Financial Accounting Home Page

divisional performance

Brief Notes on Historical Cost Accounting

Introduction

The purpose of this page is to give a very brief introduction to historical cost accounting: it does so by providing outline ideas to a series of questions:

1 The definition of historic cost accounting
2 The nature of historical cost accounting
3 The advantages of historical cost accounting
4 The disadvantages of historical cost accounting
5 Comments or recommendation
6 The way forward

Looks like the questions from an essay doesn't it? Not quite, it's the headings for a presentation. I was asked to comment on these headings by Grace but she only gave me four hours to provide the answers ... I didn't get Grace's message until two of those hours had passed by, so what you see here explains the brevity. Still, better than nothing!

1 historical cost accounting (hca) is the situation in which accountants record revenue, expenditure and asset acquisition and disposal at historical cost: that is, the actual amounts of money, or money's worth, received or paid to complete the transaction.

2 nature of historical cost accounting this is one of those idiosyncratic headings that teachers dream up (me too, probably!) that meant nothing to me without further explanation

3 the big advantage of hca is that it leads to absolute certainty and it fits in perfectly with the cash flow statement. Hca tells us exactly what has been paid and what has been received and therefore there is no doubt about balance sheet amounts. The alternatives, where accountants attempt to take inflation into account, can lead to many problems. There have been several forms of current cost accounting, purchasing power accounting and so on since the mid 1970s that have been proposed as alternatives to hca. The reason the alternatives have not survived, and IAS 15 on inflation accounting is about to be replaced, if it hasn't been already, is that no one can agree on the best way to represent accounting values. Hca provides definite values, other methods don't!

4 the disadvantages of hca include the fact that hca values can relate to transactions that could be a year old, 10 years old and as much as 100 years old. It's true that some businesses have old equipment and old stocks (inventories) that are still working well but that were bought a long time ago: the problem is that the acquisition value may be out of date and so the balance sheet is showing out of date values. Taxation problems come with inflation accounting. In times of high levels of inflation, profits are inflated and therefore the tax bill tends to increase: this is the reason that inflation accounting was developed in the UK and elsewhere in the 1970s and onwards. Guess what, though? Accountants found solutions to the inflation accounting problem that led to lower taxation but the Inland Revenue didn't like what the accountants had done and rejected the accountants' proposals ... and so it went on.

5 comments the UK and the IASC have both attempted to provide inflation accounting standards and both have had to admit defeat. The UK saw several inflation accounting committees in the 1970s and onwards as accountants attempted to get to grips with this issue. Then accounting standards appeared ... and disappeared. The problem is that when inflation is a problem, inflation accounting is a problem. When, as now, inflation is not a problem, no one cares about inflation accounting. However, government departments do still prepare current cost accounting statements!

6 the way forward this is a strange issue that tends to be unimportant as accountants don't like it. Many people believe that cash based accounting gives plenty of indication of the solution to inflation accounting problems.

Conclusion

A couple of generations of accountants have grappled with the vagaries of inflation accounting but the outcome has always been the same: forget it! The UK in the 1970s saw the Sandilands Report, Current Cost Accounting, the Inland Revenue fighting back. The IASC has recently withdrawn its own standard on inflation accounting. British government departments still use inflation accounting for themselves.

All in all, inflation accounting tends to be more of an academic than real topic. That's not to say that inflation accounting is a waste of time, although many accountants think it is. One good part of the inflation accounting debate concerns non financial indicators: accountants have worked with their management and taxation colleagues to see how they can report matters without worrying about the impact of inflation. Look at my page on divisional performance to see a few examples of what that might mean.

Duncan Williamson
27 February 2003

Write to me at any time


Webmaster Duncan Williamson 2001