Historical cost has always been the most widely used measurement system. Essentially, transactions are recorded in the books of account at the date the transaction occurred.
This original cost is maintained in the books of account and not updated for any future changes in value that might occur.
if we paid £5,000 for a building in 1980, this will be the cost that is shown in the balance sheet when we prepare our accounts in 2006. This is even when the building has increased in value to say £20,000 through inflation.
The depreciation will be based on the original value of the asset(i.e., f5,000 not t20,000)
The main strength of historical cost is that it is objective. In other words, you can objectively verify the original cost of the asset. You only need to refer to the original invoice. In addition, historical cost is very easy to use and to understand. Finally, historical cost enables businesses to keep track of their assets. There is, however, one crucial problem with historical cost. It uses a fixed monetary capital maintenance system, which does not take inflation into account. This failure to take into account changing prices can cause severe problems. In particular, as Soundbite 12.2 shows, it may not accurately value a company's worth Replacement
Historical Cost and Asset-Rich Companies
The balance sheets of asset-rich companies, such as banks, may not reflect their true asset values, if prepared under historical cost accounting. Why do you think this might be? f we take banks and building societies as examples of asset-rich companies, these businesses have substantial amounts of prime location fixed assets occupy properties in central locations. These properties were also often acquired many years indeed possibly centuries ago. ago, Using strict historical cost, these buildings would be recorded in the balance sheet at very low amounts. This is because over time money values have changed. If a prime site was purchased for £1,000 in 1700 that might have been worth a lot then. Today, it might be worth say £400 million. Thus, fixed assets will be radically understated, unless revalued.
Replacement cost attempts to place a realistic value on the assets of a company
It is concerned with maintaining the operating capacity of a business. Essentially, replacement cost asks the question:
what would it cost to replace the existing business assets with identical, equivalent assets at today's prices? Replacement cost is an alternative method of measuring the assets and profits of a business rather than principally a method of tackling inflation. In the Netherlands, replacement costing has been successfully used by many businesses, such as Heineken. As The Company Cam era 12.1 shows, Heineken values its tangible fixed assets at replacement cost based on expert valuation. the problem for the Dutch is not I convincing rest of the world that it so much the difficulties of using replacement cost, but of the is a worthwhile system.
Example of Replacement Cost
Replacement Cost in SmithX Tangible Fixed Assets(Property, Plant and Equipment)
Except for land, which is not depreciated, tangible fixed assets are stated at replacement cost less accumulated depreciation. The following average useful lives are used for depreciation purposes:
- Buildings 30-40 years
- Plant and equipment 10-30 years
- Other fixed assets 5-10 years
The replacement cost is based on appraisals by internal and external experts, taking into account technical and economic developments. Other factors taken into account include the experience gained in the construction of breweries throughout the world. Grants received respect of investments in tangible fixed assets are deducted from the amount of the investment. Projects under construction are included at cost.
Read more: Historical Cost Valuation in Real Life