Limitations of Historical Cost Accounting
Following are some limitations of historical cost accounting:
(i) Failure to disclose current worth of the enterprise. The accounts presented on the basis of historical concept do not show many effects which are due to the inflation gap. Thus, the true and fair view is not shown.
(ii) Uncomparable items in financial statements. Sometimes due to inflation, some items in financial statements show higher value, it never means that the enterprise is making progress. For example sales for three years are $20,000, $80,000 and $38,000. This addition of sales is due to inflation and not increase in sales due to efficiency. When these sales are converted on the common index number then the result will be the sales are some as these were before.
(iii) Difficult replacement of fixed assets. In historical cost concept, the depreciation is charged on the original cost. While in inflation the cost of fixed assets is increased, the rate of depreciation is not sufficient to replace fixed assets.
(iv) Inaccurate determination of profit. Historical cost accounting does not disclose correct profit or loss in an inflationary situation. Inflation always shows more profit due to over-valuation of closing stock, in such state of affair, the income tax burden increases, the employees demand more salaries and perks. The division of profits in the form of dividend does not add to general reserves.
(v) Mixing up of holding and operating profits. The historical cost accounting does not disclose what is the effect of closing stock on profit and thus profit due to overvaluation of inventories is mix up to business profits does not show the correct profitability.