Accounting Thoery

Chapter 4 - Normative Accounting Theories

The case of accounting for changing price

There are various prescriptive theories of accounting that were advanced by various people on the basis that historical cost accounting has too many shortcomings, particularly in times of rising prices. Page 83 Chapter 4

1. Historical cost accounting in times of rising prices

Historical cost accounting assumes that money holds a constant purchasing power. (Page 84)

As Elliot states:

“An implicit and troublesome assumption in the historical cost model is that the monetary unit is fixed and constant over time.

Argument for the limitation:-

However, there are three components of the modern economy that makes this assumption less valid than it was at the time the model was developed.”

• One component is specific price-level changes, occasioned by such things a technological advances and shifts in consumer preferences;

• Second component is general price-level changes(inflation); and

• Third component is the fluctuation in exchange rates for currencies.

Thus, the book value of a company, as reported in financial statements, only coincidental reflects the current value of assets. (Page 84 of Financial Accounting Theory – Deegan)

As we would appreciate, the method of accounting predominantly used today is based on historical cost accounting. The very fact that historical cost accounting has continued to be applied by business entities has been used by a number of academics to support its continued use.

Chapter 4 - Normative Accounting Theories

1. Historical cost accounting in times of rising prices (cont)

Point to note:

1. It has been argued that historical cost accounting information suffers from problems of relevance in times of rising prices. At issue is whether it is really logical to add together assets acquired in different periods when those assets were acquired with dollars of different purchasing power. (page 85)

2. There...