Prepared by Arabella Volkov
University of Southern Queensland

References
• Text – Chapter 6

Learning Objectives
At the conclusion of this lecture, you should have an appreciation of:
– the historical cost model and its application
– the reasons for the dominance of the historical cost model and the arguments against the model

Learning Objectives
At the conclusion of this lecture, you should have an appreciation of:
– historical cost valuation issues and the equity perspective adopted
– the alternative models discussed in other chapters as they relate to the historical cost system
– criticisms of historical cost accounting

Basic Concepts
Objectives of accounting
• Separation of ownership and control
– leads to: information asymmetry
• Stewardship role of accounting
• Determination of profit versus net worth (?)

Basic Concepts
Paton and Littleton:
Corporation reports should rest upon the assumption that a fiduciary management is reporting to absentee investors who have no
Independent means of learning how their representatives are discharging their stewardship

Basic Concepts
Profit
• Measures the performance of managers regarding the use of entity resources
• Income statement is most important financial statement
• Balance sheet serves as link between income statements
• Framework defines expenses and income in terms of changes in value of assets and liabilities

Basic Concepts
Paton and Littleton:
Accounting exists primarily as a means of computing a residuum, a balance, the difference between costs (as efforts) and revenues (as accomplishments) for individual enterprises. This difference reflects managerial effectiveness and is of particular significance to those who furnish the capital and take the ultimate responsibility

Basic Concepts
Costs attach theory
• Economic theory versus accounting theory
• Opportunity cost (displacement cost) vs. embodied cost
• Theory is fundamental to cost accounting

Basic Concepts
Flow of costs
• Accountants keep track of flow of costs
– Which costs have expired (expense)
– Unexpired costs (assets)
– Matching principle

Defence of Historical Cost
1. Relevant in making economic decisions
2. Based on actual not possible transactions
3. Historically this model has been found to be useful

Defence of Historical Cost
4. Concept of profit as the excess of selling price over historical cost is understood
5. Historical cost is less subject to manipulation and therefore helps prevent manipulation of accounting numbers

Defence of Historical Cost
6. Is income information based on current cost or exit price useful?
7. Changes in market prices can be disclosed as supplementary data
8.
There’s insufficient evidence to justify rejection of historical cost accounting

Defence of Historical Cost
Evidence on usefulness of accounting data
• First direction
– Determine whether sufficient information is disclosed
• Second direction
– Determine the effect on decision making
• Third direction
– Examine the correlation between share prices & accounting data

Defence of Historical Cost
Evidence on predictive value
• Using past earnings used to predict future profit
• Profit as a random walk
• Using quarterly and segment data used to predict annual profit
• Useful in predicting annual profit

Defence of Historical Cost
Evidence on predictive value
• Using financial ratios to predict financial distress
– Accounting information appears to be a good predictor of financial distress
• Using past profits to predict future cash flows
– Historical cost profits appear to be useful in predicting future cash flows

How Objective is Historical
Cost?
• Application of historical cost model involves:
– Estimation
– Choice of methods (e.g. inventory valuation)
– Other subjective judgments

How Objective is Historical
Cost?
• Many items may be included in the cost of an asset
• Outlay necessary to bring asset to existing condition and location
Example:
• IAS 2/AASB 102 ‘Inventories’ – Para. 10
(a) the cost of purchase
(b) the cost of conversion
(c) other costs

How Objective is Historical
Cost?
Example:
• IAS 36/AASB 136 ‘impairment of assets’
Para. 6
– ‘recoverable amount’ of asset
– Need to estimate future cash flows and subsequent sale price
– Estimates required to determine discounted future cash flows from non-current asset

Criticisms of Historical Cost
Accounting
• Objective of accounting
– Does the model fulfill the stewardship role?
• Information for decision making
– The model may lack relevance for decision making
• Basis of historical cost
– Going concern assumption

Criticisms of Historical Cost
Accounting
• Matching of revenues to expenses
• Notions of investor needs
– Distortion of or concealment of important company disclosures
• Historical cost under attack
– Increasing use of other valuation models

Summary
• Advantages and disadvantages of the historical cost system
• The objective of accounting
• Relevance v. reliability

Key Terms and
Concepts
• Historical cost model
• Costs attach theory
• Historical cost valuation
• Alternative models
• Historical cost accounting

Where to get more information
• Other courses
• Accounting handbook
• List books
• Articles
• Electronic sources