Limitations of Historical Cost Accounting
The limitations of historical cost accounting include:
1. Failure to disclose the current worth of the enterprise
2. Uncomparable 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.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, 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.