Historical Cost Accounting - Are Changes Needed?

Article excerpt

One of the most basic principles of financial accounting is the historical cost principle. It requires that most assets and liabilities of a business be accounted for on the basis of their original acquisition cost, subject in some cases to periodic write-offs in the form of amortization or depreciation.

Theoreticians, as well as members of the business and financial communities, have debated for years the advantages and disadvantages of historical cost. The authoritative bodies within the accounting profession have considered addressing its deficiencies in formulating standards that comprise generally accepted accounting principles (GAAP). In this regard, the Financial Accounting Standards Board (FASB) acknowledges several possible measurement attributes of assets and liabilities in its Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (1984).

Measuring Assets

In addition to historical cost, the FASB cites other financial attributes of assets which might be measured:

* current cost - the amount of cash (or

equivalent) that would have to be paid if

the same or an equivalent asset were

acquired currently;

* current market value;

* net realizable value;

* present value of future cash flows.

These measurement alternatives have varying applicability and practicality, depending upon the nature of the asset being measured. Certain assets, especially those of a monetary nature (such as cash and receivables) and those which trade in an established market (such as marketable securities and certain inventory items), lend themselves to current valuation with a great deal of objectivity.

Certain other assets, such as intangibles and items of machinery and equipment, are much more subjective. Some of these, of course, are subject to appraisal valuation, but the validity of appraisals can always be questioned. Others, such as goodwill or trademarks, cannot really be "appraised" in the traditional sense. The value of some assets is derived from their use in the normal course of business in generating net cash flows. They may have no ready market value but have intrinsic value to the business in its ongoing operations.

Forcing companies to value these assets at a given point in time to some extent voids the basic accounting concept of the going concern, a violation that itself is an argument against any departures from historical cost.

Departures from Historical Cost Include

Securities

Even though the historical cost principle dominates asset and liability valuations, there are examples of departures for which GAAP provides. In valuing assets, the following practices are applied, to cite a few:

1. Investment in marketable equity securities are reported at the lower of their cost or current market value.

2. Accounts and notes receivable are reported reduced by an allowance for estimated uncollectibles.

3. Obsolete inventory items are reported at the lower of their cost of market value (i.e., their current replacement cost).

It can be noted that each of these departures from cost results in a reduction of the carrying value of the related asset, in keeping with the pervasive doctrine of conservatism. This doctrine allows that the accounting and reporting process should not be overly optimistic, that when alternatives are faced, the option which has the least favorable effect on net income and total assets should be selected. Losses should be recognized as soon as they are objectively determined, but gains generally should not be anticipated until they have been realized through a sale.

It can be argued, then, the GAAP calls for the recognition of any material and permanent impairment in the value of an asset. Obviously, management normally has an aversion to any move that will result in a negative effect on the financial statements - making it quite easy to insist that the write-down of a given asset is not warranted. …