Question

Question 1 15 Marks For over 20 years the accounting profession in many countries has attempted to formulate a method of preparing financial statements that takes account of the effects of price increases (inflation). It seems that no proposed method of reflecting the effects of changing prices has gained international acceptance. The decision of the IASB, and the accounting standard setters in many countries, is that no form of accounting for price changes should be made compulsory, but entities are encouraged to present such information. There have been two main methods put forward by various accounting standard bodies for reporting the effects of price changes. One method is based on the movements in general price inflation and is referred to as a General (or Current) Purchasing Power Approach, the other method is based on specific price changes of goods and assets and is generally referred to as a Current Cost Approach. Some bodies have also suggested an approach which combines features of each method. Required: (a) Explain the limitations of (pure) historic cost accounts when used as a basis for assessing the performance of an entity. You should give an example of how each of three different user groups may be misled by such information. (b) Describe the advantages and criticisms of General Purchasing Power and Current Cost Accounting.

Answer 1

1) Explain the limitations of (pure) historic cost accounts when used as a basis for assenssing the performance of an entity. Following are some limitations of historical cost accounting:

(i) Failure to disclose current worth of the enterprise. The accounts presented on the basis of historical concept do not show many effects which are due to the inflation gap. Thus, the true and fair view is not shown.

(ii) Uncomparable items in financial statements. Sometimes due to inflation, some items in financial statements show higher value, it never means that the enterprise is making progress. For example sales for three years are $20,000, $80,000 and $38,000. This addition of sales is due to inflation and not increase in sales due to efficiency. When these sales are converted on the common index number then the result will be the sales are some as these were before.

iii) Difficult replacement of fixed assets. In historical cost concept, the depreciation is charged on the original cost. While in inflation the cost of fixed assets is increased, the rate of depreciation is not sufficient to replace fixed assets.

(iv) Inaccurate determination of profit. Historical cost accounting does not disclose correct profit or loss in an inflationary situation. Inflation always shows more profit due to over-valuation of closing stock, in such state of affair, the income tax burden increases, the employees demand more salaries and perks. The division of profits in the form of dividend does not add to general reserves.

(v) Mixing up of holding and operating profits. The historical cost accounting does not disclose what is the effect of closing stock on profit and thus profit due to overvaluation of inventories is mix up to business profits does not show the correct profitability.

2) Give example of how each of three different user groups may be misled by such information-

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.

Incomparability

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.

Out-dated Figures

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.