Limitations of Historical Cost Accounting
Limitations of Historical Cost AccountingLimitations of historical cost accounting
Financial statements prepared on the historical cost basis do not necessarily lead to a true and fair presentation of an entity’s performance or future potential if capital is not being maintained. Furthermore, actual assessment of performance through ratios such as return on capital are meaningless if profit are overstated, capital undervalued, and assets are valued under a mixture of conventions.
Limitations of historical cost accounting include :
• Depreciation charged on historically costed assets is only an arbitrary amount based on out-of-date values and estimated useful economic lives.
• Depreciation charges do not take into account actual replacement cost of assets at current prices.
• Profit will not reflect the actual ‘costs’ of trading, which include the replacement of assets at some point in time.
• By not accounting for inflation, there is no assurance that the entity is maintaining its capital base.
• Overstating profits by undercharging depreciation based on historical cost, and charging cost of sales at historical cost of inventories (and not current cost) can lead to the depletion of an entity’s capital through high tas charges and distributions.
• While historical cost accounting provides a consistent basis for entities to prepare accounts, inflation affects different products and markets, and hence entities, to different degree.
• Historical cost accounting makes it difficult for shareholders and analysis to assess the real performance and abiliry of mamagement because changes to current market conditions are not accounted for in the historical valuation basis.
• The true valuation of entities is difficult to assess under historical cost rules.
• Interpretation of accounts over a period of time is difficult because each year relates to different purchasing powers.
• Key ratios (such as return on total assets) are inflated under historical rules because profit is overstated (as outlined...