Historical cost accounting is an accounting system under which a business’s revenues, expenses and asset gain and disposal are recorded at historical cost. Although it is respected and recognised as the traditional system of accounting, it has a number of limitations because of the information it omits, the inaccuracy of its data and its lack of relevance and clarity. Historical costing is therefore sometimes compared unfavourably to other accounting systems such as current cost accounting.
A financial statement created under the system of historical cost accounting is simply a statement of historical facts, meaning it suffers from the omission of vital information. For example, it takes into account neither changes in the value of money nor changes in the market value of fixed assets. This leads to the financial statements failing to represent the organisation’s current state of affairs and to show the current asset prices respectively.
The profit figure recorded on an income statement that has been created according to historical cost accounting is not accurate. The accounting system records revenues on the basis of current value but records expenses at historical cost. As a result, the statement doesn’t account for the fact that expenses will cost more during periods of inflation. This leads to profits being over-stated because the differential between revenue and expenditure is calculated bigger than it really is.
For the sake of best practice, gain or loss on account of holding inventories should be kept separate from operating gain or losses. With historical cost accounting, there’s a risk that holding gain or losses and operating gain or losses will be mixed up with one another. This would cause confusion for anyone trying to work out the true performance of the company’s distribution and manufacturing operations. Without an accurate picture of operating performance, the organization may find it more challenging to optimise its operations.
Making the right decisions is a key part of running a successful business. However, accounting information prepared under the historical cost accounting system is of little use to the stakeholders making those decisions. Although historical costing is sufficiently focused on the stewardship function of accounting, it doesn’t pay enough attention to other important points of focus. As users of accounting information are typically interested in more than just the stewardship function, they find historical cost to be irrelevant to their needs.