Financial reporting - Assignment Example

Financial statements, prepared on the basis of historical cost accounting method, do not provide a fair and true presentation of equity’s performance or future prospects, if capital is inadequately maintained (Charnes, 1976). Moreover, critical assessment of equity’s performance by studying ratios, such as, return on capital employed, will be useless if capital is undervalued, profit is overstated and values of assets are misinterpreted. These sometimes occur because of historical cost accounting.

The limitations have been summarized as follows: Overestimating and valuing profits by undercharging depreciation on the basis of historical cost and recording sales cost at original cost of inventories, may result in the reduction of an entity’s capital because of high taxation charges and distribution (Belfo and Trigo, 2013). This accounting approach toughens the task for analysts and shareholders of evaluating and assessing the ability and performance of management. This is precisely because variations in the situation of the current market are not considered in historical valuation approach.

Then, owner of the entity tried to restock his inventory and realized that the cost of replacement was $2,200. They did not have enough cash to restructure to the pre-sale condition. The difficulty escalated due to the fact that the owner was unable to differentiate between the profits generated from holding the inventory for a particular time period before selling it and the revenue that was generated through trading. Had the company matched the cost of replenishment against revenue, they would have realized a profit of $300.

If this excess proceed had been withdrawn, it would have left the company with $2,200, which could be used for the purpose of inventory replacement. Thus, this example suggests the fact that historical accounting can be misleading to the user of the information (Bakar and Said, 2007). The application of general price index under this method is