The idea is simple; I pay some cash and that gives me either an expense or an asset. With the exception of freehold land, all assets are simply future expenses, as all assets except freehold land wear out. This means that sooner or later, they’ll all pass through profit and loss as an expense.
There are some well-known problems with historical costs. Most notably, they begin to fall apart in terms of reliability during a period of inflation. Depreciating the cost of a factory bought 20 years ago gives a lower depreciation charge than a factory bought last year. If inventory is held for a long time before sale, historical cost accounting matches today’s revenue with yesterday’s costs; thus overstating profit. All these things damage the relevance and reliability of financial statements and reliability is one of the core characteristics of what makes financial information useful, according to the IASB Framework.
Relevance and reliability aside, let’s face it; historical cost accounting is just not very sexy. Dreary and reliable and borne of something as mundane as debits and credits, it’s hard to get excited about a balance sheet (SOFP) that shows its assets just as what was paid for them rather than what they’re worth. So, enter revaluations and fair values. Modifying historical cost accounting for revaluations means assets are shown at a more up-to-date, relevant (and frankly higher) value. But it comes with a downside – your depreciation charges will now be higher, thus reducing profit. Your eventual profit on sale will be lower, as the carrying value used to calculate profit will be higher. Increasingly, you might come to have problems with investors not trusting the revalued amounts. So perhaps we’ve substituted one form of plodding unreliability for a higher octane form of volatile unreliability?
This is a debate that has two valid sides to the argument. But recent stock market falls and pervasive impairment losses mean that we suspect that the familiar world of pure historical cost accounting might start to look more attractive again. It might be a bit dull, but at least people know what it means.