Page 27 - DCOM409_CONTEMPORARY_ACCOUNTING

Contemporary Accounting

Notes 4. In historical accounting cost represents ‘historical cost’ whereas in inflation accounting
cost represents the cost prevailing at the date of sale or at the reporting time”.
5. Historical accounting is used in countries experiencing high inflation or hyperinflation.

2.3 Major Drawbacks of Historical Cost System

Under a historical cost-based system of accounting, inflation leads to two basic problems. First,
many of the historical numbers appearing on financial statements are not economically relevant
because prices have changed since they were incurred.
Second, since the numbers on financial statements represent dollars expended at different points
of time and, in turn, embody different amounts of purchasing power, they are simply not
additive.

Financial statements that are prepared according to the conventional or historical cost accounting
system, therefore, do not reflect current economic realities, in case of historical accounting
system; accounts are prepared without regard to changes in the price levels. The assets are
shown at the values they were purchased less any depreciation on such values. As a matter of fact
their values might have gone up on account of the inflationary tendencies. Similarly, the sales
are recorded at the current market prices while the inventories are recorded at the prices at
which they were purchased. It may be possible that goods sold may comprise those items that
might have been purchased in earlier years when the prices were lower than the current year.
Thus, neither the balance sheet nor the income statement shows the correct operating and
financial position of the business.
“In most countries, primary financial statements are prepared on the historical cost basis of
accounting without regard either to changes in the general level of prices or to increases in
specific prices of assets held, except to the extent that property, plant and equipment and
investments may be revalued.”
Ignoring general price level changes in financial reporting creates distortions in financial
statements such as
reported profits may exceed the earnings that could be distributed to shareholders without
impairing the company’s ongoing operations
the asset values for inventory, equipment and plant do not reflect their economic value to
the business
future earnings are not easily projected from historical earnings

the impact of price changes on monetary assets and liabilities is not clear
future capital needs are difficult to forecast and may lead to increased leverage, which
increases the business’s risk
when real economic performance is distorted, these distortions lead to social and political
consequences that damage businesses (examples: poor tax policies and public
misconceptions regarding corporate behaviour).

Thus assumption of a stable monetary unit does not hold good in the present times as a result the
practical utility of financial statements gets diminished. Inflation accounting is the technique of
such accounting methods as are designed to mirror the impact of rising prices on economic
magnitudes through the adoption of inflation adjusted accounts.

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