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I would like to know the answer for the following question and please explain why.
When there is inflation, the historical cost convention has the effect of
A. Overstating profits and understating balance sheet values
B. Understating cash flow and overstating cash in the balance sheet
C. Understating profits and overstating balance sheet values
D. Overstating cash flow and understating cash in the balance sheet
Thanks in advance for your explanation.
You really should watch the free lectures, because I take though this exact question!
Historic cost understates the value in the Statement of financial position (we stopped using the term Balance Sheet many years ago) because it used original cost which will be lower than the original cost.
Historic cost also overstates the profit, because depreciation is calculated on original cost which is lower than it would be if calculated on the current cost. Lower depreciation means higher profits.