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In a country where the economy is growing and prices are subject to regular increases, which of the
following are false when using historical cost accounting compared to current value accounting?1. Historical cost profits are understated in comparison to current value profits
2. Capital employed which is calculated using historical cost is understated compared to current value
capital employed
3. Historical cost profits are overstated in comparison to current value profits
4. Capital employed which is calculated using historical costs is overstated compared to current value capital employedHi John, can u please explain why statement 1 and 4 are false?I don’t really understand the reasons, do u mind provide some examples?
Hi,
It is a tough one to answer but let’s think about what historical cost is first. It is essentially when we purchase PPE, capitalise it at cost and then depreciate.
The depreciation that goes through profit or loss each year is then based on that old cost value and as time changes, if we’ve not made any changes to the value of the asset which would result in higher depreciation if the asset would now cost more due to inflationary increases then the profits are understated as we should really have that higher depreciation going through profit or loss. Hence #3 is correct.
If the asset that is held at its old, historical value is not updated to reflect cost increases then the capital employed will be lower than it should be. Hence #2 is correct.
Hope that helps
Dear Sir,
The Historical cost’s profit is overstated so reflect to the Capital employed RE should be also overstated?
I can’t understand on the correct answer of No.2.
Thank you Sir.
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