As per the traditional approach, the expense to be matched with revenue is based on

Correct — A, (a) original cost. The matching concept says that the expenses of a period must be set against the revenues that those expenses helped to earn. This question asks the next question down: once you know which expense to match, at what figure do you measure it? Under the traditional or conventional approach, the answer is the amount actually paid for the resource — its original, or historical, cost.

The reason is the historical cost convention, and the reason for that convention is objectivity. An original cost is the outcome of a completed transaction with an outside party. It is evidenced by an invoice, a contract, a payment record; two accountants working independently will arrive at the same figure; an auditor can verify it; and a court can be shown it. Every one of the alternatives on this list has to be estimated, and an estimate made by the enterprise about its own results is exactly what accounting conventions exist to keep out of the books. So goods sold are matched against revenue at what they cost to buy or make, and a machine is written off through depreciation computed on what the machine cost.

The word 'traditional' in the stem is doing real work. It signals that the question is about the conventional system and not about the alternatives that were proposed to replace it, and those alternatives are what options (b), (c) and (d) name. The criticism they answer is a genuine one. When prices are rising, matching an old cost against a current revenue overstates profit, because part of what looks like operating profit is merely the gain from having held the resource while its price rose. Distribute that as profit and the enterprise cannot replace the resource it has just consumed — its physical capital is eroded even while its accounts show a surplus. That objection produced the inflation-accounting proposals: the current purchasing power method, which restates historical figures using a general price index, and current cost accounting, which measures the expense at the cost of replacing the resource. Both remain outside the traditional approach, and both trade objectivity for relevance.

So the traditional answer is original cost, with the alternatives well understood as alternatives — which is exactly the pair of ideas an Accounts Officer is expected to hold at once.

Why the others are wrong

• (b)opportunity cost — Opportunity cost is the value of the next best alternative forgone — the return a resource would have earned in its best other use. It is indispensable in economics and in managerial decision-making, where a manager weighing whether to use a building for a new line must count the rent forgone. It is not recorded in the books of account, because no transaction takes place and there is nothing to verify: the alternative use never happened, so its value has to be estimated. This is the same distinction that divides economic cost from accounting cost, and it is the reason the two disciplines produce different profit figures for the same firm.
• (c)replacement cost — Replacement cost is the cost of acquiring an equivalent resource at today's prices, and matching it against current revenue is the central idea of current cost accounting — one of the inflation-accounting systems developed precisely because the traditional approach performs badly when prices move. Under that system the expense reflects what it will cost to carry on, and the profit reported is a profit the enterprise can distribute without shrinking. But it is the reform, not the tradition, and the stem asks about the traditional approach. Replacement cost also introduces the very subjectivity that the historical cost convention was designed to exclude, since it must be estimated afresh each period.
• (d)cash cost — Measuring the expense by cash paid out is the cash basis of accounting, and it is incompatible with the matching concept the stem itself invokes. On a cash basis a credit purchase would be no expense until it is paid for, an amount paid in advance would be an expense of the wrong period, and depreciation — which involves no cash movement at all — would never be charged. Matching depends on accrual: expenses are recognised in the period in which the benefit is consumed, whatever the timing of the payment. An option that eliminates the largest non-cash expense in most enterprises cannot be the basis on which expenses are matched with revenue.

Three ideas work together here. The accrual concept records a transaction in the period in which it occurs rather than the period in which cash moves. The matching concept sets the expenses of a period against the revenues they helped to earn, which is what makes the profit figure meaningful. The historical cost convention fixes the amount at which each of those expenses is measured — the price actually paid, evidenced by a completed transaction with an outside party. The convention's virtue is objectivity and verifiability; its cost is relevance, because a figure fixed years ago says little about current values. Indian accounting practice follows it: AS 10 requires items of property, plant and equipment to be measured at cost on initial recognition, AS 2 carries inventory at the lower of cost and net realisable value, and depreciation under the traditional approach is computed on original cost. The alternatives proposed to overcome the convention's weakness in inflationary periods are the current purchasing power method, which restates historical figures by a general price index, and current cost accounting, which measures expenses at replacement cost so that operating profit is separated from holding gains. Under the converged standards a revaluation model is permitted for property, plant and equipment as a policy choice, which softens the convention without abandoning it — but the traditional approach, which is what this question names, is the historical cost one.

Key facts

• The matching concept requires expenses to be set against the revenues they helped to earn in the same period.
• Under the traditional approach the expense is measured at original, or historical, cost — the amount actually paid.
• The historical cost convention is preferred for objectivity: a completed transaction leaves verifiable evidence.
• AS 10 requires property, plant and equipment to be measured at cost on initial recognition.
• AS 2 carries inventory at the lower of cost and net realisable value.
• Depreciation under the traditional approach is computed on the original cost of the asset.
• Opportunity cost is the value of the next best alternative forgone; it is used in decision-making but is not recorded in the books.
• Replacement cost is the basis of current cost accounting, one of the inflation-accounting systems.
• The current purchasing power method restates historical figures using a general price index.
• Matching historical costs against current revenues overstates profit when prices are rising, because holding gains are reported as operating profit.
• The cash basis is incompatible with matching, because it would omit credit transactions and all non-cash expenses such as depreciation.

Common traps

• Reading past the qualifier 'traditional' and answering with the reform that was proposed to replace it.
• Importing the economist's opportunity cost into the books; it informs decisions but is not recorded.
• Assuming replacement cost is a general accounting rule; it is the basis of a specific inflation-accounting system.
• Confusing the cash basis with the accrual basis, and so eliminating depreciation from the matching exercise.
• Treating historical cost as obviously superior; its objectivity is bought at the price of relevance, which is the whole reason alternatives exist.

• practice — not a real PYQ

  The convention that requires an asset to be recorded at the price actually paid for it rather than at its current market value is the

  • (a)convention of conservatism
  • (b)historical cost convention
  • (c)convention of materiality
  • (d)convention of full disclosure

  Answer(b) historical cost convention

• practice — not a real PYQ

  Matching current revenue against the cost of replacing the resources consumed is the central idea of

  • (a)the traditional or conventional approach
  • (b)current cost accounting
  • (c)the cash basis of accounting
  • (d)the single entry system

  Answer(b) current cost accounting