Cost Allocation

Case 9-11 Cost Allocation

a. The process of recognizing, or spreading, cost over multiple periods is termed cost allocation. Financial accounting has always favored, and required, the use of historical cost when valuing fixed assets. Although the relevance of this measurement has been questioned, there are numerous arguments to support using historical cost:

• FASB recognizes historical cost as the most reliable measure of an assets value, as this value is transaction-based and verifiable.

• Current-value measurements are often volatile, speculative, and not-easily supported since there is no underlying transaction to support valuation. These values are easily manipulated and could be utilized to smooth financials.

• Accounting standards prefer conservatism when more than one method exists in valuation. In most cases, historical cost, would tend to underestimate the value of an asset and is preferable.

• Cost-benefit analysis: utilizing historical cost is widely understood and easily practicable.

b. As previously mentioned, the relevance of using historical cost has been increasingly questioned by the accounting world. However, there are many arguments that support the relevance or decision-usefulness of historical cost:

• Historical cost is directly related to past decisions; past decisions are pivotal in evaluating future direction.

• Historical cost is reliable, and therefore, can be argued to be more-relevant than subjective current-cost measurements.

c. A current-value approach to measurement of fixed assets, in theory, would paint a more reliable picture of true financial position of a firm. However, for many of the reasons outlined above, current-value is not preferable for fixed assets.

• Is there a reliable market