The limitations of historical cost accounting include: 1. Failure to disclose the current worth of the enterprise The accounts presented using historical cost accounting do not show many effects that are due to the inflation gap. Thus, a true and fair view is not given. 2. Incomparable items in financial statements Sometimes, due to inflation, certain items in financial statements show a higher value, but this does not necessarily mean that the enterprise is making progress. For example, sales for three years may be $20,000, $80,000, and $38,000. In this case, the company's higher sales figures are attributable to inflation and not to an increase in sales. When these sales are converted on the common index number, then the result is that the sales are the same as they were before. 3. Difficult to replace fixed assets Under the historical cost concept, depreciation is charged on the original cost. Under inflation, the cost of fixed assets increases, and so the rate of depreciation is not sufficient to replace fixed assets. 4. Inaccurate determination of profit Historical cost accounting does not disclose the correct profit or loss in an inflationary situation. Under inflation, more profit is always shown due to over-valuation of closing stock. In such cases, the income tax burden increases and employees may demand higher salaries and more perks. The distribution of profits in the form of dividends does not add to the general reserves. 5. Mixing up of holding and operating profits Historical cost accounting does not disclose the effect of closing stock on profit. Therefore, profit due to the overvaluation of inventories is mixed up with business profits, and does not show the correct profitability.
Limitations of Historical Cost Accounting FAQs
Historical Cost Accounting is the recording of financial information as they are. It records all transactions at the actual value as they happened in that period. For example, if a machine was purchased for $100 and its current price is $150 then this difference is recorded as an expense.
The limitations of historical Cost Accounting include: - failure to disclose the current worth of the enterprise - incomparable items in Financial Statements - difficult to replace Fixed Assets - inaccurate determination of profit - mixing up of holding and operating profits
Sometimes, due to inflation, certain items in Financial Statements show a higher value, but this does not necessarily mean that the enterprise is making progress. For example, sales for three years may be $20,000, $80,000, and $38,000. In this case, the company’s higher sales figures are attributable to inflation and not to an increase in sales.
Yes, under the historical cost concept, Depreciation is charged on the original cost. Under inflation, the cost of Fixed Assets increases, and so the rate of Depreciation is not sufficient to replace Fixed Assets.
Historical Cost Accounting does not disclose the effect of closing stock on profit. Therefore, profit due to the overvaluation of inventories is mixed up with business profits, and does not show the correct profitability.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
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