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Tuesday, 10 November 2009

The Historical Cost Debate

Originally – before there were any GAAPs and IFRSs – all variable items as well as all constant items together with all monetary items (basically all items in financial statements) were valued at Historical Cost since money – the monetary unit of account –was generally assumed to be stable in real value over time: the infamous stable measuring unit assumption. Today, SA accountants maintain this infamous and very destructive and very economically destabilizing assumption only for the valuation of the majority of income statement items (excluding salaries, wages, rents, etc that accountants value in units of constant purchasing power) and all balance sheet constant items during low inflation and deflation.

Values used in relation to variable items include the following:

Market value
Fair value
Net realisable value
Present value
Recoverable value
Current cost
Carrying value

Residual value

“The residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.”

Value in use
Settlement value
Book value
Replacement cost
Historical cost

The Historical Cost Debate

The Historical Cost Debate is the debate over the last 100 years or so about the exclusive use of Historical Cost for all accounting purposes. The accounting profession has realized for a very long time that financial reports based on Historical Cost for all economic items do not fairly represent a company’s results and operations. As a result of this debate the pure Historical Cost Accounting model has been improved dramatically during this time, so much so, that today we have a huge volume of IFRS where under variable items are not all valued at HC but at the values as indicated above. As a result of the Historical Cost Debate variable items are today valued at, e.g. fair value or the lower of cost and net realizable value or market value or recoverable value or present value. This debate has thus been a very valid and successful debate regarding the valuation of variable real value non-monetary items.

Unfortunately, the stable measuring unit assumption is still an IFRS compliant option that everyone uses for the valuation of most constant items during low inflation and deflation. Fortunately, the option of measuring financial capital maintenance in units of constant purchasing power during low inflation has been approved by the IASB in the Framework, Par. 104 (a) in 1989. Unfortunately, no-one uses it.

SA accountants value variable items in terms of IFRSs or SA GAAP when they implement both the traditional HCA model and whenever they decide to choose to measure financial capital maintenance in units of constant purchasing power. Inflation, per se, has no effect on the real values of variable items. Inflation – per se – can only destroy the real value of money and other monetary items: nothing else.

Kindest regards,

Nicolaas Smith