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Historical cost is the amount of cash or cash equivalents paid or accrued for the purchase of production facilities, assets, or products. It also represents the original cost of fixed assets acquired for a fee and the sum of actual expenses of an organization for acquisition, construction, and manufacturing. Historical cost can be also defined as the price that is paid by a company for ownership or use of a definite asset (Bakar 2007). This cost includes necessary payments for asset’s transportation and installation for provision of services during production processes or other operations of a company (Hendriksen 1992).
The concept of accounting model that is based on historical cost estimation was established for cases where prices of production units are stable or change rarely (Hendriksen 1991). This kind of accounting does not make any predictions about demand for a product or any changes in purchasing power (Horngren 2009). Information that is obtained through historical accounting is important for owners and creditors who want to know everything about production expenses (Henke 1991). This information can be also necessary for stockholders because production costs make up the biggest part of company’s expenses that decreases its profits.
Historical cost accounting is a traditional and standard form of accounting used by companies due to its conventions that are much better to use and easier to understand than alternative accounting methods (Spiceland 2009). Historical cost accounting is the most effective method for decision making due to production costs minimization (Ijiri 1975). It is preferred because it is rather easy to see and understand what makes production such expensive. The next advantage of historical cost accounting method is its transparency, which makes it impossible to manipulate costs and prices of production (Sharma 2010). Furthermore, historical cost accounting makes it possible to control the effectiveness of management through income and profit coefficients (Carmichael 2003). This accounting method is rather useful and effective in business management; that is why this system is seen as traditional and the most popular one (Lal 2009).
Limitations of historical cost accounting can be seen in the fact that this method does not give any information about current assets of a company (Weygandt 1996). It also does not record opportunity costs of the older assets’ usage, and neither does it measure changes in values of assets caused by inflation and other economic changes.