Examining the criticisms of Historical Cost Accounting

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For many years accountants have been required to comply with the rules and guidelines set out in the accounting concepts and conventions. One accounting technique used is the historical cost convention which requires the transactions to be recorded at the original price, i.e., the price paid, in the balance sheet. The £ amount and the date of the transaction are both recorded under historical cost convention. This simply means that the assets and expenses of a firm must be recorded at the original cost when purchased and the profit is to be calculated by reducing the revenue by the original cost of the resources used. The item must remain in the accounts until it has been disposed of.

However, HCA does face much criticism due to the problems with inflation. When inflation was quite high, the IASB issued the IAS 15, as it's approach was to maintain financial accounts accurately, taking all factors into consideration, this simply meant that companies were required to produce inflation adjusted accounts, however, when inflation fell this was removed from developed countries as firms were unwilling to make such minor adjustments. However, less developed countries that are experiencing hyperinflation, are still required to produce these inflation adjusted accounts. This is why the ASB continually develops new Financial Reporting models and continually improves existing models.

Historical Cost Accounting

'Financial statements produced under this convention provide a basis for determining the outcome of agency agreements with reasonable certainty and predictability because the dates are relatively objective' [1] 

Historical Cost Accounting (HCA) has been around for many years and thus has also faced many criticisms. The main criticism put forth against HCA was the effect of inflation on the accounting concept as many problems are caused due to inflation. The main and most obvious problem is where the transaction in a certain currency should remain the same as the time of recording, i.e. the purchasing power should remain stable over time. Another problem is the effect on profits as the changes to assets, caused by inflation are ignored. Other flaws due to inflation include, business entities becomes unclear. Setting plans, decision-making and setting targets may be suboptimal if we have out-of-date data.

As an alternative to HCA, Current Value Accounting (CVA) was thought to be the most appropriate financial reporting method and so was researched and developed even further. After mush research and development the current value postulate still suffered from a number of disadvantages:

HCA is more objective and therefore is more verifiable from auditable documentation.

As HCA is transaction based, CVA destroys the accurate nature of HCA.

Due to the degree of subjectivity in measuring current value, the improvement in comparing commercial entities is a myth.

Current Purchasing Power (CPP), Replacement Cost (RC) and Net Realisable Value (NRV) are all income and value models that have been developed to either replace the Historical Cost convention or to work alongside it.

Income and value are both measured using the CPP model, this is simply done with the adoption of a price index system. By recording the price changes in a group of goods/services, which are used within the economy, we can record the price fluctuations in a particular good/service. The base point in time is the point where these commodities are determined and is indexed as 100. For example, if we have a range of goods that amount to £65 on 31 Jan 20X2, the changes recorded would be as follows:

£65 at 31 Jan 20X2

£69 at 28 Feb 20X2

£72 at 31 March 20X2

£74 at 31 April 20X2

The indexed price changes would be:

20X2 Calculation Index

31 Jan 20X2 £65 100

28 Feb 20X2 X 100 106.2

31 March 20X2 X 100 110.8

31 April 20X2 X 100 113.8

The UK, refer to this index as the Retail Price Index (RPI).

This model gives a good introduction into the gains and losses in purchasing power.

2.2 - RC

Businesses use assets and materials, the RC model simply measures the cost incurred in the replacement of these assets or materials. This is simply done by taking into account the current state of the asset and therefore replaces it on a like for like basis. If for example, a store buys a new computer at an initial cost of £5000, this is to be depreciated using the straight line method over a period of 5 years. Under HCA its value after year one would be £4000 (i.e. 5000-1000), however, if like for like replacement costs £6000 then the gross RC would be £6000 and depreciation for the 1 year would equate to £1200 meaning the original £4000 HCA figure would now be changed to £4800. With the excess £800 said to be a holding gain.

2.3 - NRV

If we use the above example to explain the NRV model we can say the asset initially cost £5000. After one year, the asset has met all the selling expenses and therefore now has a value of £4500. This simply means that the figure of £4500 would be taken to the NRV statement of financial position. So the opportunity cost of holding this asset is £4500 as this amount has been sacrificed in favour of the asset. The depreciation for the year would amount to £500, i.e. £5000-£4500.

2.4 - Three models compared.

HCA and CPP are both transaction based models which apply the capital maintenance concept. This is simply the difference between the opening and closing net assets. The RCA model and both HCA and CPP assumes that the business will continue as a going concern. Whereas the NRVA concept assumes that the business has the capacity to realize its net assets at the end of each financial period and reinvest the proceeds.

Accounting Standards Board

The Accounting Standards Board (ASB) was established in 1990 as a subsidiary of the Financial Reporting Council (FRC).

The ASB is aware that there have been unsuccessful standard setters in the past in regards to obtaining a consensus on the price level adjusting model which would be used in financial statements. Therefore, the standard setting process arrangements are overseen by the FRC and its duty is to support the ASB in its tasks and where possible, the FRC, must seek support for the ASB. The FRC issues an annual report with the first one of these being issued in November 1991, stating:

'There is no place whatever for accounts fit only for fair weather, undermining the credibility of the good reporting for which our country has earned a world-wide reputation. With the initiatives now in hand we seek accounts that may be relied upon to give good service to boards, shareholders, creditors and employees - indeed all who use accounts.' [2] 

As a result of the previous failed standard setters, the ASB has adopted a gradualist approach for specific asset and liability treatment where they would be required to move away from historical costs.

'The Role of Valuation in Financial Reporting,' which was issued in 1993 set out the views of the ASB. So, when considering the existing system of modified historic costs, three options were open to the ASB:

Remove the right to modify costs in the statement of financial position - this option has been strongly backed by both the UK and the USA as it would bring the UK into line with the USA and some of the EU countries. However, it was rejected by the ASB as the ASB would hope that the current values would be better known in the longer term in the UK.

Immediately introduce a coherent current value system - this would simply be to develop a new system where current values are taken into consideration within the

principles. The 'statement of Accounting Policies' is a system based on the value to the business. This simply means that it considers the current value system as is simply to determine the value of the asset within the business. So, if the asset is worth replacing we would replace it through the RC. If it is worth keeping, but not replacing, then use economic value, if it is not worth replacing or keeping then we would use NRV.

To improve the current historic cost system - this approach would reduce the number of anomalies and has been applied in FRS 3 and requires a new primary financial statement. 'the Statement of Accounting Principles continues to envisage that a mixed measurement system will be used and it focuses on the mix of Historical cost and current value to be adopted.' [3] 

The ASB has been faced with a great deal of difficulty from the Statement of Principles (SoP). Where the first draft was prepared between 1991 and 1995, and eventually issued in November 1995. This draft was faced with a significant amount of criticism as it was mainly focusing on the balance sheet rather than the profit and loss account. Therefore, following much discussion the SoP was issued in 1999 as a definitive document. The main objective of the SoP was to assist the ASB by explaining the concepts that underlie the ASB's work.


Accounting standards are difficult to develop and validate, especially for smaller countries. Therefore, some form of regulation was needed for the financial statements that were produced by these smaller countries. And so, led to the creation of the IASC in 1973 by a number of the accounting bodies from various countries including, UK, Australia, France, Germany, Japan, Mexico, Netherlands, Ireland and the USA.

In 2001 the IASC was replaced by the International Accounting Standards Board (IASB). Where the IASB adopted all the International Accounting Standards (IASs) that the IASC had set and any new standards set by the IASB were now to be named by the International Financial Reporting Standards (IFRSs). Similar to the IASC, there are 19 trustees who oversee any work by the IASB, these trustees are from around the globe, six from Europe, six from USA, four from Asia/Pacific and the remaining three can be from anywhere provided the geographical balance is retained.

Similar to the ASB, the IASB was unaware on how to respond to the changes in inflation rates. This led to the issue of IAS 15 in 1983 which required that replacement cost adjustments be used in the HCA accounts and also the corrected adjustments for depreciation, cost of sales and monetary items be recorded.

By 1989 the IAS 15 became optional as inflation rates fell to below double figures which meant that the companies were unwilling to prepare the inflation adjusted accounts. Then in 2003, the IAS 15 was removed, in developed countries, as part of the ASB improvement project, because the inflation rates fluctuated between 1-4%. However, in less developed countries many are experiencing hyperinflation thus inflation-adjusted accounts are still required.


No better alternative is available to replace the flawed HCA method, this explains why the Accounting bodies have not replaced HCA. Although HCA has a number of limitations, the accounting bodies seem to ignore the fact that there are also a number of benefits of HCA. Corporations across the globe recognize and accept the HCA model.

So, if the accounting bodies decide to replace HCA the question that needs to be asked is, will it be better than historical cost accounting? It will be difficult to replace as people are familiar working with HCA.

Historical Cost Accounting is and will probably remain the oldest and most dominant method to measure business performance, until, the accounting bodies are able to develop a foolproof method which will effectively replace the HCA method.