Advantages of Historical Cost

In this article we will discuss about the advantages of historical cost.

Firstly, historical cost principle automatically requires the recording of all actual transactions in the past. The market value of finished goods can be ascertained without knowing how the goods were actually produced.

But there is no way to determine the historical cost of the goods without a record of how the goods were actually produced and how the materials and labour that contributed to the production of the goods were actually obtained.

Thus, implicit in financial statements under historical cost is a supporting record of all actual transactions in the past. There is no such assurance when financial statements are prepared—under a valuation method other than historical cost. A balance sheet, for example, can be prepared based only on a year-end inventory of all assets and liabilities.

Secondly, historical cost is essential for the proper functioning of accountability, the concept upon which our modern economic society is built. Without historical cost data, a manager will have a difficult time demonstrating that he has properly utilised the resources entrusted to him by the shareholders.

The power of historical cost and double-entry book keeping has stimulated us to develop an interrelated network of accountability in describing a business enterprise’s activities. In this respect, alternative valuation data may be used as a supplementary basis for accountability evaluation, but they hardly ever replace the accountability network based on actual transactions.

For example, if a manager purchases merchandise for Rs. 1,00,000 when he could have purchased it for Rs. 90,000, the manager may be held accountable for the opportunity loss. The manager may, however, be able to demonstrate that without his special care and talent in bargaining, the firm would have bought the merchandise for Rs. 1,20,000.

Many speculations and hypothesis may be offered concerning what the firm could have done but the evaluation of accountability must always depend on what has actually happened and any speculations or hypotheses must be compared to actual events.

Ijiri argues that, “in so far as accountability remains the key function of accounting, it is inconceivable that historical cost will be replaced by another valuation method in the future, although it may be supplemented by other methods.”

Thirdly, different valuation methods could be compared in terms of their effect on performance measurement of business enterprises. The important issue concerning asset valuation is whether the economic performance of an entity should be measured based on historical cost or another valuation method.

For individual decisions each valuation method, including historical cost has some uses under certain conditions For example, with a decision to sell or to hold resources, a decision maker would want to know the best estimates of net realisable value from an immediate sale of the resources and of the discounted value of the net realisable value from a sale at some point in the future.

Replacement cost may be a crucial input to a decision to rebuild a factory. However, the fact that data collected for a specific decision are very useful for that particular decision, does not necessarily imply that such data should be recorded and reported regularly. A need for tailor-made data for a specific decision does not imply that the same kind of data will be useful for decision-making in general.

Similarly, the usefulness of such data on individual resources does not imply the usefulness of the same kind of data on aggregate resources. The disposal value of a plant is very useful information if the manager is contemplating its disposal. But the disposal value of all plants of the firm is not necessarily useful for decisions.

Fourthly, historical cost being sunk cost does not influence the optimality of the decision. Yet, there are at least three reasons why historical cost is relevant to a decision:

(а) Historical cost affects evaluation and selection of decision rules.

(b) Historical cost provides input to the “satisfying” notion.

(c) Historical cost is used as a basis for a decision objective imposed upon the decision maker by his environment.

In making a decision, the decision maker must seek any relevant or potentially valuable information, even if he knows that each piece of information may not directly affect a specific decision he faces at a particular moment in time. Historical cost is certainly an important input in evaluating the past performance of a decision rule or a method to select a decision rule.

Historical cost is also important because it provides input to what is called the “satisficing” model, in contrast to the classical model of optimising. Under complete certainty, it is clearly irrational not to optimize. However, faced with uncertainty, it is perfectly rational for a man to seek for satisficing rather than optimising his goal. The behavioural proposition of satisficing is observable in many kinds of human behaviour.

Optimising implies that the decision maker searches for all possible alternatives and selects the one that maximises his achievement with respect to a given goal.

Satisficing means that a decision maker searches for alternatives until he finds an alternative that is satisfactory for him relative to his level of aspiration. He then chooses this alternative, even if there is a chance that he may find a better alternative were he to continue his search.

For example, in the case of selling shares, optimising means that the consequences of selling the shares now, a day later or two days later should all be evaluated and the alternative that yields the best results should be selected.

However, when choosing an alternative (selling after some specified days) under uncertainty, the estimate in many cases is so unreliable that almost any alternative can be considered optimum by adjusting estimates within a reasonable bound.

In such an ambiguous situation, a decision-maker may reasonably aim at achieving a satisfactory result. Thus, instead of asking how much more he can earn by holding the shares, the questions of how much he has earned so far becomes the relevant issue to a satisfice.

In addition it is often very difficult to prove that the decision maker selected the optimum alternative under the circumstances, but it is easy to show that the selected alternative yields a satisfactory result relative to a preannounced level of aspiration. In this way, historical cost becomes an important input to a satisficing decision-maker.

Historical cost is also relevant to economic decisions because a decision maker cannot neglect the intricate social systems based on historical cost. The most typical example is the income tax. Since taxable income is based on historical cost, a decision maker cannot analyse the full financial impact of his decision unless he knows the historical cost of the resource in question.

In addition, there are many instances, where a decision maker must take into account historical cost because his environment is based on historical cost. Cost-plus contracts, pricing in a regulated industry and incentive compensation based on accounting profit are such examples.

Fifthly, business activities are all interrelated and collectively contribute to the profit making goal. Theoretically, we would be correct in saying that the final achievement must be allocated among the various factors which contribute to the achievement. However businesses generally engage in millions or billions of transactions.

Without adopting a convention that value changes occur at certain discrete points in time rather than continuously overtime, it is practically impossible to generate timely measures in accounting measurement.

Therefore, although:

(i) The procurement of materials and labour,

(ii) Production,

(iii) Sales and

(iv) Collection all contribute to profit making, profit is considered to be realised only at the point of sales under historical cost, because the sale is considered to be the most difficult or critical point in the cycle. The key question is what improvements can be made by spreading profits over several recognition points instead of retaining the present realisation principle which recognises profit only at the point of sales.