Answering the Question: How is Historical Cost Accounting Better than Alternatives?
What is Historical Cost Accounting?
Historical cost accounting looks at assets based upon the actual amount paid as opposed to accounting for inflation. Historical cost accounting goes back to the original prices paid for items when it comes to assets and liabilities, and takes account of these prices as though there has been no change in cost from when the assets were acquired and liabilities were incurred until now. One of the major criticisms of historical cost accounting is that it is inaccurate. Nevertheless, historical cost accounting is widely used. How is historical cost accounting better than alternatives? To answer this question, first we have to look at the alternatives to historical cost accounting.
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What Are Different Accounting Method Alternatives?
When it comes to accounting, you most likely have heard of cash-basis accounting and accrual accounting. There are also the completed contract method of accounting, the percentage-of-completion method of accounting, standard cost accounting, lean accounting, activity-based costing, throughput accounting, etc. If that seems like a wide variety of ways to keep track of a company’s money, that’s because it is. Here’s a quick lowdown on what these terms mean:
- Accrual Basis of Accounting - This is where a company tracks the income and expenses during the period where transactions occur, regardless of whether money is actually received during that time period. For example, an accounts receivable ledger would be tracked during the period in which the invoices went out, rather than when the payment for the invoice was received. Most large businesses use this method of accounting.
- Cash Basis of Accounting - This tracks income and expenses when they are received or disbursed. Usually, this method of accounting is only used in small businesses and for reporting on income taxes.
- Completed Contract Method - This method takes into account a company’s long-term contracts and accounts for the contracts in the accounting period during which they are completed.
- Percentage of Completion Method - This method takes the company’s long-term contracts into account depending upon the percentage of work completed during that period.
- Financial Accounting - Financial accounting manages money and prepares the information for those who are outside of a company.
- Management Accounting - Takes into account the future of a company and kept confidential. (For a complete discussion of managerial vs. financial accounting, see Radell Hunter’s article.)
- Cost Accounting - A subset of managerial accounting; cost accounting determines the budget for a company.
- Standardized Accounting, Lean Accounting, Activity-Based Costing, Throughput Accounting - These are all alternative subsets of management accounting, dealing with the internal workings of a company’s budget and day-to-day costs.
- Historical Cost Accounting - As described above; historical cost accounting is opposed to current cost accounting (this takes int account things like depreciation and inflation) and is a subset of cost-based accounting.
What Are the Disadvantages of Historical Cost Accounting?
Historical cost accounting comes into problems when dealing with assets like stocks. Additionally, historical cost accounting cannot help a company to assess the current value of any of its assets. Moreover, historical accounting does not help with determining how much money was lost on a particular asset due to inflation. Finally, historical costing does not help you when an asset has gone up in value.
If Historical Accounting Can’t Tell Me Where I’m at, Why Bother?
It might seem that current cost accounting would have an advantage over historical accounting, but this is a mistake. It has distinct advantages when it comes to assessing why historical accounting is better than alternatives. First, when producing a historical cost report, it is much more straightforward than other reports, since depreciation and inflation are not taken into account. Second, any gains that are made in the value of an asset are not taken into account until they have been actualized. Third, when taking the values of things into account, historical accounting can provide a sense of certainty - especially when there is rapid inflation occurring. Finally, historical cost accounting is a widely-used practice.