Historical Cost Accounting
| Accountants in the U.S. are required to measure financial information using the historical cost principle. |
Reporting at historical cost is only the starting point. Asset values on the balance sheet follow a mixed set of accounting rules and regulations. This currently makes financial reporting somewhere in between reliable and relevant.
The Accounting Medley, or Mixed Matrix Model
The current practice of applying different rules to different assets, liabilities, and equities is what US GAAP calls the “Mixed Matrix Model.”
Accounts Receivable
For example, companies record accounts receivable based on the historical cost principle, which shows the amount originally owed to the company by customers who purchased products or services on credit. As the accounts receivable balance ages for any customers, it becomes more unlikely that the company will collect the amount owed. GAAP requires that companies estimate and report an amount for uncollected accounts receivable. Therefore, companies report accounts receivable using the historical cost principle, adjusted to the net realizable value, or the accounts receivable balance less estimates for uncollectible amounts.
As we have seen, Sunny estimated 1% of his receivables as uncollectible. This amount is subtracted from the account receivable balance to arrive at the reportable amount of receivables on the balance sheet. He records the same amount in an expense account to show the bad debt expense on the profit and loss statement associated with uncollectible receivables. Therefore, uncollectible receivables reduces both the accounts receivable asset on the balance sheet and the net earnings on the income statement for the period.
Estimates for Bad Debts Affects the Balance Sheet and Income Statement
| Estimates for uncollectible receivables reduces both the account receivable asset on the balance sheet, and net earnings on the income statement. |
Companies use the accounts receivable turnover ratio to measure whether or not the company is effectively collecting payments for sales on credit.
Inventory Accounting
Inventory is recorded based on the historical cost principle. At year end, however, items remaining in ending inventory are measured at the lower of cost or market. This means that any items remaining are compared to the current replacement value. If the current replacement value is less than the historical cost, the items are adjusted down to account for the lost value in inventory. Inventory may lose value due to damage, spoilage, obsolescence, or lower demand resulting in discounted items.
In the retail industry, holding inventory for too long can lead to inventory write-downs due to seasonality. Companies use the inventory turnover to monitor appropriate inventory levels.
Fixed Assets: Property Plant & Equipment
Buildings, plant and equipment are recorded based on the historical cost principle, and, unlike land, are depreciated over the useful life of the asset. This includes office furniture and equipment, computer systems, vehicles, heavy machinery, buildings, and other assets that are considered “used up” over time. Depreciation aims to measure the consumption of the asset over time, eventually reducing the value to zero. For example, an asset acquired for $10,000 with a ten-year useful life and depreciated evenly over time, called the straight-line method, would incur a $1,000 depreciation expense annually until the asset value is zero on the balance sheet. The $1,000 depreciation expense is a real expense that reduces net income each year.
Therefore, buildings, machinery, and equipment are recorded at historical costs but adjusted for depreciation over time. The asset may still produce and have value after it is fully depreciated, but the asset value will not be reported on the balance sheet after it is fully depreciated.
Land
Land is also recorded on a company’s balance sheet based on the historical cost principle. As many years or even decades go by, the market value of the land may be substantially different from the value originally recorded. In markets like New York, Chicago, or San Francisco where companies acquired land for a fraction of what the market would demand today, the balance sheet still reflects the purchase of land at its historical cost.
Land improvements can increase the recorded value of land, such as landscaping, sewer installation, and other permanent improvements. Improvements that are not permanent, such as fences and parking lots, are recorded in a separate account and depreciated similar to plant and equipment.
Though land is not subject to depreciation, land write-downs may occur for impairments. An example of an impairment to land would be a toxic waste site. With the exception of impairments, land remains on the balance sheet at the original cost that the company paid for it.
Goodwill Accounting
Similar to land, goodwill is recorded at based on the historical cost principle. It is not written up to the fair value, but is tested for impairment annually, meaning the company writes down any goodwill in excess of its current value.
The transition to fair value will affect some of these accounting methods as GAAP and IASB aim to converge accounting standards worldwide.
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