Historical cost accounting is a well-established method of accounting all over the world because it is able to meet the legal requirements for financial reporting. Historical cost accounting has been able to provide information about the financial position, performance and changes in financial position of an enterprise to a wide range of users, especially during periods of stable prices. However, accounting for price level changes has been a hot topic in the academic literature because of the deficiencies of the historical cost accounting approach.
The figures for assets contained in the statement of financial position are based on cost at the time of acquisition. They are, thus, unlikely to show present day values because these figures cannot just be added together. Users of financial statements will not be able to realistically predict future cash flows related to those assets.
Overstatement of Figures
If profit is dependent on measure of capital at different dates, then profit measurement can be considered the result of comparing two meaningless totals, as the capital figure does not reflect shareholders’ purchasing power. In addition, the profit that results is usually considered overstated and any ratio employed, including return on capital, will be overstated.
Misleading Operational Levels
Historic cost gives a misleading impression of the ability of a company to continue to operate at a given level since the assets are undervalued. By adjusting for inflation and net realizable value, accountants attempt to maintain the shareholders' capital in terms of the general or consumer purchasing power.
A series of historic cost accounts can give a misleading impression of the financial trends of a company. Only if the results of different years are restated by adjusting to general price levels can comparability between years be valid. All items in the profit and loss account are expressed in terms of year-end purchasing power, while the same will be true in the balance sheet.
- “International Financial and Reporting Standards”; IASB, 2004.
- "Advanced Financial Accounting"; Ronld J. Huefner et al.; 2006
- "Advanced Financial Accounting"; Richard Baker et al.; 2010
Gabrielle Brown has been writing professionally since 2005, with work published in "Venture Capital Markets." She holds an M.B.A. from New York University's Leonard N. Stern School of Business, a Bachelor of Commerce in finance from the Queen's School of Business and a diploma in journalism from Concordia University.