Evaluate: Historic cost vs alternative measurement base

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Historical Cost or An Alternative Measurement Base?

The measurement base chosen for accounting and reporting matters. Accounting reports impact investment choices and aggregate economic activity, and so the base used to create those reports changes careers, businesses and economies (Ramanna, 2013). Financial reporting is not cut and dry. It measures "abstract and debatable concepts such as income and net assets, and it has particular features that make it to some extent inevitably subjective and even arbitrary" (ICAEW, 2006, p. 2).

For instance, allocating costs such as with depreciation, creates expenses, impact profits, causes deferred tax liabilities and changes in net assets (Feltham, 1996). All of these reported items impact investor projections of future cash flows. Because reported profits are used to sort winners and loser, allocate profits and determine careers, it is a high stakes decision. What is the best base to use?

The argument for and against historical cost spans back decades (Christensen et al., 2013). In the 1970s, the big decision was between historical cost and inflation accounting, since inflation was raging near 21% at one point (Journal of Accountancy, 1977). In more recent times, inflation accounting has been dropped from the debate as a viable alternative measurement basis. Instead, the debate generally focuses on historical cost versus fair value accounting.

In the U.S., historical cost for nonfinancial assets is still the norm but IFRS permits firms to choose upfront which base to use, fair value or historical cost. This permits the preparers to be sensitive to their users and offers more ability to decide. Of course, this flexibility also creates a headache - a decision must be made. And it reduces comparability because two firms with similar transactions and results, making the fair value versus historical cost choice differently will not have comparable reported financial items (Christensen et al, 2013).

Measurement Bases: Historical Cost

Measurement bases, even with traditional historical cost rules, includes more than just historical cost. For instance, accounts receivable are presented at net realizable value, a departure from historical cost. Inventory is reported at the lower of cost or market, again a departure from historical cost. So, historical cost accounting generally refers to measurement that are historical cost or lower (when conservatism dictation that cost might be too high) except for a few short-term marketable financial instruments which are reported at fair value. So, when we say "historical cost," we do not usually mean literally every item is historical cost. We usually mean the traditional measurement bases of cost, adjusted cost or fair value for some traded securities.

Historical cost (and adjusted historical cost) has been praised for its reliability and verifiability. It is touted for its "sound system constructor on robust pillars of prudence" (Kaya, 2013, p. 172). Historical cost is conservative, insisting the potential profits from changing in value only be recorded when an outside party makes the value clear and final by exchanging another asset for it or accepting it as satisfaction for a liability.

Measurement Bases: Income

The measurement basis has implications not just for the reporting of assets and liabilities but also the reporting of profits. If profits are based on historical costs, then expenses are costs and adjustments to lower costs when conservatism warrants a write-down. So, any increase or decrease in the value of assets or liabilities is not really part of the firms "performance" and distorts the profit report.

If one takes a different view of profits, one that says profit is really the change in economic wealth from last balance sheet date to this balance sheet date, then historical cost will not be sufficient. In order to know the wealth of a firm in economic terms, you need fair ...