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Hallo,
I have the following text and I am wondering how should I explain it to myself, why:
in the time of rising prices, the historical cost convention has the effect of overstating profits and understating statement of financial position asset values?
Thank you!
Historical cost shows the asset in the SOFP at the original cost less accumulate depreciation.
If prices have been increasing, then the current cost of the asset would be higher, and so historical cost is understating the value.We are calculating depreciation based on the original cost. If it was being calculated on the current cost, then the depreciation would be higher and the profit lower.
So using historical cost is overstating the profit.Hallo,
Thank you for the above answer.
I’d like to ask something related to depreciation.
When we buy an asset, is the money we have paid for it, e.g. $10000 going to be shown somewhere as expense. As this is money that we have really paid this year, we have a cash outflow, why isn’t this an expense?
But I don’t see anywhere where this sum is shown as influencing profit, as if we use depreciation of 10% for this year, which is 1000, yes this will show in the income statement, but what about the other 9000, which we have really paid, yes this is shown in the SOFP as the the value for the asset, but our cash or bank a/c is 10000 less, not 1000 less? Aren’t the 10000 an expense, I know it will go out of the cash a/c, why the cash a/c is not part of the I/S, when it is an outflow of money, still should be kind of expense.
Thank you!
We pay out cash either to buy an asset (which then appears on the Statement of financial position), or to pay an expense (which then appears on the Statement of profit or loss and reduced the profit).
When we buy a non-current asset, it appears on the Statement of financial position. As the asset is used up, we depreciate it – reducing it value on the SOFP and charging the cost of reducing its value to the Statement of profit or loss.
You really should watch the free lectures – Chapter 2 explains the difference between capital and revenue expenditure, and the later chapter on depreciation explains why and how we depreciate.
Hallo,
I will check the info. I know there is capital and revenue expenditure, but am trying to see if an asset costs 10 000 and the depreciation is 1000 = the cost to the B/S will be 9000 and the expense to the I/S will be 1000 for the current year. I am wondering, how is it that we have paid 10 000 in cash, so we have really paid that money and it is a cash outflow, but we only recognize 1000 as an expense, and not the whole sum, only because we want to have higher profit, is this the only reason?
Thank you!
Paying out cash does not automatically mean that there is an expense – we pay out cash to some people because we owe them money. Paying people because we owe them is not an expense!!!
Buying something like a machine for $10,000 is in a sense an expense because we need the machine. However if the machine is going to last for 10 years (and earn us money for 10 years) then we simply spread the expense and charge a bit each year. If it is straight line depreciation then we charge 1,000 of it each year – the expense year by year of ‘using it up’.
We have to do this – it is an accounting standard ‘rule’.
(I really do not think you are watching the lectures because I take quite some time stressing and explaining the above in the lecture on depreciation. You cannot possible pass the exam just trying to learn from questions – you have to study first, either from a Study Text or by watching the free lectures, and then practice questions.)
Hallo,
Yes, sure, actually I have watched the lectures, but sometimes I am asking myself questions, e.g. I know that we depreciate over the life of the usage of an equipment, but cannot really understand the logic of a standard “rule”, I understand how it is done, but sometimes I don’t understand why the accountants do it, what do they try to achieve with this, the reason for doing it. For example, why accountants divide the expenditures into capital and revenue, I would combine this, so that it is more obvious how much profit we have made at the end, now we are looking at two different places B/S and I/S to see how much profit we have, isn’t this confusing?
Thank you!
We do not look in 2 places to see how profit we have made in the year – we only need look at the Income Statement to find out the profit.
In the income statement we have all the income earned for the year, and all the expenses incurred for the year (including the cost of ‘using up’ part of the non-current assets).
(Just because a car may have cost us 10,000 to buy, we cannot say it cost us 10,000 to use it in the first year. We still have the car, it still is worth something, we will carry on using it next year. So we charge against this years profit the cost of using it this year, which is what depreciation is)
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