How can historical cost accounting mislead users of financial statements

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Table of Contents

1.0 Introduction: Page Number

1.1 Partnership..........................................................................................................2

1.2 Cash Flow...........................................................................................................2

2.0 Literature Review:

2.1 Historical.............................................................................................................3

2.2 Cash Flow Statement..........................................................................................3

2.3 Intangible Assets.................................................................................................3

Scenario:

Summarised Income Statement......................................................................................4

3.0 Task 1:

3.1 Nicolex’s Cash Flow Statement..........................................................................5

4.0 Task 2:

4.1 The way in which the use of historical cost accounting may

mislead users of financial statements.........................................................................6

4.2 Reason why historical cost accounting remains in use in

spite of its limitation...................................................................................................6

4.3 Procedure to follow while valuing intangible assets............................................8

Conclusion...................................................................................................9

References...................................................................................................10

1.0Introduction

1.1Partnership

A partnership is a business run by two or more persons who agree to contribute assets to the business and share in the profits and losses. Since there are two or more owners, separate capital accounts are maintained for each owner and special journal entries are required to account for withdrawals, distribution of income, introduction of new partners, and retirement of partners and liquidation of the partnership. Partnerships are common in the same services provided by sole traders but a partnership would have the advantage of being able to raise more money because each partner could make a financial contribution. The liability for any debts of the business would be the partners.

1.2Cash Flow

A statement of cash flows is a financial statement which summarizes cash transactions of a business during a given accounting period and classifies them under three heads, namely, cash flows from operating, investing and financing activities. It shows how cash moved during the period by indicating whether a particular line item is a cash in-flow or a cash out-flow.

2.0Literature Review

2.1Historical Cost

Historical cost is a term used instead of the term cost. The term historical cost helps to distinguish an asset's original cost from its replacement cost, current cost, or inflation-adjusted cost. Accounting is concerned with past events and it requires consistency and comparability that is why it requires the accounting transactions to be recorded at their historical costs. This is called historical cost concept.

2.2Cash Flow Statement

A statement of cash flows is a financial statement which summarizes cash transactions of a business during a given accounting period and classifies them under three heads, namely, cash flows from operating, investing and financing activities. It shows how cash moved during the period by indicating whether a particular line item is a cash in-flow or a cash out-flow.

Cash flows in the statement are divided into the following three areas. Firstly, cash flows from Operating Activities which this section includes cash flows from the principal revenue generation activities such as sale and purchase of goods and services. Secondly, cash flow from Investing Activities which it related to activities that are intended to generate income and cash flows in future. Lastly, cash flow from Financing Activities which it flows related to transactions with stockholders and creditors such as issuance of share capital, purchase of treasury stock, dividend payments.

2.3Intangible Assets

Intangible assets are either acquired in a business combination or developed internally. In case of acquisition in a business combination such assets are recorded at their fair value, while in case of internally generated intangible assets the assets are recognized at the cost incurred in development phase. In relation to the development of internally generated intangible assets there are two phases such as research phase and development phase. All costs in research phase are expensed in the period incurred while costs incurred in development phase are capitalized. For example, goodwill, patents and copyrights.

Scenario:

Summarised Income Statement

Workings

Non-Current Assets- Cost

Opening balance

8000

Disposal

800

Revaluation reserve

500

Cash (balancing figure)

3300

Closing balance

11000

11800

11800

Non-Current Assets- Depreciation

Disposal

450

Opening balance

4800

Closing balance

5600

Income statement

1250

6050

6050

Non-Current Assets- Disposal

Cost

800

Depreciation

450

Profit on sale

150

Cash

500

950

950

3.0Task 1

3.1Nicolex’s Cash Flow Statement

Nicolex

Cash flow statement for the year ended 31 December 2013

Cash flow from operating activities

Net profit before taxation

2350

Adjusted for:

Depreciation

1250

(-)Profit on sale of plant

(150)

Interest expenses

300

Operating profit before working capital changes

3750

Decrease in inventories

400

(-)Increase in receivables

(900)

Increase in payable

500

Cash generated from operations

3750

(-)Interest paid

(300)

(-)Income taxes paid

(600)

2850

Cash flow from investing activities

Purchase of non-current assets

(3300)

Proceeds of sale of non-current assets

500

Net cash used in investing activities

(2800)

Cash flow from financing activities

Proceeds of issue of loan notes

1000

(-)Dividends paid

(750)

Net cash from financing activities

250

Net increase in cash

300

Cash at 1 Jan 2013

100

Cash at 31 Dec 2013

400

4.0Task 2

4.1The way in which the use of historical cost accounting may mislead users of financial statements

Ignoring general price level changes in financial reporting creates distortions in financial statements may mislead users such as reported profits may exceed the earnings that could be distributed to shareholders without impairing the company's ongoing operations, the asset values for inventory, equipment and plant do not reflect their economic value to the business future earnings are not easily projected from historical earnings, the impact of price changes on monetary assets and liabilities is not clear, future capital needs are difficult to forecast and may lead to increased leverage, which increases the business's risk and when real economic performance is distorted, these distortions lead to social and political consequences that damage businesses, for examples poor tax policies and public misconceptions regarding corporate behaviour.

4.2Reason why historical cost accounting remains in use in spite of its limitation

1. Historical cost is relevant for making economic decisions

Historical cost affects the evaluation and selection of decision rules. To determine which decision rules to use, managers need information about the quality of their past decisions. Historical cost is directly related to past decisions. Thus, historical cost is an important input for such cases. Historical cost is used because it is imposed on the decision maker by his environment. The fact that historical cost is employed in many different contexts, such as taxable income and cost-plus contracts, cannot be denied.

2. Historical cost is less subject to manipulation

Historical cost is based on actual, not merely possible, transactions. It is the acquisition price of the assets. The managers only have to record all the assets and liabilities at their acquisition price. Historical cost is therefore basically verifiable. Thus, this minimises the risk of manipulation of figures by the managers.

3. Historical cost is useful for control purposes

In conventional accounting, the objective of accounting is seen as involving mainly the stewardship function of management. Income is the essential measure of that function. The income statement provides the evidence for determining how effective management has met its responsibilities.

4. Historical cost survives test of time

Historical cost has survived the test of time. Most users of accounting data believe that accounting income is useful and that it constitutes a determinant of the practices and thought patterns of decision makers.

Some criticism, Historical cost is not relevant for decision making. Historical cost has usefulness, but it is insufficient for the evaluation of business decisions. The focus of conventional accounting on the stewardship function of accounting is not the only focus of accounting. The history of accounting reveals that the primary role of accounting is to meet the needs of users of accounting information. Users of accounting information are not only interested in the stewardship function, but also in increases and decreases in the value of their investments as represented by the net assets of the company. Then, Historical cost accounting is misleading the implementation of the historical cost concept can be misleading, meaning that it cannot guarantee the quality of justice and honesty within the information it carries.

4.3Procedure to follow while valuing intangible assets

1. Company, Industry and Market

Market size and prevailing economic conditions can help indicate how much market share the property can obtain for the company and how long obtaining that market share is likely to take.

2. Income and Revenue

Next, a valuator tries to project how much income and revenue a company will realize from the intangible asset during its estimated useful life. In performing this projection, the valuator tries to come up with economic income rather than accounting income.

3. Benefit Base

The benefit base is the likely economic return from the intangible asset. To do so, the valuator looks at the operational income the company can expect to bring in because of the property, taking into account expected royalty rates, cost savings or excess income associated with the property.

4. Fair Market Value

The rate should account for the risk associated with the returns. A greater risk produces a higher rate and a lower value for the intellectual property.

Conclusion

We can conclude that cash flow statement have three activities such as cash flow from operating activities, cash flow from investing activities and cash flow from financing activities which their have own function that can be use by user to do some financial statement.

References

http://accountingexplained.com/financial/principles/historical-cost

http://accountingexplained.com/financial/non-current-assets/intangible-assets

http://www.accountingcoach.com/terms/C/cash-flow-statement

http://accountingexplained.com/financial/partnerships/

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