Accounting - Historical cost and non-current asset valuation
Historical cost and non-current asset valuation
In preparing reports, we are currently guided by the historical cost
principle. This principle states that non-current assets should be valued
at the cost at which the asset was acquired. This cost includes costs
involved in getting the asset ready for use. For instance, if you were to
buy a combustion stove for your restaurant at a cost of $1500 it may also
cost you a further $400 to have the stove installed. The depreciable cost
of the stove becomes $1900.
The advantage of using historical cost is that it is based on objective
evidence rather than subjective opinion. However, the problem with some
non-current assets such as property is that they usually increase in value
over a number of years.
This creates problems when assessing the performance of a business.
Supposing a business has a net profit of $30 000 and total assets of $300
000. The ROA (return on assets) is 10% and in the absence of other
information may be regarded as satisfactory. However, the $300 000 in
assets may include premises valued (historical cost) at $200 000. The
assets may have been bought in 1979 and may be 'worth' seven times that
amount today, $1 400 000. If that information was reported in the balance
sheet total assets would be $1 500 000. The ROA would be 2% and much less
likely to be regarded as satisfactory.
This information may substantially affect decision making in the business.
The business may now consider selling the premises and ending the business,
renting elsewhere or seeking a more profitable activity.
The decision to reflect more current values for non-current assets is an
aspect of current cost accounting. Using this approach the business
attempts to show the non-current asset at current or replacement values.
This has certain ramifications. Depreciation also has to be adjusted to
allow for changes in current values. This brings into question the purpose
of depreciation itself. Is it intended to allocate the cost of the asset
over the life of the asset? This is the definition currently used. If the
depreciation is based on current or replacement values then this suggests
the purpose is to provide for the replacement of the asset. This is a
purpose not currently met. What happens if you do not intend to replace the
asset or if you do, with a more expensive asset? There are no ready answers
for these questions.
Assessment of performance becomes more difficult if the base against which
profit is measured constantly changes. Is the improvement in performance
due to increased profit or decreased asset valuation? The use of ratios, as
a measure of performance, loses its value with these changes and a careful
examination of actual reports becomes important.
Finally who carries out these valuations and is the expense for a sole
A business upwardly values premises by $20 000.
Revaluation of premises
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