the shortcoming of historical cost accounting when price are changing
Historical cost accounting is the traditional method of accounting where assets and liabilities are recorded at their original purchase price and are not adjusted for changes in market value over time. While this method has its advantages, such as simplicity and objectivity, it also has several shortcomings when prices are changing. Here are some of the key limitations:
1. Irrelevant information: Historical cost accounting fails to reflect the current value of assets and liabilities. As a result, financial statements may not accurately represent the economic reality of a business. For example, if the prices of inventory or property have increased since their purchase, the balance sheet may show values that are substantially lower than their actual worth.
2. Distorted profit calculation: Changes in prices over time can significantly impact the calculation of profit or income. If the prices of inputs used in production increase, the cost of goods sold may be understated, leading to artificially inflated profits. On the other hand, if the prices of inventories decline, it can result in inventory write-downs that reduce reported profits.
3. Loss of purchasing power: Inflation erodes the purchasing power of money, making historical cost financial statements less meaningful as time goes by. When prices steadily increase, the value of money decreases. This can mislead users of financial statements who are concerned with the company's ability to maintain its operations and generate a return on investment.
4. Inaccurate decision-making: When prices are changing, historical cost accounting can lead to poor decision-making. Managers may not be aware of the true current value of assets and liabilities, which can affect their judgments on investments, pricing, and resource allocation.
To address these shortcomings, alternative accounting methods have been developed, such as fair value accounting and inflation accounting. Fair value accounting adjusts the values of assets and liabilities to their current market prices, providing a more accurate reflection of their worth. Inflation accounting, on the other hand, adjusts historical cost figures using specific price indexes to mitigate the effects of inflation. These alternative methods aim to provide financial information that is more relevant and reliable in times of changing prices.