' The University of Birmingham College of Social Sciences Birmingham Business School Department of Accounting and Finance Accounting

Theory (07 !7"# $istorical Cost Accounting Introduction When assessing the limitations of historical cost accounting (HCA) there is a tendency to assume that the system actually being used to calculate the figures reported in the balance sheet and income statement is a pure or unadulterated version of HCA. o that! for e"ample! one commonly e"pressed limitation of HCA is that it does not ta#e into account changing prices. It is argued that this limitation undermines the reliability of the balance sheet figures for non$current assets! for e"ample! because the HCA amounts do not faithfully represent their current values % they are merely unamortised historical costs &hich are out of date.

Ho&ever! HCA is never implemented in its pure form. As Appendi" ' ma#es clear! HCA is actually a mi"ed measurement system in practice! i.e. as implemented by I() ! for e"ample. *n this basis! actually implemented HCA is a comple" system of measurement of assets and liabilities &hich incorporates not +ust historical costs ta#en from purchase invoices but also valuations &hich depend upon sub+ective +udgements of the future and not +ust past transactions. ,ut even in its purest form! HCA contains +udgements about the future and a good e"ample of this is the depreciation calculation &hich re-uires estimates of useful life and future scrap values.

With fe& e"ceptions! such as cash in the entitys domestic currency! amounts in todays financial statements all reflect estimates of the future. (,arth! .//01 .23) o that incorporating estimates of the future into HCA may not be a violation of principle even in theory. 4he use of the accruals principle for non$current assets re-uires estimates of the future. 4he -uestion is not &hether estimates of the future should be incorporated in financial statement but to &hat e"tent5

)ecoverable HCA

*ver time the pure HCA system has been changed to incorporate changing prices &here they affect the recoverability of historical cost. (or e"ample! inventory is valued at the lo&er of cost and net realisable value (6)7). ,ecause the selling price less costs of disposal is lo&er than the cost! the latter cannot be recovered and it is considered prudent to &rite do&n cost to 6)7 in order to ta#e the loss as soon as possible. A provision for doubtful debts does e"actly the same thing for trade receivables. Indeed! the same rule applies to non$current assets and is illustrated in Appendi" ..

It may be that for many non$current assets! such as plant and machinery &ith very specific application to the entitys business! 6)7 is much lo&er than even unamortised cost. Ho&ever! plant and machinery is rarely &ritten do&n to this amount because the entity intends to use the assets (and not sell them) to generate future cash inflo&s (&hich &hen discounted &ill e-ual the assets value in use). 4his value in use amount &ill usually be higher than the assets cost other&ise purchase of

3 the plant and machinery &ould not have been economically rational in the first place (i.e. most plant and machinery has a positive net present value in capital e"penditure budgets). Hence! it is not the case that the balance sheet value of a non$current asset under recoverable HCA is automatically its unamortised cost. 4his is only the case &hen value in use is higher and the entitys estimate of the future is that it &ill recover at least the unamortised cost through future cash inflo&s. 8nder the recoverable HCA system! current values are incorporated into the balance sheet and income statement &hen they are lo&er than historical cost! &hether gross or net. Historical cost operates as an upper limit. 4his approach results in a mi"ed measurement system but it has &idespread support.

9odified recoverable HCA

9ore controversy arises! ho&ever! &hen the recoverable HCA system is further modified to include up&ard revaluations to current (or fair) value. (or e"ample! the IA , seems to be moving to&ards a fair value measurement model for at least some I() . 4his is the result of various factors such as ne& &ays of doing business (e.g. share$based payments! interest rate s&aps and &arranty provisions &hich do not seem to have an initial cost)! large disparities bet&een fair values and historical costs (e.g. intangible assets) and the undesirability of the perceived manipulability of HCA income statement results (e.g. on investment portfolios).

Attitudes to up&ard revaluations of assets differ across countries. (or e"ample! acceptable in the 8:! but not in the 8 ! are up&ard revaluations of land and buildings provided the revaluation amount enters e-uity through a revaluation reserve and not

C the income statement. Hence the 8:! and I() ! uses a mi"ed measurement model called modified recoverable HCA. *ne of the ma+or arguments against increased use of fair value in accounting measurement revolves around the increased volatility of the balance sheet and income statement amounts reported in financial statements. 7olatility in this argument is considered undesirable as entities &ish to report smoothly increasing income figures &hich! it is claimed! reflect better the underlying long$term performance of the entity.

Ho&ever! the issue of volatility in the conte"t of the increased use of fair values needs to be considered carefully. Assume that the reported fair value in a set of financial statements is ;<. 4he reported figure is managements best estimate of ;" &hich stands for the true fair value! itself unobservable. Consider the follo&ing table.

Assets Asset ' >stimate ' >stimate . 4otal Asset . >stimate ' >stimate . 4otal

< ? '' ./

" '/ '/

(< % ") $' @' /

=. ' ' .

A 'A ./

'/ '/

$A @A /

.A .A A/

If volatility is measured by the variance! the fair value of asset . is more volatile than the fair value of asset '. Ho&ever! < is the actual reported amount &hich is estimated &ith error! designated B.

A < D " @ B! &here B is the estimation error! and

=<. D =". @ =B. 4he volatility of the reported amount consists of inherent volatility (") and estimation error volatility (B).

4he lo&er the estimation error volatility! the greater the verifiability of the amount (a greater number of people &ould reach the same estimated result) and hence the greater its reliability as an estimate. (4o this e"tent! reliability is a measurement notion.) When inherent volatility is high! it is more difficult to estimate fair value. Ho&ever! this &ould ma#e actual estimates of " (i.e. < as reported) more relevant because of their information content. (In this sense! relevance is an information notion.) In addition! the reported amount &ould also be more reliable the greater the inherent volatility as long as reliability is interpreted as representational faithfulness. 4he larger the covariance bet&een < and "! the greater the representational faithfulness of < in terms of &hat it purports to represent! i.e. an asset &hich is inherently volatile. 4his is the economic reality and not strictly spea#ing an accounting measurement problem.

9i"ed measurement volatility is not captured in the e-uation above but arises &hen assets and liabilities are reported in financial statements using different measurement attributes. (or e"ample! under I() ! investment assets may be reported using fair value but fi"ed interest liabilities are recorded at historical cost. A change in the mar#et rate of interest &ill change the fair value of the assets but the change in value of the liability &ould not be reported.

Conclusion

4he HCA system as actually used in practice (at least in I() ) is comple" and may perhaps best be characterised as modified recoverable HCA(9)HCA). 4here is a tendency to include more fair values in financial statements. 4his may lead to more volatile numbers in the balance sheet and income statement but this may be acceptable in terms of relevance and reliability as long as the underlying asset or liability is inherently volatile.

2 Appendi% &' Summary of (F)S measurement re*uirements +as at ,cto-er 00!. E ource1 ICA>W (.//0) 9easurement in (inancial )eporting! '/$''.F

Asset/0ia-ility Groperty! plant and e-uipment Intangible assets >"ploration and evaluation assets for mineral resources Assets held on finance leases

1easurement Basis HC or (7 HC or (7 HC or (7 Ho&er of (7 at ac-uisition date and I7 of minimum lease payments at that date! less subse-uent depreciation (7 (7 6et (7 &hen harvested ome at (7! others at HC Ho&er of HC and 6)7 HC plus a proportion of the e"pected profit 6ot covered by I() hence may be measured on various bases Gro+ected unit credit method using discounting 9ust not be discounted ,est estimate of settlement obligation! discounted &here material Ho&er of related assets fair value at ac-uisition date and the I7 of the minimum lease payments at that date! less amounts &ritten bac# so as to produce a constant periodic

Gension scheme assets ,iological assets (living plants and animals) Agricultural assets (inancial instruments Inventories Construction contracts 9ineral resources (mines! oil and gas &ells) Gension scheme liabilities Ieferred ta" liabilities Grovisions

(inance lease liability

L rate of interest on the remaining balance Initial cost of assets and liabilities ac-uired in a business combination (7 at ac-uisition date Internally generated intangibles Jenerally not recognised. Where recognised measured at HC unless ac-uired in a business combination &hen they may be recognised at (7 at the date of the combination (7 of goods and services or (7 of e-uity instruments granted (7 of e-uity instruments granted )estatement in terms of current purchasing po&er

Joods and services received in a share$based payment transaction 4ransactions &ith employees (inancial statements of companies that report in the currency of a hyperinflationary economy

Definitions of (F)S measurement -ases Basis HC Definition Jross cost less depreciation! calculated ta#ing into account its e"pected useful remaining life and its li#ely residual value. Ho&ever! if the assets recoverable amount is less than its depreciated historical cost it must be &ritten do&n to its recoverable amount! &hich is the higher of its net (7 and its value in use. 7alue in use is the discounted value of its future attributable cash flo&s. (7 less selling costs 4he amount for &hich an asset could be e"changed! or a liability settled! bet&een #no&ledgeable! &illing parties in an arms length transaction 9ar#et valueK estimated valueK present valueK selling price less the costs of disposal plus a reasonable profit allo&anceK selling price less the sum of coats to complete and costs of disposal! plus a reasonable profit allo&anceK current replacement costK depreciated replacement costK reference to an active mar#etK the amount that a third party &ould charge

7alue in use 6et (7 (7

(7 in a business combination

? Appendi% ' )ecovera-le $istorical Cost Decision Tree

)ecoverable historical cost D lo&er of

Historical cost

)ecoverable amount D Higher of

7alue in use

6et realisable value

ource1 ICA>W (.//0)1 (igure 3.'.