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181PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
ACCOUNTINGACCOUNTINGFinancial and Organisational Financial and Organisational
Decision MakingDecision Making
Chapter 18
Appraisal of the historical cost system
Slides written by Sandra Porritt
designed by Tony Van Eekelen
18.2
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Learning ObjectivesLearning Objectives
• In this chapter you will be introduced to:
– the basis of the historical cost system in its pure form
– the strenths of the pure historical cost system in relation to the objectives of financial reporting
18.3
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Learning ObjectivesLearning Objectives
– the weaknesses of the pure historical cost system in relation to the objectives of financial reporting
– the major adjustments from the pure system made by the modified historical cost system
18.4
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
– the extent to which financial statements prepared under conventional accounting principles serve their intended purpose
Learning ObjectivesLearning Objectives
18.5
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
IntroductionIntroduction
• Historical cost system
• Provision of relevant and reliable information for the purpose of accountibility
• What happens in practice
18.6
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Objectives for investors and Objectives for investors and creditorscreditors
• accounting information that is relevant and reliable
• for decisions to be made
• information to be free from bias and a faithful representation of events
18.7
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
RelevanceRelevance
• Stewardship
• Performance evaluation
• Financial stability
18.8
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
ReliabilityReliability
• information to be free fom material error and bias
• implies that the information can be relied on for decision making
• implies the appropriate measurement of revenue, expenses and valuations of assets and liabilities
18.9
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
The pure historical cost systemThe pure historical cost system
• Assets – original buying price established by actual
tranactions– asset values are not changed irrespective of
changes in general price level
18.10
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Relevance to stewardshipRelevance to stewardship
• refers to the managers responsibility for the protection and the efficient use of the organisations assets
18.11
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Relevance to performance Relevance to performance evaluationevaluation
• criticism that under inflationary conditions historical cost profit may result in an overstatement of profit
• failure to account in current terms makes comparison between entities difficult
18.12
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Relevance to financial stabilityRelevance to financial stability
• problems of capital maintenance and performance measurement
• a long established firm disclosing large profits may be unable to meet current replacement costs necessary to remain in b usiness
18.13
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
ReliabilityReliability
• despite the weaknesses historical cost rests on its reliability
• it is a system of primary entries supported by transactions
18.14
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Benefits of historical cost systemBenefits of historical cost system
• system most used throughout the world
• based on a simple capital maintenance concept– protects creditors– used by courts to determine what constitutes the
company’s capital
18.15
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Modifications to historical cost Modifications to historical cost systemsystem
• conservatism or prudence in certain circumstances
• revaluation of assets upwards
18.16
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Influences on accounting Influences on accounting practicepractice
• external reporting influenced by– accounting standards– companies legislation– stock exchange listing requirements– political influence
• public opinion
• taxation law
18.17
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
ConservatismConservatism
• holding losses
• expenditures (of future benefit) expensed
• long-term intangible assets - written off
• expenses deliberately overestimated
• liabilities may be overstated
18.18
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
ExamplesExamples
• inventory valuation– lower of cost or net realisable value
• software development costs– policy of expensing costs immediately even
though they have future economic benefit
18.19
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Claimed advantages of Claimed advantages of conservatismconservatism
• secret reserves…………………..productive assets depreciated excessively
• hidden reserves ……………..the difference between historical cost and market value
18.20
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Secret reservesSecret reserves
• asset depreciation
• allowance for doubtful debts
18.21
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Management toolsManagement tools
• used to produce a stable entity………
• higher share value……..
• associated advantages………..
• improved credit rating …………
• lower interest on borrowed funds……...
18.22
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Arguments against conservatismArguments against conservatism
• misleading to parties• takeover bids• inefficient management• contradicts reliability quality of accounting
18.23
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Land held by a companyLand held by a company
DR Land CR Asset Revaluation Reserve
18.24
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Is revaluation beneficialIs revaluation beneficial
• market value disclosclosures reveal hidden asset– current prices = useful information for
investment / credit / decisions
• only when applied consistantly and universally
18.25
Chapter 18: Appraisal of the historical cost system
PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
SummarySummary
• Accountants have adopted conservatism in order to overcome the deficiencies of historical cost accounting
• Opportunities exist for the manipulation to suit some users
