According to Wikipedia, the historic cost is the first characteristic of a financial item that is related to money. It’s based on the suggestion of the stable measuring unit. If the value of liabilities and assets hasn’t changed from the acquisition date, they can be demonstrated at their historical cost. This is a reason why the balance sheet value items may differ from the right value.
According to Business Dictionary, assets should be recorded on a balance sheet at the obtained value, instead of the current market cost. To measure the capital, we can use the historic cist. Such a standard also helps match changes in expenses.
The Income Statement includes costs of sold or used items which are based on the historical cost. Under conditions of accounting based on the historical cost, records about the value of liabilities and assets include their cost when they have been purchased for the first time (Wikipedia).
In 1945, a land and buildings of a company were sold for $100,000. Now the expected market value of the company is estimated at the level of $30 million. Despite this fact, the balance sheet still has a record of such an asset at $100,000.
Current Purchasing Power Accounting (CPPA)
According to Wikipedia, in 1989, IFRS authorized an accounting model CMUCPP (Capital Maintenance in Units of Constant Purchasing Power). This model could be used instead of the traditional accounting based on the historical cost.
In CPPA, historical cost is re-stated at current purchasing power. Thus, we have to multiple historic values by various factors of conversion. The component of conversion is calculated according to a certain formula:
- Conversion factor is a price index at the date of conversion divided by a price index at the date when an item arose;
- Average Price Index is the initial price index summarized with the final initial index, divided by two;
- Average conversion factor is the final price index divided by an average price index;
- Conversion factor at the beginning is the final price index divided by the initial price index;
- Conversion factor at the end is the initial price index divided by the final price index.
- CPP Value is the historical value multiplied by the conversion factor.
Impacts on Financial Statements
A supplementary statement is based on the general price index and shows historical items taking into account present value. At the same time, financial statements are based on the historical cost. To see how the value of money changes, we can convert the historical cost items. Wholesale price index, as well as retail price index would be appropriate for such a purpose. This approach considers changes in the price only regarding the general price level, but changes in the price of a particular item are not considered.
On 30 June 2013, a closing balance of N Company inventory was equal to $10,000. The company acquired this inventory during the last three months of the financial year. If on July 1, 2012, the index of the general price was 140, on December 31, 2012, it was 144, and on June 30, 2013 – 150, then the average for the period from July 2012 to June 2013 is 145, and it’s 147 for the period from April 2013 to June 2013. To update inventory with Current Purchasing Power Accounting, we have to use the following formula: book value of the inventory is multiplied by the general price of the current month, divided by an average index of three months, which is $10,204.
Current Cost Accounting
The process of the current cost accounting implies assessing of benefits taking into account current replacement, instead of the purchasing price.
According to Glossary of Statistical Terms, a general principle that allows us to assess the gross value added is that the intermediate utilization, as well as yield, is valued according to the cost at the time when a product was processed. The same principle is applied to GDP estimation. If some goods are withdrawn from inventories, they shouldn’t be valued at the costs at which they were delivered to the inventories, but at the prevailing price instead.
All the accounting systems used during the preparation of financial reports, as well as reports and the cost of systems, are not regulated by any rules like Generally Accepted Accounting Principles. This is a reason why accounting systems of various organizations or even those of different parts of the same organization, may differ.
Advantages of Historic Cost
Historic cost implies a simple procedure, since it records gains as long as they can be recognized. This is a reason why such a method is still used in accounting.
Disadvantages of Historic Cost
Historic cost includes the cost at the time when an item was purchased for the first time, and it doesn’t consider the current market price. This fact may cause difficulties under conditions of inflation, because the real market cost may be either lower or higher.
The method of historical costing is a traditional method used even now. At the same time, it doesn’t take into account the market cost, thus being a bad solution.
Advantages of Current Purchasing Power
- With this method, the management gets reliable data, which allows it to plan its policy.
- This method keeps historical accounts, preparing them based on supplementary features.
- It uses a measuring unit.
- It doesn’t consider shareholders and the purchasing power of their capital, which makes this method convenient for shareholders.
- It allows calculation facilities to work on a purchasing power by holding monetary units.
Disadvantages of Current Purchasing Power
- This method is unable to minimize drawbacks of historical cost.
- It doesn’t take into account the change in the cost of individual items, though considering how the purchasing power changes.
- It may be hard to find an appropriate price index.
- Using the statistical index number, such a method is a bad solution for individual firms.
Purchasing power allows us to apply a method that is very useful during the inflation. This method is appreciated by shareholders, and it helps managers get the necessary information.
Advantages of Current Cost Accounting
- It can be used in case of bankruptcy, and during the process of liquidation of the company. It helps in obtaining the owner’s total loss.
- This method avoids using the initial purchase price, replacing it with the present asset value.
- It’s useful for business, since it records higher asset values.
- It helps fix certain disadvantages of the system based on the historical cost.
Cost accounting monitors how resources move through a company, which helps provide the right connection between specific outputs and specific costs. It also allows us to assess losses, and determine the most profitable sources.