Improvements to make HCA reflect price level changes

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The Historical Cost Accounting (HCA) concept has attracted significant criticisms since the price level of UK started to rocket around the 1970's. The inflation generated problems and concerns over HCA, exposing the weaknesses. As a result, three main models have been proposed to replace the HCA. In this essay, it will be illustrated that (1) the weakness, strength and problems of HCA; (2) Comparisons between CPPA/GPPA, RCA, NRVA, that have been proposed to replace HCA; and (3) The approach of the ASB and IASC/IASB in relation to this topic.

2. Strength, Weakness and Problems, with HCA


HCA is described as the "accountant's view", which is more likely intuitive and traditional. Income statement is based on actual cost of transactions, which reflects the historical cost in both profit and loss account. Wood & Sangster (2009) explained that HCA is simple to understand - it defines an asset is valued at what it cost, less an amount representing the effect of its use so far upon that value. The HCA is therefore considered to have 3 strengths:

Objective - verifiable with historic documents

Factual - based on verifiable figures

Consistent - the concept is understandable across sectors

Wood & Sangster (2008) states the Historical Cost method is the most commonly applied. Melville (2009) agrees on this point and described HCA as "widely understood and well-established, serving the needs of users for several centuries. It possesses … objectivity, in that the historical cost of an asset is usually an objective fact.


However, Elliott and Elliott (2009) explained that the HCA is not always objective due to different definitions of revenue and cost, and the need for estimates. This creates discrepancies between individual accounts thus reducing the overall accuracy. Elliott and & Elliott (2009) claimed that HCA has 4 weaknesses:

Principles of Historical Cost and Profit Realisation - where the system produces a mix of values and realised income items

Prudence Concept - the method of calculating profit is stricter than cost

Unrealised Capital Profits - the system does not consistently recognise capital profits

Going Concern - accountants are reluctant to predict the longer term

Melville (2009, p.268) identified similar weaknesses, as follows:

Profits are overstated

Depreciation charges are inadequate

Gains and Losses on monetary items are not disclosed

Holding gains on inventories are not identified

Non-current asset values reported in the statement of financial position are unrealistic

Accounting ratios are misleading


Elliott and Elliott (2009, p.60) classified the inflation-generated problems into 5 categories:

Overstated Profit - inflationary changes ignored

Distorted Comparability - disadvantage on assessment of performance

Suboptimal Decision-making Process (based on out of date data)

Misleading, or at least Confusing Financial Report - mismatching revenue with historical cost levels

Increasing Unrealised Profits (as a result of inflation)

Comparisons between CPP/GPP, RC and NRV

There are three main models have been proposed to replace or operate with the historical cost convention. They are mainly concluded as 3 models (Elliott & Elliott, p.61):

Current Purchasing Power Accounting (CPPA) or General Purchasing Power (GPP);

Replacement Cost (RC) or Current Entry Cost;

Net Realisable Value Accounting (NRVA) or Current Exit Cost;

Current Purchasing Power Accounting (CPPA)

The CPP model measures income and value by adopting a unique price index system, where price levels movements are measured by a group of goods and services in general. The basket of commodities is chosen in order to represent a true and fair point of view of the price level. In the UK, the Economic indicator RPI (Retail Price Index) is similar to this approach where "a barometer of fluctuating price levels covering a miscellany of goods and services as used by the average household." (Elliott & Elliott, 2009)


It is showing several virtues as being objective due to the nature of transaction based. However, it may become subjective if government agency is involved in constructing of the barometer. In the UK, the Retail Price Index is published by the government.

In addition, shareholders capital is objectively measured in terms of purchasing power units. Profit is calculated by deducting the maintaining the money value of capital funds, which involves price level changes.

Further, CPP initiated the concept of monetary items as different from non-monetary items. As Elliott and Elliott (2009, p67) states that "it is the attendant concepts of gains and loses in holding net monetary liabilities compared with holding net monetary assets. Such gains and loses are experienced on a disturbing scale in times of inflation."


The CPP is still HCA based but adjusted to take general price movements into accounts. The model does not take into account of individual price changes but focusing on general price level changes.

Therefore, the balance sheet produced by using such method is considered misleading because it may be assumed as a current value document.

Additionally, it creates an alien unit of measurement, as Elliott & Elliott explained (2009, p67) "It still labelled by the £ sign. Thus we have the HCA £ and CPP £."

Last, the concept of profit is misleading. It fails to provide for the increased cost figures that have been already recorded in a previous stage. Elliott & Elliott (2009) concluded that "the maintenance of the CPP of shareholders' capital via this concept of profit is not the maintenance of the entity's operating capital in physical terms."

Current Entry Cost, or Replacement Cost (RC)

The rationale behind the RC is to adopt the current replacement cost (less any depreciation) to assess income and value. Elliott and Elliott (2009) illustrated that "the valuation attempts to replace like with like and thus takes account of the quality and condition of the existing assets.


Its unit of measurement is generally regarded as acceptable standard of reporting and easy to understand. In contrast, Elliott & Elliott (2009, p68) says, "The CPP system employs an artificial unit based on arithmetic relationships, which is unfamiliar."

The model also distinguishes holding gains from operating income, which can improve the accuracy of operating profit by maintaining the physical operating capacity of the entity. Dividends are distributed properly under this method.

Also it initiated realistic current values of assets. This improved the accuracy of balance sheet compared to using the CPPA and/or HCA method.


The model is subjective on the estimation of the replacement cost. RCA does not reflect the factual nature of HCA where the adoption of replacement cost is open to manipulation. Although it is based on commodities that have similar raw material or operating assets, the managers hold the control over the "similarity".

Also the assumption is based on replacement cost, but if the assets are not to be replaced by similar assets it would calculate an equivalent replacement cost - however such calculation will give different results within the firm. (Elliott & Elliott, 2009)

Current Exit Cost, or Net Realisable Value Accounting (NRVA)

The Net Realisable value adopted the Economist's view on cost, which represents the opportunity cost - the best alternative forgone. The current values always reflect the level of the current opportunity cost.


Elliott and Elliott (2009, p68) explained that this method records the "selling price" of existing possession, which is the value to the potential sale. The owner should always record the potential sale price of existing possession.

Furthermore, NRVA avoids the need to estimate depreciation and its associated assessment. Elliott and Elliott (2009) stated that "depreciation here is treated as the arithmetic difference between the NRV at the end of a financial period and the NRV at its beginning." What is more, this core concept is based on opportunity cost and it is more authentic in terms of being a true or real cost. Once a disposal of asset takes place, the equivalent cash alternative will replace the asset value recorded, thus producing more realistic cost figure/value.


The NRVA has the same subjective trend of measuring as RCA because the potential sales figure is obtained by estimation rather than actual figure. Elliott and Elliott (2009) argue that it is less prudent than RCA because NRV will tend to be higher in some cases than RCA. The NRV can also be considered an irrelevant approach because the assets are intended to be utilised rather than sold. In some cases, it is impossible to determine the potential sales price by using existing knowledge and experiences. Even worse, it may not find a suitable market to carry out such valuation. Therefore under such circumstances the NRV is unrealistic.

Last, Elliott and Elliott (2009, p69) states that NRVA violates the concept of the going concern, which is based on that there is no intention to liquidate the entity. However, by accepting NRV approach it implies the possibility of a cessation of trading.

Comparison between methods

Wood & Sangster (2009, p.442) compared the four methods of valuation in the contexts of time and valuation basis, in a chart:




Entry Value

Historical Cost

Replacement Cost

Exit Value

Realisable Value

Present Value

The Approach of ASB and IASC/IASB

ASB stands for Accounting Standard Board (UK), and the IASB stands for International Accounting Standard Board. Both organisations are dedicated to responsible for the development and improvement of Financial Reporting standards. Differences between the approaches to inflation accounting exist.

Approach of Accounting Standard Board (ASB)

The unsuccessful previous standard on inflationary accounting, which is mainly due to lack of consensus structure on how to adjust price level changes, is being revised in order to present a true and fair aspects of assets and liabilities for accounting information users. There were 3 options that have been considered by the ASB in 1993, as follows:

Forbid to modify cost/value in the balance sheet

This movement refers pulling the system back to the principles of HCA strictly with current values shown as note. Elliott and Elliott (2009, p. 82) implied that this option has strong support from the profession both in the UK and USA by quoting a report from Ernst & Young (1994) and AICPA "this is an advantage not just in terms of reliability, but also in terms of relevance..." and "... because it provides them with a stable and consistent benchmark that they can rely on to establish historical trends... "

To initiate a consistent current value system in first priority

In order to develop a system that accurately reflects the current value, the ASB promoted the concept of "value to the business" which allows the co-existence between different current value systems. If the asset is worth replacing, then use the replacement cost (RCA); and if it is not worth replacing, then use the (a) economic value if it is worth keeping and (b) use the Net Realisable Value (NRV) if it is not worth keeping. (Elliott & Elliott, 2009, p.83)

Imply additional improvements to the present modified HCA system

ASB prefers this option for eliminating anomalies and standing at the development point of view by adding various improvements on an ad hoc basis. ASB predicted that a mixed measurement system will be adopted which focuses on the mixture of HCA and CCA. It is viewed that time is needed in order to transform HCA completely to a full current value system successfully. Also by given the failure experience in the past where the attempt of transforming fully into current value system, a similar attempt will not be conducted now. ASB has applied the new regulation in FRS 3 with the requirement of (1) a new primary financial statement, (2) the statement of total recognised gains and losses to report unrealised gains and losses arising from revaluation. (Elliott & Elliott, 2009, p.84)

Additionally, due to the short-term nature of such option, it opens the possibility of adopting longer term policies in the future.

Approach of International Standard Board (IASB/IASC)

The IASB/IASC is mainly focused on building a consensus that HCA systems are failing to give a true and fair view, where such consensus is influenced by the current inflation rate. In 1983, IASB issued a mandatory standard IAS 15 Information Reflecting the Effects of Changing Prices in order to tackle intense inflationary pressure, for example, the hyperinflation. It requires HCA accounting report to include either: (a) the current GPI or (b) the replacement cost plus depreciation.

As the inflation rates fell below the significance level (e.g. 10% and beyond), companies are reluctant to prepare accounts by using inflation-adjusted accounts. Therefore in 1989 the mandatory requirement IAS 15 became optional. In recent years, the inflation rates in developed countries have ranged between 1% and 4% and so in 2003, twenty years after it was first issued, IAS 15 was withdrawn as part of the ASB Improvement Project. (Elliott & Elliott, 2009, p. 84)


The HCA system has displayed inadequacies when tackling with different price levels, and it has been concluded that it has several problems, especially in those countries have hyperinflation. Several concepts and methods therefore had been built to replace or operate alongside the historical cost convention. Although most people does not consider inflation as a significant problem recently, especially in the developed countries, such as the UK, there are still demands for "value accounting" to be included in the modern accounting concept in order to overcome the accuracy difficulties caused by changing price levels.