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Lecture 10

BU457 Lecture 10: Historical Cost Accounting Revisited

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Bixia Xu

Historical Cost Accounting Revisited Comparison of Different Measurement Bias • Present-day accounting practice can be described as mixed measurement model • Some accountants argue that historical cost accounting is more useful to investors than current value accounting o Past performance is the best predictor of future performance o The firm’s current and past earnings performance represents the foundation upon which projections of future earnings can be based o Under historical cost, the statement of earnings is the primary financial statement o Balance sheet assumes greater importance, with the income statement oriented to an explanation of the changes in assets and liabilities during the period o Since asset and liability values are volatile, the income statement will so be volatile o This volatility reflects the volatility of the firm’s environment, which, supporters argue, should not be artificially smoothed Characteristics of Historical Cost Accounting in Relation to Current Value • Relevance Versus Reliability o Historical cost accounting is relatively reliable since the cost of an asset or liability to a firm is usually a verifiable number that is less subject to errors of estimation and bias than are present value calculation o However, historical costs may be low in relevance as cost may equal current value at the date of acquisition, this equality will soon be lost as current values change over time o Relevance of current value accounting generally exceeds that of historical cost, but the need for estimates when conditions are not ideal opens current value accounting up to problems of reliability • Revenue Recognition o Current valuation of assets and liabilities implies revenue recognition as changes in current value occur o Under historical cost, valuation of inventories at cost and accounts receivable at selling price implies revenue recognition as inventory is sold o Thus current value accounting implies earlier revenue recognition than under historical cost • Recognition Lag o Recognition lag is extent to which the timing of revenue recognition lags behind changes in real economic value o Current value accounting has little recognition lag, s
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