Historical Cost Accounting (HCA): Meaning, Benefits and Limitations

In this article we will discuss about Historical Cost Accounting (HCA):- 1. Meaning of Historical Cost Accounting 2. Benefits of Historical Cost Accounting 3. Limitations.

Meaning of Historical Cost Accounting:

Historical Cost Accounting (HCA), also known as conventional accounting, record transactions appearing in both the balance sheet and the profit and loss account in monetary amounts which reflect their historical costs, i.e., prices that are generally the result of arm’s length transactions.

The historical cost principle requires that accounting records be maintained at original transaction prices and that these values be retained throughout the accounting process to serve as the basis for values in the financial statements. HCA is based on the realisation principle which requires the recognition of revenue when it has been realised.

The realisation principle has an important implication affecting both the profit and loss account and the balance sheet. The principle requires that only realised revenues be included in the income statement. In the balance sheet, the realisation principle requires adherence to the historical cost of the assets until the asset is sold, despite any changes in the value of the assets (resources) held by a business enterprise.

Benefits of Historical Cost Accounting:

Arguments which are advanced in favour of HCA are listed as follows:

1. Accounting data under HCA are generally considered free from bias, independently verifiable, and hence more reliable by the investing public, and other external users. Financial statements can easily be verified with the help of relevant documentary and other evidence. Because of the verifiability feature, accounting profession has more preference for traditional accounting

2. Historical accounting reduces to a minimum the extent to which the accounts may be affected by the personal judgements of those who prepare them. Being based on actual transactions, it provides data that are less disputable than are found in alternative accounting systems.

3. It has been generally found that users, internal and external, have preferences for HCA and financial statements prepared under it. According to Mautz, “if those who make management and investment decisions had not found financial reports based on historical cost useful over the years, changes in accounting would long since have been made”.

Ijiri, a strong supporter of HCA, argues that HCA has played a significant role in the past and will continue to be important in financial reporting in the future. Berkin favours historical cost because of its ability to present actual events without arbitrary adjustments by management. According to him, if corporate income was arbitrarily adjusted to show the impact of inflation, labour would be in an untenable bargaining position.

4. Historical accounting is also defended on the ground that it is only the legally recognised accounting system accepted as a basis for taxation, dividend declaration, defining legal capital, etc.

5. Historical cost valuation is, among all valuation methods currently proposed, the method that is least costly to society considering the social costs of recording, reporting, auditing and settling disputes.

Limitations of Historical Cost Accounting:

In an economic environment, where prices are constantly rising, as has been the case in most countries of the world, HCA suffers from some limitations.

The drawbacks of HCA are listed as follows:

1. In times of inflation, the value of money declines and, therefore, the monetary unit (e.g., rupee in India) which is used as a standard of measurement does not have a constant value and shrinks in value as the prices rise.

The HCA ignores this decline in the value of rupee and keeps adding transactions acquired at different dates with rupees of varying purchasing power. Thus, in historical accounts, the monetary unit (e.g., rupee in India) used to measure incomes and expenditures, assets and liabilities, has a mixture of values depending on the date at which each item was originally brought into the accounts.

The HCA is based on the assumption of stable monetary unit which assumes that:

(i) There is no inflation, or

(ii) The rate of inflation can be ignored.

This assumption does not prove true during inflation because of the change in general purchasing power of the monetary unit. This creates serious problems in measuring and communicating results of a business enterprise.

2. Secondly, HCA does not match current revenues with the current costs of operations. Revenues are measured in inflated (current) rupees whereas production costs are a mix of current and historical costs.

Some costs are measured in very old rupees (e.g., depreciation), other tend to be in more recent rupees (e.g., inventories), while still others reflect current rupees (e.g., wages, salary, selling expenses and similar current operating expenses).

In general, whenever there is a time lag between acquisition and utilisation, historical cost may well differ significantly from current cost. Accordingly, HCA tends to report ‘inflated’ or “inventory’ profits and lower costs of consuming stocks and fixed assets during a period of increasing prices.

‘Overstated’ profits become harmful in the following respects:

(a) Over-distribution of dividends.

(b) Settlement of wage claims on terms which companies could not afford.

(c) Excessive taxation on the corporate sector in general and inequitable distribution of tax burden between companies.

(d) Under-pricing of sales.

(e) Investors being misled as to the performance of companies.

3. The ‘inflated’ profits resulting under HCA are not the real profits but exaggerated and illusory. This causes the depreciation allowance to become inadequate to replace fixed assets and finance growth and expansion.

In periods of inflation, therefore, inflated profits result in substantial fall in the operating capital and in turn, in the operating capability of a business enterprise. This is a major problem and is best illustrated by two examples.

Example 1: Replacement of Inventory:

A company buys 20,000 items each year on January 1 and sells them all by the end of the year. In 2007 the price was Rs. 5 each, but the supplier announces that on January 1, 2008 the price will be increased to Rs. 6. During 2007 the items were sold at Rs.6 each and the company had other expenses of Rs. 10,000.

Under HCA, the profit and loss account will appear as follows:

When the company decides to buy new inventory to replace that which it has sold, it will need Rs. 1,20,000 (Rs. 6 X 20,000), but its cash resources amount to only Rs. 1,10,000 (sale proceeds Rs. 1,20,000 less expenses Rs. 10,000).

Thus, despite making a profit it is not in a position to maintain its operating capability without borrowing or raising further capital. Like this, change may occur in the prices of the other inventories also. The longer the delay between goods being acquired and their being sold, the more serious the situation is likely to be.

Example 2: Replacement of Fixed Asset:

On January 1, 2007, a firm buys a machine for Rs. 1,00,000 which it expects to last for five years and have no scrap value. It has no other assets or liabilities and distributes all of its profits to its shareholders. Its profits before providing for depreciation is expected to be Rs. 30,000 per year. Taxation is to be ignored.

The profit and loss account of the firm for each year will be as follows:

The cash generated by the business each year amounts to Rs. 30,000 represented by the trading profit; the depreciation charge merely amounting to an accounting charge in order to spread the cost of using the machine over its expected life.

After five years, the firm will have generated Rs. 1,50,000 and distributed Rs. 50,000, leaving a balance of Rs. 1,00,000 representing the original capital, which may be returned to the owners, or reinvested. However, if there have been significant increase in prices in the meantime, the firm will find that it has insufficient funds to replace the equipment, which has now reached the end of its economic life.

As with inventories, it is probable that a firm will replace fixed assets on a frequent basis, and that the funds retained by virtue of depreciation will not be used for direct replacement of the same machine.

However, the overall impact of the rise in the prices will be the same. By charging depreciation on the historical cost, rather than upon the current cost of consuming the assets, the accounts will fail to show the true cost of maintaining the operating capacity of the business.

In a business where the rate of inflation is faster than the rate of profit growth, there is undoubtedly an erosion in the total operating wealth and capability of the business. Capital intensive industries such as steel, aluminum and engineering are hard hit because of increased replacement costs and intense competition from producers with more modern facilities.

Therefore during inflation, additional funds are needed to finance operations (e.g., inventories, plant and equipment, working capital, other assets) in order to support a given physical volume of production and sales. The level of these additional funds (investment) is likely to increase as a result of rising prices, but this will not be measured by the amount of distributable profits reported by historical cost accounts.

4. Inflation causes many other problems and dislocations, such as the following, which are not considered in HCA. The result is that historical cost figures become of less and less significance and the value of accounts for decision-making is severely restricted.

(i) Growing uncertainty about magnitude of future costs and price changes for materials, labour and capital equipment impair the company’s ability to finance itself internally because corporate income-taxes are based on stated nominal profits rather than real profits.

This has led to the corporate sector to depend largely on external funds rather than on retained earnings. Consequently, the cost of borrowings, i.e., the rate of expected return has increased as well as higher debt equity ratios in the corporate sector. Similarly, equity costs tend to increase as debt cost increase because equity shareholders also require a higher return in view of the increased risks and the decreased purchasing power caused by inflation.

(ii) Business responds by requiring higher returns on new capital projects than in lower inflationary periods. This usually requires significant increases in selling prices, which may be difficult to impose because of competition or price controls.

(iii) During high inflationary periods, the economic situation becomes uncertain for common man as well as businessman. Businessmen attach more importance to the risks in new investments. Projects expected to give marginal return are given up and thus new productive activities are curtailed.

This leads to a fall in overall investments and productive activity throughout the economy, resulting in curtailed growth, fewer new jobs; increased unemployment etc. Increased productivity and output are essential to offset the decline in the value of the currency and in general standard of living.

(iv) There is no distinction in the historical cost accounts between real and fictitious growth. A rising figure for sales over a period of time might be seen to indicate a growth in sales, but the truth may be different.

In order to determine the actual position, it is necessary to know how individual product prices have changed over the period. The same problem arises in relation to the trend in profits, but in this case the position is further complicated by difficulties in measuring the profit figure itself.

5. HCA is defended on the ground of its assumed objectivity. Objectivity is claimed because historical cost numbers are derived from actual transactions that have been entered into by the enterprise itself rather than (sometimes) from transactions that are being entered into by others in the market-place.

The objectivity that is claimed is largely unfounded because of the existence of alternative, generally accepted methods for computing depreciation, inventory valuation and similar such items. As a result, there is a serious credibility gap in financial reporting. Further, it is also argued that there is no definitive source of the accepted principles.

Chambers observes:

“This whole array of sources (of accounting principles) is so open-minded that it is no exaggeration to say that almost anything can be a ‘generally accepted principle’—the availability of alternative rules makes it possible for companies to select sets of rules which ‘on the whole’ grossly misrepresent income.”

6. Although historical cost generally represents ‘current market value’ at the time of transaction, however, as time passes, the cost (value) of non-monetary items in the balance sheets tends to move further and further from their current value due solely to changes in the value of money (inflation).

This phenomenon (under valuation of assets) renders the historical cost balance sheet of limited significance to interested external parties such as investors and creditors, who may well be more concerned about the current value of the economic resources owned by an enterprise than about the original cost of these resources.

Historical cost-based balance sheet does not truly represent the resources held by an enterprise at the balance sheet date, for the values at which they are carried do not relate to that date but to the date on which they were acquired.

HCA, thus, is forced to exclude highly relevant information about changes in the value of resources that may have supervened between their acquisition and use or between their acquisition and the accounting date if they are still then held. HCA is appropriate only if prices, in fact, do not change between the date that resources are acquired and the date they are used or the accounting date, if that comes first.

7. Since historical accounting is based on realisation principles, profit can easily be manipulated. By accelerating or retarding the timing of the realisation of gains, profits can be increased or decreased. Management’s ability to control what profits are reported is known as ‘income smoothing’. Income smoothing is possible under other accounting approaches also. But with the recognition of all gains accruing in a period rather than gains realised in the period, the scope for income smoothing is much reduced (in other approaches) than that of HCA.

To conclude, the HCA has several drawbacks, which emerge mainly from two of its underlying principles: stable monetary unit and realisation principle. Additionally, there are problems that arise because of several acceptable, alternative accounting methods, resulting in a multitude of possibilities for presenting the same transactions.

Solomons sums up the case against HCA in the following words:

“The information it (HCA) provides about the financial position of an enterprise is not relevant to the situation of the enterprise at the accounting date. The information it provides about income does not faithfully represent ‘better offness’, and what it discloses about financial position does not faithfully represent the position as it exists at the accounting date. HCA results in invalid and misleading comparisons. Insofar as it is riddled with arbitrary allocations, its numbers are incapable of being verified by reference to events and conditions outside the enterprise. In sum, its results are woefully lacking in the qualitative characteristics (relevance, reliability, representational faithfulness, neutrality, comparability, materiality, conservatism) that (are) seen to be the criteria by which accounting information should be judged.”