Thursday, March 17, 2011

Paper 1.1 Chap:5

Paper 1.1
Chapter 5
The Accounting Concepts - Part 4 (Historical Cost Accounting vs. CPP vs. CCA)

Traditionally, accounts were prepared to fulfill the needs of the owners of the business
and to assist the managers’ for the business to make decisions about the future.
Yet, it was later made clear that the accounts prepared under the historical cost
convention provided misleading information because of the inability to reflect the
changing price levels.


1. When property appreciates in value, the historical cost convention which values it
at its purchase cost, wouldn’t reflect its true and fair value. This means that unrealized
holding gains are not recognized until the period in which the asset is realized, rather
than spread over the period during which it was owned.
2. Depreciation based on a Fixed Assets Historical Cost may be inadequate to
finance the replacement of the Fixed Asset if the appreciation in value is larger than
the depreciation charged!
3. Furthermore, the depreciation charge wouldn’t fully reflect the value of the asset
consumed during the accounting period.
4. The following example applies to stock appreciation during a period of inflation.
During Inflation No Inflation
Sales (100 Units) $ 500 $ 500
Less: Cost of Sales
Opening Stock (100 Units) $ 200 $ 200
Purchases (100 Units) $ 200 $ 200
Closing Stock (100 Units) ($300) ($100) ($200) ($200)

Gross Profit $ 400 $ 300

Basically, the trading account above compares the gross profit of a certain company at
two different accounting periods, one being inflationary whilst the other excludes
inflation. At the beginning of the year the trader had 100 units of stock at a cost of
$200, during the year the trader purchased 100 units at a cost of $200, and at the
year end, the Historical Cost of the 100 units remaining after the sale of $100 units is
$300 due to the appreciation in stock, and thus, inflating profit by $100.

5. HCA ignores any holding gains or losses of net monetary items during a period of
a change in prices/
6. The effect of inflation on capital maintenance is not known. Capital maintenance
is the amount of sufficient retained profit to ensure that the net assets at the end of
a period are at least equal to those at the beginning of the period. I.e. to keep the
capital intact.

As a result of all the previous examples, one can see that over time, the inability of the
HCA to account for changes in price level means that one cannot obtain realistic, true
and a fair view of the company’s accounts from one period to another.

Reasons for Continued Use

1. Easier and cheaper to record transactions, and analyze them based on their HC.
2. The figures are easy to obtain and they are objective and readily verifiable, being
tied to actual transactions, whereas other methods seem to be subjective.
3. HC is easier to understand and users are aware of its limitations.
4. Since revaluations of fixed assets are permitted, the problems associated with
understating the value of property are avoided.

The Current Purchasing Power
The use of the CPP means that the profit for the year is calculated after an adjustment
designed to reflect the effect of general price inflation on the purchasing power of
equity shares. In other words, if you refer back to the example concerning the
appreciation in the price level of the closing stock, you’d find, that previously, $200
would be adequate to purchase 100 units of stock, whereas, now, the 100 units cost
$300 to purchase, thus the purchasing power has dropped by $100, or by 1/3rd.

The Current Cost Accounting

This method of accounting doesn’t attempt to cater for general prince inflation, instead,
profit for the year is to be calculated after allowing for the effects of price increases,
specifically on the operating capability of the particular business.

a) In other words, assets are stated at current value, which is what we do when we
revalue property.
b) Holding gains are excluded from profit in the P&L. how?