Historical Cost in Islamic Accounting Perspective

M. Dawud Arif Khan

and Moch. Buchori Muslim

Institut Ilmu Al Quran (IIQ) Jakarta

Universitas Islam Negeri (UIN) Syarif Hidayatullah Jakarta

Keywords: asset measurement, historical cost, fair/market value.

Abstract: The research is to search for the meaning of the events of social and culture that is based on the perspective

and experience of researcher, in this case related to the concept of historical cost, evaluated from the sharia’s

perspective.This study uses a qualitative-interpretive approach, The main source of this research is the

Conceptual Framework of the Preparation and Presentation of Sharia Financial Statements, Accounting and

Auditing Standards for Islamic Financial Institutions, the books of classical Islamic jurisptudence and

conventional accounting books with GAAP and IFRS approach. Other sources are taken from the literatures

those discuss the concept of valuation of assets in accounting. This study supports the formulation of

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and Institute of Indonesia

Chartered Accountants (IAI) which states that the basis of measurement that is commonly used by Islamic

entities in the preparation of financial statements is historical cost. This study concludes that the historical

cost accounting concept in accounting is not contradictory to sharia principles and commonly used by sharia

entities in the preparation of financial statements, combined with other measurement basis, as long as the use

of other valuation concepts produces relevant and reliable information in financial reporting.

1 INTRODUCTION

Valuation is always related to measurement term,

which involves assigning monetary amount at which

the elements of the financial statements are to be

recognized and reported (Keith Alfredson att., 2007).

In accounting theory, the main problem related to the

question about measurement is how should the

assets and liabilities of a company be measured? On

the basis of its historical acquisition price, at the

selling price, is it updated first with the current price,

or uses the present value of the future cash flows

that can be generated? (J. Godfrey attt., 2010).

Kieso said, “GAAP requires that companies

account for and report most asset and liabilities on

the basic of acquisition price. This is often reffered

to as the historical-cost principle. Cost has an

important advantage over other valuation: it is

reliable” (Donald E. Kieso and Jerry J. Weygandt,

1995). Pyle and Larson stated that accounting

principle called the cost principle should be borne in

mind when reading financial statements. Under this

principle, all goods and services purchased are

recorded at cost and appeare on the statements at

cost. For example, if a business pays $50,000 for

land to be used for carrying on its operations, the

purchase should be recorded at $50,000. It makes no

difference if the owner and several competent

outside appraisers thought the land “worth” at least

$60,000. It cost $50,000 and should appear on the

balance sheet at that amount. Furthermore, if five

years later, due to booming real estate prices, the

land’s market value has doubled, this makes no

difference either. The land cost $50,000 and should

continue to appear on the balance sheet at $50,000

even though is estimated market value is twice that

(William W. Pyle and Kermit D. Larson, 1984).

Kieso stated that the implementation of the

historical cost principle still requires careful

consideration of which acquisition value is used.

However, the question "what is the acquisition

price?" Is not always easy to answer Donald E.

Kieso and Jerry J. Weygandt, 1995). Accounting

Principles Board (APB) (Richard Vangermeersch;

Michael Chatfield and Richard Vangermeersch, 1996)

gives opinion that in applying the cost principle, cost

1052

Khan, M. and Muslim, M.

Historical Cost in Islamic Accounting Perspective.

DOI: 10.5220/0009922710521058

In Proceedings of the 1st International Conference on Recent Innovations (ICRI 2018), pages 1052-1058

ISBN: 978-989-758-458-9

are measured on a cash or cash equivalent basis. If

the consideration given for an asset or service in

cash, the acquisition price is measured at the entire

cash outlay to secure the asset or service. If it is

something other than cash, the acquisition price is

measured at the cash equivalent value of the asset

given or the cash-equivalent value of the asset

received, whichever is more clearly evident (APB,

1973).

The history of historical cost cannot be separated

from the beginning of the development of

accounting theory. In the early 20th century (1900s),

the management of companies played a major role in

the formulation of accounting principles and as a

result many different companies might use different

accounting techniques for the same problem (Ahmed

Riahi Belkaoui, 1993). That is, the use of the

historical cost principle has not been standardized

and its application can also vary among companies

that existed at the time. The period before the

formulation of the historical cost principle by

Godfrey et al. referred to as pre-theory period (J.

Godfrey att.), Belakoui called is as the development

of double-entry bookkeeping (Ahmed Riahi

Belkaoui, 1993), and Chasteen et al called is as

pre-formal theory era (Lanny G. Chasteen att.,

1992).

Godfrey et al, Belkaoui, and Chasteen agreed

that the 1930s was one of the important periods in

the development of accounting theory, especially

with regard to the application of historical cost

principle in the measurement and valuation of assets.

They also agreed that the economic crisis that hit the

world in this period had a significant influence on

the perspective of accounting and financial reporting

issues (J. Godfrey att.; Ahmed Riahi Belkaoui; L. G.

Chasteen, R. E. Flaherty; M. O’Connor).

The economic crisis in the 1930s period raised a

big question about the role of accounting in financial

reporting and the ability to provide reliable

information for decision making. Stephen Zeff

reports that Healy and Kripke, two prominent

practitioners, strongly criticized the practice of

write-up accounting that were prevalent in the

United States in the 1920s. They saw a lot of

practices in recording the value of company assets

that were "elevated in value" during that period (J.

Godfrey).

The problems that arise regarding accounting in

this period are the magnitude of the influence and

role of management in the formulation of accounting

principles. Diffusion of share ownership gives

management a full control over the format and

contents of accounting disclosures. The results of

this dependence are (Ahmed Riahi Belkaoui):

1.1. The accounting technique adopted is not

supported by theoretical aspects.

1.2. The focus is on determining taxable income

and how to minimize income tax.

1.3. The techniques adopted are more motivated by

income smoothing.

1.4. Complex problems are avoided and solutions

with policies are more adopted.

1.5. Different companies may use different

accounting techniques for the same problem.

This situation caused a lot of dissatisfaction

among users of financial statements in the 1920s.

William Z. Ripley and J.M.B. Hoxley, specifically

voiced the debate over the issue of improving the

quality of financial reporting standards, so that it

would be more useful for economic decision-making.

Adolph A. Berle and Gardiner C. Means also

pointed to company wealth and industrial company

strength, and called for protection for investors

(Ahmed Riahi Belkaoui).

The SEC's former chief accountant, Lynn Turner,

told the New York Times that many accounting

frauds, such as Funding Equity, occurred during the

1920s, and helped cause the recession disaster in

1929 and encouraged the formation of the Stock and

Exchange Commission (SEC). The SEC was created

to administer various securities acts. Under powers

provided by congress, the SEC was given the

authority to prescribe accounting principles and

reporting practices (Richard G. Schroeder and

Myrtle W. Clark, 1995). This explains why Belkaoui

called this period an Institutional Contribution

Phase.

The significance of the 1920-1930 period was

also signed by the beginning of the standardization

of the application of the historical cost principle in

the world of accounting. Godfrey et al. states that

prior to the 1930s, the main focus of accounting was

on the use of transactions based on historical cost

which were actually a consequence of the

application of the conservatism principle. However,

although known as an empirical period in the

development of accounting, there is a logical debate

about the level of benefit of measurement

procedures. This is related to the world economic

crisis which began in 1929 (J. Godfrey). Godfrey et

al mentions that after the Wall Street crash of 1929,

the traditional historical cost system was

implemented, although it was not systematically

codified as a basis for capital valuation, and for

economic recording and reporting and related

company activities, until the end of the 1930s (J.

Godfrey).

Historical Cost in Islamic Accounting Perspective

1053

The experts' view shows the importance of

establishing the historical cost principle as the initial

milestone in the establishment of modern accounting

theory. This was also supported bt Chasteen et al.

which states that prior to the 1930s accounting

measurements were still based on individual

accountants' considerations (corporate accountants

and their auditors), so the bias level of comparability

of financial statements was very high (Lanny G.

Chasteen att.).

After the 1930s, professional associations and

standard-setting institutions emerged and grew, so

that accounting standards became relatively

standardized, and measurement refers more to the

objectives of financial reporting. The establishment

of the SEC and its encouragement to professional

institutions to standardize accounting standards is

one of the starting points for the development of

accounting standards, including measurement and

assessment standards, which are better (Richard G.

Schroeder and Myrtle W. Clark). Paton and Littleton

stated that company reports should based on the

assumption that management reports to investors

who do not adequately understand the situation

faced by management. The value presented by

management must be relatively objective and

verifiable. Such value measurement can only be

realized using the historical cost system (W. Patton

and A.C. Littleton, 1940).

2 ADVANTAGES AND

DISADVANTAGES OF THE

HISTORICAL COST

PRINCIPLE

The extensive use of historical cost principles in

accounting and financial reporting shows that the

principle is considered good and has substantial

benefits. Some of the advantages of this principle

include:

2.1. Objective and reliable

Historical cost is objective, because the value

used is a value that can be easily traced to

transaction documents. Pyle and Larson stated

that the objectivity principle supports the idea

that transactions are recorded at their cost

(William W. Pyle and Kermit D. Larson). Kieso

stated that cost has an important advantage: it

is reliable (Donald E. Kieso and Jerry J.

Weygandt).

2.2. Provides comparable information

The historical cost principle provides

information that can be compared from period

to period, because assets are recorded at

historical prices.

2.3. Does not present a holding gain (loss)

Pyle and Larson stated that since the assets are

for use in the business and are not for sale,

their current market value are not particularly

relevant and need not be shown (William W.

Pyle and Kermit D. Larson).

2.4. Relevant in making economic decision

Jiri (1975) proposed three reasons why

historical costs are relevant for decision

making (Nur Barizah and Julia Mohd. Said,

2007):

2.4.1. It is difficult to be manipulated, because

based on actual transaction,

2.4.2. It is useful for control purposes. The

income statement provides a basis for

determining how management has

fulfilled its responsibilities. Past

transaction records are needed for

accountability.

2.4.3. It has been proven reliably so far. Until

now, this concept is still considered

relevant, especially for small and

medium enterprises.

Godfrey et al. also has presented the arguments

of the supporters of the historical cost principle,

including that the relevant for decision making,

based on actual transactions, has been proven

reliably so far, and the profit report generated is

realistic. In addition, accountants must avoid

modifying internal data. One means to avoid this is

the application of the historical cost principle (J.

Godfrey).

However, historical costs are also not spared

from criticism because of the disadvantages inherent

in this principle. The disadvantages that can be

identified are: (1) understatement of expenses, (2)

the statement of financial position of the company is

unrealistic, (3) historical costs are not relevant for

decision making, (4) historical cost accounting can

mislead readers of financial statements (Nur Barizah

and Julia Mohd. Said).

Historical cost principle also received criticism

from Muslim scholars. Husain Syahatah for example,

stated that the determination of the value of the asset

should be based on the prevailing market value

(Husein Syahatah, 2001). Gambling and Karim

(1991) as quoted by Iwan Triyuwono (2006) states

that related to the determination of the amount of

zakat, the measurement of the value of the entity's

assets by using the current cost accounting becomes

more appropriate compared to the historical cost

ICRI 2018 - International Conference Recent Innovation

1054

accounting (Iwan Triyuwono, 2000).

Conceptual framework prepared by AAOIFI

stated that measurement attributes refer to the

attributes of assets and labilites that should be

measured for financial accounting purposes. For

example, asset attribute that may be selected for

measurement in financial accounting may include

the acquisition cost of the asset, the net realizable or

cash equaivalent value of the asset as of a given date,

the asset’s replacement cost as of a given date or any

other attribute whose measurement would result in

relevant information. The choice of the attribute(s)

that should be measured for financial accounting

purposes should be guided by the relevance,

reliability, understandability and comparability of

the resulting information provided to users of

financial statements (Accounting and Auditing

Organization for Islamic Financial Institutions,

2002).

In Indonesia, the Sharia Accounting Standards

Board of Institute of Indonesia Chartered

Accountants (IAI) has also released a Conceptual

Framework of the Preparation and Presentation of

Sharia Financial Statements. It states that

measurement is the process of determining the

amount of money to recognize and include every

element of the financial statements in the balance

sheet and income statement. This process involves

choosing a particular measurement basis (Sharia

Accounting Standards Board of IAI, 2015). A

various measurement bases are used in different

degrees and combinations of financial statements,

they are: historical cost, current cost, and

realizable/settlement value (Sharia Accounting

Standards Board of IAI).

Although many Muslim scholars expressed the

idea that the measurement and valuation of assets

should use fair value rather than hisotrical cost, as

mentioned above, the Islamic accounting standards

published by AAOIFI from Bahrain and IAI from

Indonesia, still adopt the historical cost. In fact, the

IAI Sharia Accounting Standards Board clearly

states that the measurement basis normally used by

sharia entities in the preparation of financial

statements is historical cost. This is usually

combined with another measurement basis.

3 STUDY OF THE HISTORICAL

COST CONCEPT ACCORDING

TO THE ISLAMIC SCHOLARS

(ULAMA)

The valuation of assets in fiqh literature is more

related to the purpose of calculating zakat and the

distribution of inheritance and fai asset (Abu Ubaid

Al-Qasim, 2008). However, the values of the views

of the ulama should also include the idea of assets in

general, because they are not substantially different

from the past with the present.

The basis for estimating the value of an asset is a

history of Abū ‘Amr bin Ḥamās who told that his

father said: "Umar ordered me, ‘Pay zakat on your

property!’. I answered, ‘I have no property except

arrows and animal skin.’ Then Umar said, “Estimate

their value, and then pay the zakat!’.” The order

from Umar is the basis for the process to do estimate

the value of asset. This Abū ‘Amr's story can also be

found in al-Umm by Imam al-Shāfi’ī (Muhammad

bin Idrīs Al-Shāfi’ī, 1987).

The discussion of asset valuation has been

recorded in the fiqh literature, in the section

concerning the calculation of merchandise related to

zakat. Yūsuf Qarḍawī stated that in the opinion of

jumhur (ulama), goods at maturity (zakat) are valued

at the market price of that time (Yusuf Qarḍawī,

1993). This is in line with the current value or fair

value concept. Wahbah al-Zuhaili mentioned that

traders estimate the value of their merchandise at the

end of each year according to the price at the time of

issuing zakat, not the price at the time of purchase.

Merchandise is combined at the time of valuation,

although different in type (Wahbah Al-Zuhaili,

1997).

How about historical cost concept, is there

reference(s) in classical fiqh literature? The idea of

historical cost in classical literature fiqh can be

found in the books of the Shāfi’iya who proposed

that the merchandise is determined in value by what

is used by the merchant to buy. Shāfi’iya said that

merchandise was valued in accorandce with the

purchase price, because the niṣāb was based on the

purchase price (Wahbah Al-Zuhaili).

al-Shāfi’ī mentioned that merchandise is an item

purchased or acquired intended for commerce. When

it has been one year (haul) since it was owned, the

merchant must value the merchandise with a

currency that is more widely used in his country,

dinar or dirham. If the merchandise is purchased

with nuqūd (gold or silver), which is obligatory for

zakat, or with goods that are obligatory on the value

Historical Cost in Islamic Accounting Perspective

1055

of zakat, then the remain property is calculated

based on the day he bought the items (Muhammad

bin Idrīs Al-Shāfi’ī). This concept is in line with the

conservative idea which is the basis of historical cost

concept, which is using the basis of the asset value at

the time of acquisition (J. Godfrey att.).

al-Nawāwī explained that the merchandise was

estimated at the end of ḥaul (year), because it was

related to al-qīmah (valuation). Assessing

merchandise at any time is not easy, then the

estimation for the valuation is carried out at the time

of the occurrence of the obligation, namely at the

end of ḥaul (year). The ḥaul is calculated since the

possession of merchandise at niṣāb. This is the

opinion of al-Shāfi’ī. If there are merchandise being

sold to obtain other merchandise, then it does not

break the count of ḥaul, because the zakat of

merchandise is related to its value, and the value of

the second item and the value of the first item is one

(Abū Zakariyā Muhyī al-Dīn al-Nawāwī, nd).

From the description, it is known that the

acquisition value (purchase price) is the basis for

calculating niṣāb and is used to determine the

amount of zakat that will be issued. This concept is

in line with the historical cost principle in asset

valuation.

Al-Khaṭīb Al-Sharbinī also said that the

merchandise was estimated to be of value at the end

of each ulaul to what he bought. This is if

merchandise is purchased using money. If not, then

it is estimated to use the value closest to the money

used in the merchant's territory or country

(Muḥammad Al-Sharbinī al-Khaṭīb). This confirms

the basic use of measurement that is closer to the

purchase price.

al-Malibarī stated that the niṣāb of merchandise

determined at the end of ḥaul (year), even though

ownership (at first) is less than one ni

ṣāb. The profit

generated in the current year is added to the initial

capital, if it is not in the form of gold / silver

(money). If is in the form of money, it is not added

to the initial capital. The capital is paid for zakat

according to the calculation of the year, and the

profit is also paid for zakat based on profit's year

(Zain al-Dīn al-Malibarī, 1980).

Following the description in Fatḥ al-Mu'īn above,

the benefits that have been realized (in the form of

money) must be separated from the ḥaul calculation

for its zakat. This shows the tendency of al-Shāfi’īs

to choose the concept of realization in the matter of

muamalah, so that it does not recognize the concept

of unrealized profit. Profit is the amount that has

actually been received in cash, so the unrealized

amount has not been recognized as profit.

The discussion in some of the fiqh literature

above, besides limited to the valuation of

merchandise inventory, also relates to the problem of

calculating the zakat of merchandise. Even though,

the concept of valuation can be adopted for the

purposes of Islamic financial reporting.

The accounting concept for merchandise

inventories valuation adopted today is closer to the

opinion of the Shafi'iyyah, which are tend to the

acquisition value, although there are differences

regarding the concept. Inventories are usually stated

at the lowest of the historical cost or net realizable

value (LCNRV) (Sharia Accounting Standards Board

of IAI). The application of this concept can be found

in the accounting standard for the salam agreement,

which states that at the end of the financial reporting

period, inventories acquired through salam

transactions are measured at the lower of cost or net

realizable value (Sharia Accounting Standards Board

of IAI).

4 CONCLUSION

Islamic accounting standards developed by

AAOIFI in Bahrain and another by the Indonesian

Institute of Accountants (IAI) in Indonesia use the

reconstruction approach, that is, following the

objectives, principles, and conventional accounting

concepts that already exist, then testing them from

the Sharia point of view. Parts that are in line with

the Sharia will be accepted and used, while parts that

are not in accordance with the Shariah will be

rejected.

Following this approach, sharia accounting

standards adopt the qualitative characteristics that

are not in conflict with sharia, including that

financial statements must present relevant and

reliable information. Jiri and Godfrey et al. support

the opinion that historical costs are relevant for

decision making. When referring to reliable

qualitative characteristics, Kieso and Weygandt state

that historical cost has an important advantage, that

is reliable. Pyle and Larson stated that the objectivity

principle supports the idea that transactions are

recorded at their cost. Within the framework of

sharia accounting, there is a paradigm of

responsibility for trust, and fulfillment of social

responsibility. If the concept is accountability, then

the historical cost becomes more relevant than the

current value.

From the study of the books of the Ulama, we

have the results that the idea of historical cost can be

found in the books of the Shafi'iyyah who porposed

ICRI 2018 - International Conference Recent Innovation

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that the merchandise is estimated in value with what

is used to buy, in accordance with the purchase price,

because the niṣāb of merchandise is based on the

purchase price. In relation to the calculation of zakat

and niṣāb, the author prefers the approach of the

Shafi'iyyah. The purchase price is certain and has

occurred, while the estimated current value is

approximate and there is a possibility of not being

realized. Benston mentioned that fair values other

than level 1 (quotation prices in active markets)

enable for manipulation and are not easy to verify.

Zakat should be based on a more certain basic value.

In addition, matching between business practices

and markets cannot always be done, because some

types of businesses are not market-based, so it is not

easy to get an estimate of the current value.

Based on the discussion on the issue of the

relevance and reliability of financial reporting above,

there is enough evidence that the use of historical

costs is still relevant and can be accepted in the

sharia perspective. Following the concept promoted

by the Shafi'iya, the measurement of assets should

be based on historical value. This is considered more

beneficial, especially if it is associated with the

calculation of zakat.

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