Historical Cost Convention and the Accrual Concept for Stewardship - Essay Example

A Research Paper on:- "The use of the Historical Cost convention and the accrual concept for stewardship and for decision making" Topic The Historical Cost Convention Introduction The historical cost convention is unarguably one of the most debated topics in the theoretical base of accounting. Some are of the opinion that it should be done away with, while others believe that it plays a vital role in presenting an accurate picture of the business concern. The Historical cost convention has different uses and dimensions for stewardship and for decision making purposes. Meaning of the HISTORICAL COST CONVENTION: "The historical cost principle requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities."1 The historical cost convention means that an asset must be shown in the books of accounts at its cost of acquisition, or its "purchase price". It is this purchase price which is referred to as the "historical" cost. An extension of this discussion will lead to interesting questions. The asset must be shown in the books at the purchase price. It is not to be shown at the market value. This is done to ensure a "true and fair" picture of the financial position of the firm. It is commonly noted that the asset which is purchased by the company will increase/decrease in value over time, because of market forces. In such a case, the correct representation of the asset will lie only in showing them at their original, historical cost. Showing the asset at its market value will portray the asset at a value which may be inflated or deflated, as the market forces may be. This will defeat the purpose of financial accounting, which involves giving a "true and fair" view of accounts. Example An area of land was purchased by X and Co. for $50,000 in 2000. Today, as on 11th October 2006, the value of that property stands at $80,000. In such a case, as per the historical cost principle, the value of this land will be $50,000 in the books. Showing it at the inflated price of $80,000 will be against the accounting principle of prudence2, and it will inflate the profits of the firm, which may influence prospective outsiders. The Use of the Historical Cost convention for Stewardship: We know that Assets less Liabilities equals equity. So, greater the assets, greater the equity. However, since investors, creditors and other outsiders need to know the accurate information, which can be provided only with an accurate stewardship, there has to be a method that makes the selection of asset-value uniform. And that method is the historical cost principle. Not only does the historical cost convention make the value of assets uniform and unambiguous - as the cost of acquisition is shown as the asset value - it makes the whole process of number crunching an easier one. Evaluating the assets at their market value allows a lot of ambiguity to creep in. Since market value is always subject to volatility, the value of assets would always be subjective. The historical cost principle, in such a situation, evaluates the assets at the cost of their acquisition, making the value objective and uniform3. In such a case, the historical cost convention is particularly useful for stewardship. As discussed earlier, the historical cost convention requires the asset to be valued at its acquisition cost only. This means that only the money which we have actually spent is to be shown in the books. An inflated value of the assets goes against the principle of prudence. Stewardship, which plays the important role of communication of information to outsiders, involves presenting the financial position of the firm as accurately as possible, and of course, keeping in mind all norms. The historical cost convention enables this function to be done with vital ease. Upon employing the historical cost principle, the books of accounts present an impartial view of the financial position of the business concern. This naturally, helps prospective outsiders make a fully informed decision, which can easily save the firm a lot of unwanted future problems. Another important use of the convention for stewardship is that it makes the entire accounting process straightforward and devoid of any complications. The historical cost of the asset makes it immune to volatile market forces. Use of the Historical Cost Convention for Decision-Makers: While historical cost plays a vital role of displaying accurate financial data in cases of stewardship, it is not so useful in case of decision making. The cost of acquisition is useful as far as numerical convenience is concerned, but the cost of acquisition does not play any role whatsoever in important financial decisions, for the simple reason that the cost of acquisition cannot be treated as an authentic value of the asset for any given point of time. Clearly, the usefulness of the historical cost principle is zero when it comes to decision making. Decision makers rely on the concept of "relevant cost". Relevant cost means the cost that takes into consideration all prevailing circumstances - be it political, legal, financial, or managerial - and has nothing to do with the cost of acquisition. Logically, it is possible to take a sensible decision only when all parameters are carefully analyzed. The historical cost convention actually makes it difficult for decision makers to come to an informed decision. Besides, concerned parties are interested in knowing the value of the asset at that particular point of time, and not interested in knowing the cost at which that asset was acquired. Decision makers prefer historical cost only in cases of fixed assets, such as land, where the value appreciates over time. In such a situation, the historical cost, which is lower in value as compared to market cost, helps in reduction of tax liabilities. Criticism The historical cost convention has come under severe criticism because of certain obvious flaws. First of all, using the historical cost principle does not permit stewards to present relevant financial information always. The correct value of assets is determined only by market forces, as volatility is an integral part of the corporate world. Just for the sake of minimizing calculation, the historical cost convention does not allow stewards to present the assets at their market value. Prospective outsiders, such as creditors, investors and other stakeholders are naturally not interested in knowing the cost at which the asset was acquired, but are more interested in knowing the market value as accurately as possible. In other words, we may say that the market value of assets is more relevant than the historical value. Volatility of markets and change in value are perhaps the defining platforms of modern accounting. The historical cost convention fails to capture these two parameters, and so faces a natural criticism. As far as decision makers are concerned, the historical cost convention is rarely used. As discussed in the previous section, there is very little use of historical cost in taking important decisions. Decision makers are bound to do their job by taking into account all relevant changes in circumstances, any prevailing instability, and current trends in the market. And the historical cost convention does not have any scope for taking changes into account. Given the current level of competition in the markets, businesses are obligated to present as accurate financial information as possible, if they are to woo their investors and creditors. In such an important condition, the historical cost convention is obsolete. Conclusion Historical cost convention is highly useful from the angle of stewardship. By presenting a prudent and accurate view of the financial position, all prospective creditors, investors and other parties are well-informed to take their decisions. This eliminates a lot of unwanted problems for the business concern. For example, if an asset is shown at an inflated value, investors may carry a false impression of the company. This may again be the sole reason for their investment. In future, supposing the value of that asset falls greatly, due to some reasons, the value will have to be shown at a much reduced value, which may anger the investors. So, Historical value is based on a "play-it-safe" angle. Keywords It is important to remember here that the historical cost convention is meant only for assets, which are not for sale. The historical cost convention is not, in any way, concerned with the stock of goods which is meant for sale purposes. Topic 2: The Accrual Concept Introduction The accrual concept may be seen as the trademark of modern day accounting. It is logical, accurate, sensible and of course, scientific. The accrual concept is one of the most convenient principles of modern-day accounting. Were it not for this principle, nothing related to credit transactions would ever be recorded as financial data. It is of utmost importance in presenting a true and fair view of all financial information to all outsiders, and is extremely instrumental in the task of decision making. Meaning of the Accrual Concept: "The most commonly used accounting method, which reports income when earned and expenses when incurred, as opposed to cash basis accounting, which reports income when received and expenses when paid"4. "Under the accrual basis: 1. Income is recorded when a sale occurs or when services are provided, even if you do not receive any payments from your customers at that time; and, 2. Expenses are recorded when you receive goods or services, even if you pay for them at a later date."5 The accrual concept, plainly stated, means that revenue recognition has got practically nothing to do with receipt or payment of cash. Under the accrual basis of accounting, revenue and expenses are recognized the moment a legal obligation for their occurrence is created. This means that a credit sale of goods will be treated as revenue, because the customer has a legal obligation to pay for those goods now, or in the future. In any case, revenue pertaining to this sale is said to be recognized the moment the transaction is complete. The same is true for expenses as well. Once a legal obligation has been enforced, that we must pay, it is important to record this expenditure in the books of accounts immediately. This will alone give a fair view of financial data to outsiders, and of course help decision makers to make an unbiased, well-informed decision. Example (1) A Sells goods worth $3000 to B on credit on 12th October, 2006. In this case, B does not pay for cash, but receives the goods. But due to the accrual system, A will record the sale in the books as $3000, even though he has not received any cash. This is because B is bound to pay him in the future. So, it can be safely recorded as a valid business transaction. Let us assume that B pays A on 15th October, 2006. So, in this case; a. Revenue is recognized and recorded in the books on: 12th October; and b. Cash is received by A on 15th October, which will subsequently be recorded in the cash book. (2) V is supposed to pay his employees an annual salary of $24000. He has not paid salaries to them for one month, i.e. salaries to the tune of $2000 are outstanding. However, while preparing the books of accounts, V is supposed to record a salary expense of a full $24000 - even though he has not actually paid the employees a month's salary in cash. This is because of the fact that since V is bound to pay his employees that amount, he has to provide for it in his books in order to show the correct profit. Use of the Accrual Concept for Stewardship: Stewardship requires that all relevant information pertaining to the business' financial status should be provided to concerned parties. The accrual system helps in the purpose of stewardship by doing just that - providing relevant information. In today's world of hectic competition, most business contracts are of an executory nature, i.e. of a kind where the parties discharge their obligation in the future. The cash basis of accounting, which recorded only actual cash receipts and payments, is obsolete in modern times owing to the prevailing competitive circumstances. The accrual concept of accounting presents the best possible picture of affairs to the concerned outsiders, making them better equipped to take their decisions. Use of the Accrual Concept for the purpose of decision making: Decision makers are much, much more informed because of the accrual system of accounting. The most important benefit to decision-makers is that of accurate information. The cash basis of accounting is short-sighted, recording only cash receipts and payments in the books. However, in actual practice, it is not always possible that big transactions are settled in cash. The business transactions are mostly of a deferred nature, where both parties discharge their obligations in the future. Thus, the cash system of accounting hides relevant information that is acutely essential to take a business decision. The accrual system of accounting is long-sighted and scientific. It informs the management of any possible event that may arise in the future. Loosely stated, it provides for all relevant 'permutations and combinations' of the business' financial dealings. Therefore, decision makers have a much broader angle when they follow the accrual system of accounting. Secondly, decision makers are benefited from the accrual system of accounting because of its close semblance to many prevailing standards and laws. The concept of full disclosure, for example, asks that all 'relevant' and important financial data must be made available to outsiders. The accrual system of accounting helps in doing just that, because most of the relevant information outsiders are supposed to know does not comprise of any actual cash dealings. In a nutshell, the accrual concept of accounting is of great use to decision makers because of its all-pervasive scientific nature. Criticism There are very few points on the grounds of which the accrual concept of accounting can be criticized. It is in fact, the most popular, comprehensive, accurate and reliable method which can be used for modern-day accounting. The accrual basis of accounting makes the process of book-keeping cumbersome for stewards. The cash basis of accounting is extremely simple and records cash receipts and payments as they occur. However, the accrual concept records revenue and expenses as they are formed, regardless of their occurrence. This means that assumptions play an important role in the accrual concept - which may not always be true. Secondly, the accrual concept of accounting is based on recognizing corresponding revenues and expenses. Recognition of revenue may or may not be uniform in the corporate world. In such a situation, confusion may arise with relation to recognition of revenue and expense for the corresponding period. Conclusion The accrual system of accounting is of great help to both stewards and decision makers. The extent of its usefulness is very, very large. Stewards use the accrual basis to present the most accurate financial position of the business concern, and decision makers use the accrual basis for taking well-informed decisions. Though difficult to synchronize, the accrual concept is a principle that is far more reliable than the cash basis of accounting. Keywords While recording expenses under the accrual concept, it is to be kept in mind that only the expense concerning the current accounting year is to be recorded. Even though an expense may be certain in the long-run, it can be recorded in the books only if it actually pertains to that accounting year. For example, A company plans to purchase Machinery worth $45000 in 2009, as a part of its expansion plan. This expense, however relevant and certain will not feature in the books of accounts, because it does not concern the current accounting year. The accrual concept of accounting does not mean that any future expense will be recorded. Only that expense, which is part of the current accounting year, will find a place in the books of accounts. References (1) GAAP - Generally Accepted Accounting Principles (website), "Accrual vs. Cash basis of accounting". URL:http://cpaclass.com/gaap/ (2) Wikipedia article, "Generally Accepted accounting principles". URL: http://en.wikipedia.org/wiki/US_generally_accepted_accounting_principles (3) Real Life accounting (website), "The Historical Cost Convention". URL: http://reallifeaccounting.com/blog/articles/615.aspx (4) Minnasian, Mark: Cash vs. Accrual accounting. URL: http://biztaxlaw.about.com/od/accountingbasics/a/cashvsaccrual.htm (5) Accrual Basis accounting, Investorwords.com university. URL: http://www.investorwords.com/61/accrual_basis_accounting.html (6) Wikipedia article, "Accounting methods". URL: http://en.wikipedia.org/wiki/Cash-basis_versus_accrual-basis_accounting Read More