order current value accounting to analyse each product line, product- line managers need to know two factors. A distinct unit within a brand or product line distinguishable by size, price, appearance or some other attributes. For instance, LCD, CD- ROM drive and joystick are various items under palm top product type.

Automotive manufacturers, for instance, can use CCA to reflect technological advancements and production cost changes, helping them stay competitive in a rapidly evolving market. Companies that follow generally accepted accounting principles must use the historical cost method for certain assets. More specifically, this accounting method is required to be used when reporting fixed assets. Many users would prefer the concept of measurement reliability, but the Conceptual Framework provides clarification concerning measurement uncertainties which are defined in terms of faithful representation. Faithful representation of information does not mean that that information must be accurate in all respects. As the use of estimates are an essential part of the preparation of financial information and this does not necessarily weaken the usefulness of the information.

Staff training and adjustments to financial systems are necessary to accommodate dynamic asset valuations. Careful planning and execution are required to ensure a smooth transition and regulatory compliance. Historical cost also prevents the overvaluation of assets, especially during times of high volatility. If the probability of the event is low, then recognition in the financial statements may not be the most relevant information.