Measurement Model
 Historical Cost
 Current Cost (CAA)
 Prepared by:
 Carly Wong
 Ingrid Yeung
 Carmen Wong
 Priscilla Wong
Historical Cost Model
Historical Cost Model
The model has been around since the
1400’s
Until after WWII, inflation was not really
part of our economic environment
The essence of the model is that all
transactions are recorded at their
acquisition or original cost
Historical Cost Model (Cont’d)
Form of payment is irrelevant
Assumes aggregation of monetary units
from different periods acceptable
Acquisition cost of depreciable assets is
allocated over asset’s effective service life
– Historical cost depreciation is matched against
current dollar revenue creating an illusory net
income component
Argument for Historical Cost
Historical cost is relevant in
making economic decisions
 Decisions making concerning future
commitments => need data on past transactions
as the basis for judging
 History cost is relevant for decision making
1.
Affecting evaluation and selection of decision rules
=> historical cost is directly related to past decisions
=> determine the quality of the past decision
=> serve as a basis for the forecast
2. Providing input to the “satisficing” notion
=> decision makers do not seek to optimizes but to satisfice
=> consider how much earned rather than how much can earn
Historical cost is relevant in
making economic decisions
3. Imposing on the decision maker by their
environment
=> employed many different contexts
e.g. taxable income , cost-plus contracts
Historical cost is based on actual,
not merely possible transactions
 Record of the actual transactions
=>supporting documents are provided
=>determining how effectively management
has met its responsibilities
=>increasing the accountability-primary
objective under stewardship function
 Current cost or exit price accounting
Basis of year end market prices without
reference to actual transactions
Throughout history, financial
statements based on historical cost
have been found to be useful
 Financial reports based on historical cost useful
for over the years
 Modern industrial and managerial accounting
practices based on trial and error for many
years
 => not useful => changed
The best understanding concept of
profit is the excess of selling price
over historical cost
 Profit is accepted as a measure of successful
performance
 Profit requires sufficient use of time , place and form
be added to the materials, products or services
purchased above the cost
 Historical cost is the basis idea of profit
 E.g. decision on whether continue a product line or not
depends on the favorable spread between revenue and
cost
Accountants must guard the integrity of
their data against internal modification
Historical cost is less subjective to
manipulation than current cost or selling
price.
Littleton => these are still wholly outside
the prior decisions and the recorded
experience of the enterprise
Accountants must guard the integrity of
their data against internal modification
Mautz => whom would you trust to value
the assets of any major company, how are
current values to be determined, how
would an accountant ascertain that the
values are a fair presentation, can an
accountant withstand the pressure by
managers to accept optimistically valued
assets?
How useful is income information based
on current cost or exist price
Is it useful to show as income an increase
in the value of an asset that the firm has no
intention of selling?
If the price of an asset at the end of the
year is lower than it was during the year,
this encourages criticism of management
by shareholders for not having disposal of
the asset earlier.
How useful is income information based
on current cost or exist price
Current cost and exist price accounting
induce a short-term view of profits.
In many cases, management may believe
that disposing of assets is not the more
profitable alternative – reasons for holding
an asset other than realizing an immediate
profit.
Changes in market prices can be
disclosed as supplementary data
 Historical cost does not differ materially from
current cost.
– Supplementary data on current prices are a practical
and sufficient way of dealing with such information
without having to shift from historical cost to a current
cost basis.
– Adopted by the Australian Accounting Standard setters
in 1976.
• Supplementary statement in addition to their conventional
financial statement
Changes in market prices can be
disclosed as supplementary data
 Based on studies of the relationship between
accounting data and the market reaction to the
data, the efficient markets hypothesis in
semistrong form states that security prices always
reflect publicly available information.
– Implying that the method of disclosing any
information including current values, whether shown
in the text of the financial statements, as a footnote, or
as supplementary data, makes no difference to the
market.
There is insufficient evidence to justify
rejection of historical cost accounting
Most of the research studies indicate that
current cost data do not provide any more
information than historical cost data
Traditional accountants argue that there is
no persuasive empirical evidence that
indicates that current cost or exist price
accounting information is more useful than
historical cost information
Criticisms of historical cost
accounting
Objective of accounting
Provide useful information for economic
decision making is taken to mean
providing information to the stewardship
function of management.
– Historical cost accounting reveals that the
primary role of accounting is to meet the
decision-making needs of users
– Forward-looking decision-usefulness approach
Objective of accounting
Information on the stewardship function
does not necessarily restrict accountability
to the original amounts invested directly or
indirectly by equityholders.
Investors are interested in knowing about
the increases or decreases in the value of
their investments as represented by the net
assets of the company
Objective of accounting
 Historical cost system fails in its underlying
function of providing objective information.
– It is far from objective and is open to manipulation
– Monograph 10 questions the validity of the historical
cost information and attacks a basic tenet of the
system, which is that historical cost information
ensures the maintenance of an entity’s capital base.
Information for decision making
 Historical cost=> management needs historical
cost data in order to evaluate their past decisions
as they contemplate future commitments
 Past decision was right or wrong must ultimately
be ascertained by what happens in the
marketplace
 Historical cost has usefulness, but it is
insufficient for the evaluation of business
decisions.
Information for decision making
Historical cost accounting adopts a
financial capital concept.
However, capital regarded as the nominal
dollar investment in the firm rather than the
purchasing power of the investment. After
the year of acquisition, historical costs do
not correlate with the events of the year.
Information for decision making
(Cont’d)
Historical cost overstated income in a time
of rising prices because it offsets historical
cost against current inflated revenue.
Highly questionable for the relevance of
historical cost for decision making.
Basis of historical cost
Historical cost is under the ‘going concern’
assumption
Sterling => questions the validity of the
assumption
– The high rate of business failure would make
it difficult to build an evidential case for a
projection of continuity. No business has ever
continued ‘indefinitely’ into the future.
Historical cost under attack
 Balance sheets contain outdated cost prices or
valuations => hardly to say to be true and fair
 A lot of departures
– All non-financial assets of GTEs be measured using
‘deprival value” concepts
– Liabilities be measured using present value
 Departures provide more relevant information
than historical cost
Notions of investor needs
 Historical cost cause either a distortion or concealment
of important company disclosures=> goal of
conventional accounting are ill-conceived
– Because accountant:
• Have naïve, simplistic view of investor and their needs
• Accept old-fashioned, fundamentalist view
 Share market analysis and corporate analysis are
different
– Market analysis mainly of trying to ascertain what
other investor are thinking
– Corporate analysis not really concerned about
corporate facts but about the psychology of the
market
Matching
 Going concern assumption does not underlie the use of
historical cost
 Matching concept-when revenues are earned, the
expenses incurred in earning those revenues are
matched (offset) against the revenues to calculate
income
 Conventional accounting puts emphasis on deciding
whether a cost should be deducted form revenues in the
current period or be deferred to future periods
=>responsible for deferred charges and that are not
assets and deferred credits that are nor liabilities
Matching
 Decisions are based on the matching principle
=> in most cases the matching of costs and
revenues is a practical impossibility
e.g. cost allocation- not capable of being
verified or refuted because there is no way to
select one method over another except
arbitrarily
Current Cost Accounting (CCA)
Definition of current cost
accounting
a cost calculated to take into
consideration current circumstances
of cost and performance levels
 adjusting to constant purchasing
power by using the average inflation
rate in the current year
Business Profits
 composes into 2 parts
– current operating profit
– realizable cost savings
 Current operating profit:
– excess of the current value of the output sold
over the current cost of the related inputs
 Realizable cost saving:
– increase in the current cost of the assets held
by the firm in the current period
– both realized and unrealized cost changes.
Business Profits
– realizable cost savings = holding
gains/losses
– Holdings gains:
• a saving attributable to the fact that the
input was acquired in advance of use
• this savings is attributable to holding
activities.
Why we need to measure
separately?
 Holding assets and liabilities  enhance the
firm’s market position
 managers and others want to know if these
holding activities are successful
 Under the conventional accounting  gains
are only recorded when the assets are
disposed  impossible to show it unless
assets are bought and sold  mislead the
investor to determine which firm is more
efficient
Assumption of the CCA
 Without the measurement of the holding
gains/losses
  confuse the evaluation of management
decision
  hinders the allocation of resources in the
economy
  CCA suggest that separation of holding
gains and operation profits gives credit to
the appropriate managers
Financial Capital Concept vs.
Physical Capital Concept
 CCA provides more useful information than
conventional accounting
 supports can be divided into 2 camps
– those who believe in the financial capital
concept
– those who believe in physical capital concept
 Difference: “whether or not holding gains or
losses are included in income”
Financial Capital
 firm invests financial resources with the
expectations that the investment will create a
higher level of cash inflow
 recovery of the amount of financial resources
invested is a return of capital
 cash flows in excess of the amount financial
resources invested are a return on capital
 holding gains cost savings and the increases in
future cash flow of the assets
Physical capital
physical units denoting the firm’s operating
capability
emphasize on the need to know the firm’s
operating capability has been maintained
 continue in businesses
the holding gains capital maintenance
adjustment
Argument Against CCA
Realization principle
– it violates the traditional realization principle
– because the changes in market price of the
assets in use is irrelevant
– fixed asset is not more valuable to a firm
simply because its current cost has risen
– asset value lies in its service potential, not its
market value
Argument Against CCA (Cont’d)
Subjectivity
– another problem is the subjectivity of
determining the amount of the increase in cost
– if there is no reliable secondhand market,
current cost must be the new asset expected to
replace the old one
– adjustment has to be made between the actual
asset and the replacement
– it is difficult to calculate
Argument Against CCA (Cont’d)
Subjectivity
– another problem is the subjectivity of
determining the amount of the increase in cost
– if there is no reliable secondhand market,
current cost must be the new asset expected to
replace the old one
– adjustment has to be made between the actual
asset and the replacement
– it is difficult to calculate
Argument Against CCA (Cont’d)
viewpoint of exit price
– cost implies opportunity cost or sacrifice of the
next best alternative
– current sacrifice faced by a company is to sell
the asset rather than use it
– but not to purchase the item because company
has already owned it
– so current cost, which is the price to purchase,
is irrelevant
Argument Against CCA (Cont’d)
Allocation problem
– allocation of current cost is arbitrary and lack
in real-world counterparts
– backlog depreciation is charged to income or
to a capital account
– cause difference in amount of income reported
Argument Against CCA (Cont’d)
Technological changes
– improved assets will more than likely replace
existing assets
– so current operating profits would be poor
predicators of future profits
– investors would be misled by the current
operating profit as a basis for predicting future
cash flows
Argument Against CCA (Cont’d)
Sum up:
– current cost information is irrelevant to most
investment decisions
– it does not focus on the firm’s ability to
command financial resources in the firm’s
quest to adapt itself to the environment
Argument For CCA
 Recognition principle
– current cost accounting violates the conventional
principle of recognizing a holding gain only for
unrealized holding gains from a financial capital view
– unrealized holding gains represent actual economic
phenomena occurring in the current period
– therefore should be recognized if there is sufficient
objective evidence to support the price changes
Argument For CCA (Cont’d)
Recognition principle (cont’d)
– market price of fixed assets are not relevant
– however, whether the firm intends to use or
sell a fixed asset is not pertinent
– the change in the price of the asset is relevant
– determination of periodic income should be
based on what actually happened in the current
period, not on what might occur
Argument For CCA (Cont’d)
 Subjectivity
– current cost accounting lacks objectivity?
– current cost is not based on actual transactions in
which the firm is a participant
– however, objectivity is relative
– even under conventional accounting, some figures are
more objective
– therefore, the question is whether current costs meet a
certain minimum level of objectivity that the
accounting profession is willing to accept
Argument For CCA (Cont’d)
Subjectivity (cont’d)
– market prices are relatively easy to obtain
the objectivity of their current costs would be
acceptable
– E.g current cost of fixed assets can be obtained
from secondhand dealers
– No market prices are available
appraisals, calculations of reproduction costs
and use of index numbers
Argument For CCA (Cont’d)
 Viewpoint of exit price
– Value at exit price is unusual because the firm is
normally a buyer
– utilizing exit prices when liquidation is not
contemplated is misleading
– e.g. a customized asset used by the company is of
great value, but when a firm is under liquidation, the
value of the asset is greatly reduced as it is customized
for the company’s own use
Argument For CCA (Cont’d)
Viewpoint of exit price (cont’d)
– however, the company decides to keep and use
its assets rather than sell the asset
– because the management of the company
believes its value in use is greater than its exit
value
Argument For CCA (Cont’d)
Allocation problem
– allocation problem exists in most accounting
method, even the conventional historical cost
accounting also has the allocation problem
Argument For CCA (Cont’d)
 Technological changes
– current operating profit = indication to make a positive
long-term contribution to the economy
– it also indicates that the production process in use by
the firm is effective
– if profit > interest earned on the net assets at current
cost
the existing production process is worth continuing
Argument For CCA (Cont’d)
 Technological changes (cont’d)
– current operating profit is primarily representative of
the long-term profit capability of the firm under the
existing production process, assuming that existing
conditions remain relatively the same
– the technological changes are not taken into account
– When a new machine changes the cost of production,
the price of the old must adjust
the price of the old asset reflects the technological
change
Conclusion
current cost accounting performs
significantly better than historical
cost income
because historical cost accounting fail
to adjust for inflation
No doubt, CCA data provide useful
information to managers
Conclusion (Cont’d)
 Question: whether benefits exceed the cost
of gathering the information?
 On a cost-benefit basis
– historical cost information are almost provided
in the capital markets
 Objectivity:
– information obtained from genuine transaction
that have occurred
– Information is capable of being verified
Conclusion: Historical Cost Accounting is
better