Accounting for Price Level Changes- Limitations of Historical Cost - Management Duniya

Accounting for Price Level Changes- Limitations of Historical Cost

Limitations of Historical Cost:

Utility of accounting records seriously impaired:

Financial Statements / reports based on historical cost fail to reflect of such changes in purchasing power on the financial position & profitability of the firm.

Unrealistic Profits:

Under the historical accounting system depreciation calculated on the basis of historical cost of old assets is usually lower than that of those calculated at current value or replacement value. This results in more profits on paper which if distributed inful will lead to various consequences of various statements/ over statements of profits as more taxes, more bonus will be demanded by the employees, more dividend to shareholders etc.., Thus there will be reduction of capital & ultimately the company may go in to liquidation.

Insufficient Provision of Depreciation:

Under the historical accounting system depreciation is calculated on the original cost of fixed assets with the results that only the amount equallent to the original cost of fixed assets is available for its replacement when its life is over.

Fixed Assets values are unrealistic:

In times of rising prices the conventional system of accounts based on historical cost does not give true & fair view of the business enterprise as is required under the companies act 1956 as fixed assets are shown at their historical cost & not at current values.

Different Basis:

In conventional system of accounting fixed assets as shown at the historical cost where as operating expenses & incomes are taken at current prices. Thus different bases  adopted & not desirable for having correct & reliable information about the business.

Return on capital employed misleading:

Return on capital employed which is very useful for the valuation of the business by its bonus, creditors & management will not be correct & may leave to misleading decisions.

 Matching Principle violated:

Financial accounting is based on historical cost. It shows closing stock at cost or market price whichever is lower.  Sales are shown at current purchasing power of the rupee while stocks are shown at cost or market price whichever is lower.

In correct ascertainment of operating capacity:

Cost of goods sold is understated because replacement cost of inventory consumed or used in not matched against revenue giving rise to higher figure of profit. It thus does not five true & fair view of the operating capability of the enterprise.

Difficulty in comparison of profitability of 2 plants:

In case of price level changes comparison of profitability of two plants setup at different dates becomes difficult.

Mixing up of holding gains & operating gains:

Historical cost accounting mixes up the holding gain & operating gain & does not help to take proper decision.

Misleading inter-period & inter firm comparison:

Financial Ratios calculated based on historical cost will not give correct view no meaningful information will be available for correct decisions.

Source: A/c Books & Notes

Tags: Account, accounting, Accounting Management, accounts, Assets, Capital, Cost, Decision, Expenditure, expenses, finance, Fixed asset ratio, Fixed Assets, Fixed assets turnover ratio, historical cost, income, liabilities, limitations, Liquidity, Liquidity position, Loss, Management, manager, Profit, profit & loss account, Profit and Loss, return capital employed, Return on capital employed ratio, revenue, tax
By: Management Duniya