The following sample essay on Historical Cost Assumption dwells on its problems, providing shortened but comprehensive overview of basic facts and arguments related to it. To read the essay, scroll down. The depreciation charged to income statement which has an impact on the profit figure is also a problem that may mislead users. A. Rash pointed out: “we have very little, If any, basis for choosing depreciation methods and parameters to apply to fixed assets, which has led to some accountants calling It arbitrary.
Thus, all accounting figures that depend on allocations- primarily inventory and fixed assets-must be viewed as the product of arbitrary allocations over periods. The book values of these assets, therefore, cannot be considered anymore appropriate or ‘correct’ than many other possible figures.
It is extremely important to be aware of this allocation problem and of Its potential effects on the meaning and liability of accounting statements, especially since the statements prepared nowadays are generally based on HOC.
” Such problems relate to both the profit and loss statement as well as the balance sheet. Following focus would be on the problems that HOC encountered while price increasing, which means that current values are significantly higher than carrying values. Understatement of assets tends to overstate gearing and leads to a low asset per share value.
With a high gearing and a low assets value, the company would also be difficult to fled financing source and all these can make the company vulnerable too takeover. Due to the above, inter companies comparison of performance can be invalidated.
Historical cost can be thought of as “mixed values” in that historical costs may represent out of date values (when particular assets were acquired many years ago), but in other cases they may represent current values (when assets have been acquired recently).
Thus equivalent assets may be shown at consideration of different cost. Where assets, particularly land and buildings, are being used as security to raise finance, It Is the current value that lenders are Interested In, not the historical values. Problems caused in the income statement: Certain costs being understated comparing to their current cost. E. G. Depreciation charges being based on out of date values of their respective assets, and the cost of sales figures may be understated as it does not include current values for bought in items or manufactured goods.
The understatement of operating costs leads to an overstatement of profit, this may result In a higher taxation, wage demand and dividend expectation (based on overstated earning per share). The combination of these effects is that a company may overspend or over distribute its profits and not maintain its capital base. 408) Therefore the primary objective of CUP is to keep the financial statements updated with the general price movements hence prevent the financial statements from being distorted by Inflation and help the users make better decision.
Therefore firstly the base period should be determined, In which the value of the basket of general products Is taken as a ease Tort ten consequent years to compare Walt n. As ten TLS example given, 2003 is taken as the base year and the value of the basket of general products at that point of time is indexed as 100. Secondly, adjust the value of each on-monetary item according to the RIP changes with the same proportion.
For example, in 2008 the RIP was 1 10, comparing to the base year it increased by 10%, hence the value of that piece of land should be also adjusted by the same percentage, which is 110,000. One main advantage of using CUP is it is easy, for both the preparers as well as for the financial statements users. CUP accounts is Just a set of improved HOC financial statements which has adjusted for the general price movements, as the technique described in question 2, it is easy to convert HOC into CUP accounts.
The preparers only need to convert non-monetary items by using the general price index. As what C. L. TAIGA MADAM TAIGA() further discussed, “It eliminates the necessity of price level changes without having to develop a new structure of accounting I. E. It preserves the historical based accounting system that is nowadays used. ” C. L. TAIGA also pointed out that “restating the value of non- monetary items at historical cost converted of general price level changes is no more meaningful than historical cost alone, as it suffers all shortcomings of historical cost method.
However, Richard et al. 1988) argued that the simplicity could also be the disadvantage of CUP approach: The second advantage of CUP approach is that the conversion is objective and verifiable because it is based on a general measure of price change (egg. RPR) that is applied universally. As a result, no matter what kind of industry or business the companies are operating in, the price index they can choose to convert is only one, there is no alternative hence no subjective choices allowed.
Moreover, such price index is calculated by an independent department (usually government function) so that no companies would have right to override it or manipulate it. C. L. TWIG further discussed that the single price index used not only promotes its objectivity but also promotes comparability: “It eliminates the effects of inflation from financial information by requiring each enterprise to follow the same objective procedure and use the same price level index, thereby preserving comparability of financial statements between firms and of a single firm as well. For instance, the general price increased by 10% however, the value of the stock that the company A is holding increased 5% only as these stocks do not fall into he category of general products and neither follow the exact trend of the price change of them.
By using CUP it would overstate the CUP value of stocks hence distorts the comparison. This again becomes the shortcoming which reduces the comparability since the method used cannot really reflect the truth of the impact of inflation on the companies and left the financial statements half way between HOC which is reliable, and CUP which is relevant to inflation, again neither the fish nor howl. The third advantage of CUP is it measures profit after maintenance of hardliners’ capital in real terms. In particular, it shows the real gains and losses arising on monetary items, and hence users of these accounts can assess the success or failure of the financial management policy.
And in times of inflation, it is better to keep non-monetary items since they would be subject to price increases. But in times of deflation, it is better to keep monetary items since it is not subject to price decreases. Therefore by the knowledge and skills the management have about their company as well as ten Ministry Ana ten wangle economy, teen snouts De addle to 00 some reasonable predictions and adjust the level of monetary and non-monetary items in the company based on their forecast to increase its profitability.
As a conclusion, CUP is a set of improved HOC which adjust for the general price movements and give the users a purchasing power view of the respected company’s financial performance as well as financial position. It has the advantages of HOC such as objectivity, simple to use and easy to understand, etc, and it also remains the disadvantages of HOC such as it does not providing a up-to-date values nor does the refit and loss account have up-to-date charges for assets consumed.
In addition, whether it effectively adjusts for the inflation effect is also being argued as the general price movements may not reflect the change in price of what the company would consume, and moreover, one single price index used universally is not realistic because of the variety of the industries and business that the companies are operating in. However, improving is better than nothing. CUP still has a lot of problems but at least it provides a closer view on the financial information that has men impacted by inflation.
As what the International Monetary Fund Statistics Dept, International Monetary Fund defined, “a holding gain or loss is a change in the monetary value of an asset or liability resulting from changes in the level and structure of prices, assuming that the asset or liability has not changed qualitatively or quantitatively. ” “holding gains may be realized or unrealized. A holding gain is said to be realized when the asset in question is sold, redeemed, used, or otherwise disposed of. It is unrealized if the asset is still owned.
In addition, a realized holding main is usually understood as the gain received over the entire period that the asset is owned, but a holding gain is determined with reference to a specific accounting period. ” “The firm uses a FIFO cost flow assumption and derives its historical cost data. The assumed current cost data resemble those that the FAST suggested in SFA No. 89. The term ‘income from continuing operations’ refers to revenues less expenses based on current, rather than historical, costs.
To that subtotal, add realized holding gains to arrive at realized income. To that, add unrealized holding gains to arrive at economic income. Arguments for the recognition of holding gains: As what mentioned above, the recognition of holding gains would have great impact on the profit reported, and with a profit that has adjusted for the change of value in assets holding, shareholders would know that how their assets value change due to the skills of the management in selling and buying assets.
Anyway, the funds to buy and sell assets are from the investors hence they have the right to access the holding gains as well as the performance of the management in this area from the source of financial statements. Arguments against the recognition of holding gains: Use of replacement cost enables a company o measure both current operating profit, which is the profit charging the replacement cost of assets consumed at the time of consumption instead of historical cost, as well as the holding gains, including realized and unrealized, and to report there various components separately.
This split enables: Users to evaluate management skill in selling (for example, given the cost of replacing the assets sold or consumed is 500 and whether the management could manage to sell it higher) and management skill in buying whether they are able to make prediction of the future prices of particular assets Ana make relent calicles sun as when to Duty Ana Duty at want price). Has further discussed this point: Help Users to draw on their knowledge of the markets the company operates in to predict future current operating profit and future cash flows.
As the profit has been adjusted for the physical capital maintenance in the current market condition, it gives a more up-to-date view of the industry performance such as whether it is in a decline trend and whether they are about to pull out their investments or continue to invest in, etc. Help users to compare the dividends paid with current operating profit to ascertain whether the company will be maintaining its physical capacity, expanding or contracting, as an aid to the prediction of future cash flows.
Provided the company actually intends to replace its assets, and to continue in the same line of business, the income figure based on ARC, with holding gains taken to income as under a system of financial capital maintenance, will be closer to a measure of economic income and value than HOC who’d since, proving the company is acting rationally in its decision to replace, placement cost measures the minimum value of expected cash flows.
The better the market, the nearer will replacement cost be to present value of future cash flows. It follows, therefore, that it will also be a better predictor of future cash flows. Disadvantage: as mentioned in part a, it might be difficult to find a second hand market, Therefore ascertainment of replacement cost might prove highly subjective and give the management chances of manipulate.
Tom (1996) further discussed this point: “it is also a problem of finding appropriate and credible replacement costs for individual resources, for such figures are not always readily available or computable because of the nature of the resources concerned (an example of such resources would be highly specialized and custom built machinery) in other words, a particular resource may not be replaced in the future or a resource may be replaced by an equivalent one rather than an identical one.
Like historical cost, the depreciation which represents the consumption of the goods sold is also subject to arbitrary allocations against income. It is also subject to the aggregation problem, for example, does one look at replacing individual assets, which eight prove more expensive than the cost of replacing the whole team of assets with a new technology? Although the business income concept is based on current values, it only utilizes values for resources which are accounted for through the traditional historic cost system.