a) The historical cost convention looks backward but the going concern convention looks forwards.
i. Does the traditional financial accounting, using the historical cost convention, make the going concern convention unnecessary? Explain with examples.
ii. Which do you think a shareholder is likely to find more useful- a report on the past or an estimate of the future? Why?
i. The historical cost convention says that all the assets especially long term assets should be valued in the financial statement at the cost that the business paid for it while purchasing it, even if the current value of the noncurrent asset and liabilities have changed after that, there is no need of recording that in the books of accounts. While the going concern convention or assumptions suggests that business will continue its operations for the foreseeable future or period of time.
Traditional financial accounting using the historical cost convention does not make the going concern convention unnecessary, instead, the Going concern assumption is the very basis on which historical cost convention stands. The logic behind this statement is that when a business is started, its owner starts it with a view or intention of continuing it for the foreseeable future and purchases its assets, borrows funds having the same intention in the mind that is drawing profits by using these assets and liabilities for the foreseeable future. Therefore, any changes or fluctuations in the value of long-term assets and liabilities would not actually be realized by the business as it is not going to sell it in in upcoming years. So, it is logical that the business using going concern convention values its assets and liabilities on cost.
Historical cost example: A land was purchased by the business owner for $500,000, and its current value is $650000, now as per the historical cost convention the value of the land would be recorded as $500,000 only and there will be no adjustment for $150,000 in the books of accounts.
The second example would be a company that is making losses continuously for the previous few years, so now this company will have to value its assets and liabilities on market value because it does not seem that the company would be able to continue for a foreseeable period of time, thus cannot be categorized as a going concern. And that makes the principle of historical cost invalid.
The second example completely proves that Ongoing concern convention is the foundation for historical cost convention. Therefore, historical cost needs going concerned with convention for its validity.
ii. Shareholders before making investments in certain stocks or company will look into past as well as future information relating to the company:
The shareholder will look into past trends to understand the financial soundness of the business, the value of its asset and liabilities, its profitability, dividend-paying capacity. They will also look into financial ratios like price earning ratio to understand how much the share is providing a return for each dollar of earning, profitability ratios, return on equity ratios, asset turn over ratios, debt to equity ratios for knowing the debt-equity mix of the company, dividend yield, and many other different ratios. The point is that all this information can only be available by looking at the financial report on the past year’s performance.
Now needless to say that future estimation is majorly based on the past trends, thus for even deriving the future estimation of the business, the shareholders would need the past performance trend of the businesses. The future estimation can also be impacted by any new business line launch in an existing business, expanding of the target market, changing of other things that will impact the future estimation of the business.
So, as a whole, it can be safely said that shareholders need both to report on the past and future estimation of the business for making investment decisions. But in a way, it can be said that past report is a little bit more useful as it paves the way for future estimation itself.