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Chapter 5

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ACCT 301
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Chapter 5 Traditionally, accounts were prepared to fulfill the needs of the owners of the business and to assist the managers’ for the business to make decisions about the future. Yet, it was later made clear that the accounts prepared under the historical cost convention provided misleading information because of the inability to reflect the changing price levels. Examples 1. When property appreciates in value, the historical cost convention which values it at its purchase cost wouldn’t reflect its true and fair value. This means that unrealized holding gains are not recognized until the period in which the asset is realized, rather than spread over the period during which it was owned. 2. Depreciation based on a Fixed Assets Historical Cost may be inadequate to finance the replacement of the Fixed Asset if the appreciation in value is larger than the depreciation charged! 3. Furthermore, the depreciation charge wouldn’t fully reflect the value of the asset consumed during the accounting period. 4. The following example applies to stock appreciation during a period of inflation. During Inflation No Inflation Sales (100 Units) $ 500 $ 500 Less: Cost of Sales Opening Stock (100 Units) $ 200 $ 200 Purchases (100 Units) $ 200 $ 200 Closing Stock (100 Units) ($300) ($100) ($200) ($200) Gross Profit $ 400 $ 300 Basically, the trading account above compares the gross profit of a certain company at two different accounting periods, one being inflationary whilst the other excludes inflation. At the beginning of the year the trader had 100 units of stock at a cost of $200, during the year the trader purchased 100 units at a cost of $200, and at the year end, the Historical Cost of the 100 units remaining after the sale of $100 units is $300 due to the appreciation in stock, and thus, inflating profit by $100. 5. HCA ignores any holding gains or losses of net monetary
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