Accounting Methods Explained – Assignment Example
The underlying assignment aims at identifying limitations of historical cost accounting. Along with it, areas of current cost accounting, exit price accounting, current purchase power accounting, and continuously contemporary accounting are also discussed along with their advantages and disadvantages. In the end, the conclusion is also drawn on the basis of such discussion in order to outline and recommend best option and area of accounting. In all, the underlying assignment provided an opportunity to gain an insight regarding different areas of accounting and identifying and recommending best possible area.
Historical cost accounting & its limitations
This is one of the most widely used accounting methods in the past years when all the financial items and transactions are recorded on the basis of original cost. More specifically, historical cost accounting states that business firm should record all the financial transactions on original cost instead of market value (Zack 2009).It is considered unfair on the part of business firm, if they record financial transactions on market value instead of original cost. The main assumption and reason behind this concept is that the actual money paid or received by the business firm at the time of conducting financial transaction should be recorded and entered in books. Due to this, historical cost accounting is being criticised on various grounds. Some of the limitations of historical cost accounting are:
1) Inappropriate at the time of changing and rising prices
The accounting experts argued that historical cost accounting cannot be used in the case of changing and fluctuating prices. It is said that historical cost accounting ignores market value and therefore fail to reflect true and accurate picture of financial transactions. For example, according to historical cost asset should be entered in books on the basis of acquisition cost. This fact is completely ignored that price and value of asset changes over the period of time. An asset purchased in the past time may become cheaper or expensive in coming time. In other words, time value is always attached with the asset and this fact cannot be ignored in order to get accurate assessment of financial transactions. The significance of time value in assessing and valuing financial transactions increase at the time of comparing corporate performance as it can change value of assets and transactions (Delaney & Whittington 2010).
2) Capital maintenance perspective
The historical cost accounting is also inappropriate as per the capital maintenance perceptive. As per the phenomenon of capital maintenance perspective, a firm can said to have earned profit only when amount and value of net assets increases at the end of the period. In other words, assets value is measured and compared both at the beginning and end of the period in order to determine whether the business firm has gained on account of purchase of assets.
Historical cost accounting cannot be used for this purpose as value of assets at the time of purchasing and disposing will vary significantly. This is obvious as assets is purchased at original cost and entered in books while asset will be sold on market price which is not considered by historical cost accounting. Therefore, actual contribution and gains on account of asset transactions cannot be calculated and determined accurately under this accounting method.
3) Distorted operating result
Historical cost is also criticised on the ground of distorting operating results. At some instances, it is argued that historical cost overstates and exaggerates the operating result. This limitation of historical cost accounting stems from the fact of its ignorance of changing prices. It is said that historical cost accounting ignores changing prices and therefore there are the chances that profit figures are overstated and shareholders gain inaccurate picture of the operating performance of the organisation. Historical cost accounting enters any gain and losses in the books only when it is actually received.
In other words, the concept of accrued gain and loss is not taken into consideration by the concerned accounting system (Schroeder 2011). Like, if some assets have been purchased in the past time at very low price in the expectation of selling it at the high price in the future time, historical cost accounting will enter profit and loss on assets in the future period only when the assets are ultimately sold. In this way, this method of accounting places all the gains earned in previous years in the subsequent periods and thus distorts operating results of previous as well as subsequent periods.
Current cost accounting: Advantages and disadvantages
As the name indicates, this method of accounting considers value of assets on the basis of their current replacement cost. The price originally paid at the time of purchasing assets is not taken into consideration by the current cost accounting. In this context, the most evident advantage of this method of accounting is its applicability in the times of changing prices. More specifically, the valuation of assets is adjusted in light of market value prevailing currently for the assets. The time-value attached with the assets is not ignored and assigned significant importance by the current cost accounting (Ahmad 2012).
It is believed and accepted that assets value can be increased or decreased with the passage of time and therefore assets should be recorded at market prices in order to have accurate assessment and picture of financial transactions. Current cost accounting also offers the advantage of having accurate idea of the corporate performances as all the transaction and entries are recorded on the basis of realised value.
On the other hand, there are also various disadvantages of current cost accounting like volatility of market price of assets often result in overestimation and underestimation of assets. The volatility of market price creates the possibility of making financial information unreliable and unrealistic. It becomes difficult for the investors and shareholders to arrive at a decision on account of volatility and fluctuation in market price. It has been seen many times that changing and volatile market price develop a kind of fear and resistance attitude among investors and shareholders regarding their return and likely earnings. In this context, business firm often face difficulty of gaining investors and shareholders confidence.
Exit-price accounting: Advantages and disadvantages
Exit price accounting is a unique method of accounting takes into account when a business firm or an entity decides to exit or leave the industry. This is evident as when any business firm decides to leave or exit the industry, concerns related to assets arises. In simple terms, every business firm owns and possess certain kinds of assets which are required to be dealt properly at the time of exit (Walton & Aerts 2006). Exit price accounting serve and facilitates this task through providing business firm a method of accounting for determining value of assets. In this context, exit price accounting state that assets should be sold on the net selling price recorded in the balance sheet at the date and time of exit of business firm.
Exit price accounting is considered as more reliable and relevant source of providing information to the users i.e., investors and shareholders. It is so because investors and shareholders are interested in real, reliable and relevant value of assets. It can also be understood in the manner that at the time of exit or leaving the industry, business firms are required to make assessment of its current and non-current assets.
Such assessment is made in order to settle claims of creditors, determining return or earning available to shareholders, and ascertaining liabilities of business firms. It is equally important to gain an accurate and real assessment of current and non-current assets in order to plan and conduct the exit decision in a proper and effective manner. Exit price accounting can serve this task through satisfying all the stakeholders i.e., investors, shareholders and creditors through providing them real and reliable worth of their investments and assets.
The significance of exit price accounting can be understood with the help of an example. Like, depreciation is understood as a decline and fall in the market price of current and non-current assets. According to exit price accounting, no depreciation is charged when price and value of assets increases or there is no change in the value of non-current assets (Dutta. 2010).
On the other hand, there are also some negatives associated with the exit price accounting. The advocates of historical cost accounting and current cost accounting argue that approach and scope of exit price accounting is too short and narrow in its nature. It is said as all the assets and balance sheet items are evaluated on the basis of exit prices or prices prevailing in the market at that point of time. There is possibility that exit prices and prices prevailing at the time of firm’s decision of leaving from the industry might be too low and thereby valuing the assets and other balance sheet items at low value.
The main point in criticising exit price accounting is its emphasis on price changes rather than the fact that business operations are conducted with efficiently or not. In other words, experts state that performance of firm also depend on operating efficiency with which the business operations are conducted (Debarshi 2009). This fact is ignored by the exit price accounting and it emphasis only on financial value of assets at the time of exit. The fact that financial value of assets is not the only criteria of measuring firm’s performance as firm’s operating efficiency cannot be tested only with the financial value of assets as there are many cases where firm operating efficiency is high but financial value of assets is high and vice-versa.
Current purchase power accounting: Advantages and disadvantages
The introduction of current purchase power accounting is considered as a revolution and new invention in the field of accounting. This method of accounting is primarily used for removing defects and shortcomings of historical cost accounting. For this, an approved general price index is selected for converting and transforming the value of balance sheet and profit and loss items in present value. In other words, all the items recorded on the basis of historical cost accounting are converted into present value using an approved price index under current purchasing power accounting method. This is done through preparing a supplementary financial statement showing all the historic items on the basis of current market value. The approved price index usually used for converting and transforming historic items on the basis of current market value can be retail price index or wholesale price index.
The most evident advantage of current purchase power accounting is that it takes into account price change factor into consideration. There is also some other advantages like that under this method of accounting, the historic account and financial statements are also kept and maintained. In other words, business firm has the advantage of having both historic as well as new financial statements (Whittington 2003). On the other hand, negatives of current purchase power accounting include difficulty in selecting appropriate general price index. The business firm often face difficulty in selecting suitable price index for converting historic financial items on the basis of market price. Secondly, it is also argued that conversion of historically recorded financial transactions in terms of current market value entail heavy amount of time and effort.
Continuously contemporary accounting: Advantages and disadvantages
This method of accounting rests on the assumption that economic and financial environment of business firm changes constantly. For example, inflation, fluctuation in exchange rates, variation in price levels, and technological innovations bring simultaneous changes in the valuation of financial items and transactions. The underlying accounting method calculates and determines the value of assets in light of changing purchasing power of money.
In simple terms, assets and balance sheet items are calculated and valued on the basis of current cash price in this accounting method. For instance, net realisable value of asset if sold presently in current market conditions and environment. The main purpose of continuously contemporary accounting is to assist and help business firm in arriving at most feasible and practical decision. It is evident as awareness and knowledge among business firm regarding current case price of assets surely assist and help in arriving at best possible decision. In this regard, continuously contemporary accounting leads business firm to determine and calculate predicative selling prices of assets in order to calculate and arrive at profit figures likely to earn by the business firm on account of selling those asset in the market (Nobes 2007).
The strengths of continuously contemporary accounting method are that it is easier and convenient in adopting and implementing in balance sheets and financial statements. It is said that this accounting method always make managers and other strategic personnel of business firm aware regarding predictive purchasing and selling prices of assets. The awareness and knowledge regarding predictive selling prices enable business firm to arrive at most feasible and practical decision thereby allowing the firm to make best use of emerging market opportunity and business trends. The estimates and calculated figure under continuously contemporary accounting is also considered more accurate and realistic by the shareholders as it provides assessment of assets on the basis of current cash price.
On the other hand, adoption and implementation of continuously contemporary accounting also suffers from various limitations and drawbacks. The first set of limitation relates with its change and shift required in prevailing accounting practices. In detailed terms, accounting practices of majority of business firms are based on cost based system i.e., entering and recording assets and financial transactions on the basis of cost incurred in purchasing them. In other words, current cash price is often ignored by the business firm at the time of recording and preparing financial statements. In this context, implementation of this accounting method require business firms to calculate current cash price of all the assets and thereby increasing amount of time and resources entailed in it.
Conclusion & recommendation
On the basis of above discussion, it can be said that each and every accounting method has its own significance and implication. Every accounting method is suitable for implementation in different conditions and environmental settings. It can be recommended that current purchasing power accounting is most suitable option and alternative for business firms. There are some reasons and factors behind considering it as the most suitable option and alternative.
Firstly, it will offer the business firm knowledge, awareness and availability of both historical prices as well as prevailing market prices. Secondly, business firm can easily compare the historical and current market prices on account of having supplementary and main financial statements. In other words, the main financial statement will contain originally recorded historic prices while supplementary financial statement will contain market prices of assets (Greuning & Koen 2001).
On this basis, business firms can easily compare, evaluate and arrive at best possible decision. Besides, this accounting method improves effectiveness of decision making of managerial authorities. This is so because managers and authorities can easily compare historic and current market price of assets and balance sheet items and thereby can formulate financial plans and polices accordingly.
Ahmad, M.R. 2012. Inflation Accounting Practices in India’s Corporate Sector. Atlantic Publishers & Dist.
Debarshi, B. 2009. Financial Statement Analysis: For University of Calcutta. World Bank Publications.
Delaney, P.R. & Whittington, O.R. 2010. Wiley CPA Exam Review 2011, Financial Accounting and Reporting, Volume 3. John Wiley and Sons.
Dutta. 2010. Cost Accounting: Principles And Practice. World Bank Publications.
Greuning, H.V. & Koen, M. 2001. International Accounting Standards: A Practical Guide. World Bank Publications.
Nobes, C. 2007. Introduction to Financial Accounting. Cengage Learning EMEA.
Schroeder, R.G. 2011. Financial Accounting Theory and Analysis: Text and Cases. John Wiley and Sons.
Walton, P. & Aerts, W. 2006. Global Financial Accounting and Reporting: Principles and Analysis. Cengage Learning EMEA.
Whittington, G. 2003. Inflation Accounting: An Introduction to the Debate. Cambridge University Press.
Zack, G.M. 2009. Fair Value Accounting Fraud: New Global Risks and Detection Techniques. John Wiley and Sons.