Capital Maintenance Method in Accounting
Added on 2019-11-20
9 Pages2774 Words262 Views
Finance
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Accounting
Part AHistorical CostThe historical cost method is adopted by IFRS for measurement basis of its financialinstruments such as assets, liabilities and equities. The main objective of general purposefinancial reporting as per the IFRS framework is to present all the relevant and usefulinformation to the potential investors. As per this, the concept of ‘stewardship’ in historic costmodel refers that the measurement basis adopted by a business entity needs to provide all theinformation regarding its resources to the primary users for effective decision-making(Conceptual Framework for Financial Reporting 2010, 2010). The method of historic costing isbased on recording the value of assets at their original purchase price. The profit is important inthe model as the method of historic cost reflects the actual profit realized by an entity without incomparison to the investment incurred in purchasing the assets without undertaking the inflatedadjusted market value of the assets. The model incorporates the use of matching and costconcepts in determination of profits by ensuring that expenses incurred by a business entity arerelated to the profit realized in the same accounting period in the income statement (McWattersand Zimmerman, 2015). The net worth of a business entity reflects the assets owned by it by deducting all itsliabilities. However, in historic cost model do not reflect the current market valuation and thus itdoes not determine the fair value of assets and therefore is inappropriate in predicting the actualnet worth of a business entity. The model incorporates the use of fixed capital method underwhich the cost of fixed assets remains constant throughout without taking into account itsdeprecation or other market value changes. The main valuation issue under the approach ofhistorical costing is that it records unrealistic value of fixed assets. This is because the methoddoes not have any provision for measuring assets depreciation and as such income statementdeveloped with the use of historic costs does not depict actual profitability. However,, themethod is being widely used by business entities for recognizing and measuring the value oftheir assets. The main reason for the dominance of this model as compared to other costingapproaches is that historic costs recorded for fixed assets on balance sheet can be easily verified.This is due to documentation of the costs at the time of purchasing the assets through the help ofinvoices, payments and other such evidences. The historic costs of the assets remain unaltered
during the end of an accounting period and thus can depict the actual profit realized by abusiness over the use of its fixed assets in relation to the cost incurred during its purchase(Hirschey, 2008). The major drawback of the historic cost method is that it does not meet the demands ofend-users of financial reports who want to analyze the actual profitability of a business entity inrelation to the current values of assets. The financial reports developed through the use ofhistoric cost principle only depict the historical facts and fails to present the actual financialposition of a business entity. However, the method of historical costing is less subjected tomanipulation as compared to other accounting methods. This is because of the fact that othermethods of costing such as fair value and replacement costing although reflects the real price ofassets but are often subjected to manipulation. The methods used in determining the fair value ofassets and liabilities are more subjective and thus the value obtained is less reliable as comparedto historic cost approach. The biasness on the part of the management can also result ininappropriate measurement of assets and liabilities values. The manipulation is not all possibleunder the historic cost approach as the data is supported by evidences such as invoices andreceipts made at the time of assets purchases. As such, the less risk associated with the use ofhistoric cost method helps in increasing the confidence of investors by improving thetransparency in business operations. Therefore, it can be said that historic cost model is a morereliable accounting method used by businesses for valuing their assets and liabilities in thepresent competitive business environment also (Hirschey, 2008). Positive Accounting TheoryThe term positive accounting theory reflects a branch in academic accounting researchthat finds application in understanding and estimating the accounting principles and practices.The theory emphasizes on implementing the predictions obtained from real world situations intoreality in the accounting transactions. It tries to provide an explanation to the accounting policiesselected by a firm under a given set of conditions (Riahi-Belkaoui, 2004). The theory helps thebusiness entities to develop a proper understanding of the actual accenting events and thenpredicting the methods for addressing such situations. On the other hand, the theory of normativeaccounting provides suggestions to the business entities on the basis of theoretical principlesrather than emphasizing on the actual market conditions impacting their operations. As such, the
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