CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND OF THE STUDY
Inflation is the general rise of prices in the economy as a result of an excessive supply of money. Inflation is measured as the change in purchasing power of Dollar. Glenn and Daniel (1987; 854).
Inflation is persistent in the economy today. Price inflation has affected company accounts to a great extent because it reduces the real valve of money overtime.
Inflation is relevant to company accounts in a number of ways. The phenomenon which gives rise to increase in price level makes the information on most financial reports deviate from what the person who prepared it had in mind.
Financial accounting reports should give a true and fair view of transactions that had taken place in an establishment while guiding management to a better decision for better performance. The stewardship of management is measured based on their performance as disclosed in financial statement.
Investors, Creditors, Shareholders, Employees and Government are all interested in the operation of any business enterprise. They can measure performance by a true and fair view of a financial statement which is almost impossible by the effect of inflation on these reports. Most account have been prepared according to Historical Cost Convention which means that items are recorded in the accounts at their historical cost. Similarly, the cost of goods are recorded in the account at their historical cost, and profit is calculated accordingly.
In a stable economy, prices are not expected to change in a shortrun and as a result items recorded on Historical Cost bases provides objective true and fair view of business. In the present dispensation when the entire world has found herself in a continued menace of price changes, historical cost accounting has become unrealistic (Aroh 1990: 23). Though it is not always easy to measure the rate at which movement occurs, and even to where it could be measured , it is not easy to continue adjusting.
Corporate organizations are involved. This means that a company might be making a profit on its trading operation after changing depreciation while being unable to generate enough funds internally to replace worn out fixed assets. The loss of operating capacity within the company would not be apparent from either the balance sheet or the profit and loss account (Ezejelue,1990:37).
Fixed assets deprecation, the cost of sale and funds for working capital are three aspects of accounting in historical cost account fail to provide the users of accounts with satisfactory information because of inflation: Historical cost accounting tends to overstate operating profit in the sense that if a company distribute all of its reported profit after tax as dividend to shareholders, it will be left with inadequate funds in the business to sustain operations at the same level as before at least, not without borrowing heavily or issuing new shares to raise more capital
With the profit figure remaining very high due to under valuation of stock and under depreciation of fixed assets, there is every tendency for employees to demand for higher wages.
High profit declaration of course attracts high taxes and the shareholders of such company will expect high dividends. In effect, investors and all users of financial information are misguided by financial reports rendered in such situations.
Stemming from the above. It is necessary to incorporate current values into financial data i.e. current cost accounting. Wood and Sangster (1999: 457).
Ezeugwu (1999:179) maintained that historical cost accounting has the following advantages
- Depreciation represents the original cost of the asset, the actual cost represents the sacrifice involved in purchasing the assets, so charging depreciation is the recovery of original cost and therefore those that advocate recovering replacement cost are guilty of distortion of a fundamental accounting principle.
- Calculation or estimation of replacement cost is besets with difficulties. There is no generally accepted method of ascertaining what replacement cost should be .There is even confusion on which year should be taken as a basis for calculating replacement cost; should it be the current year being dealt with or should it be the actual year in which the asset is to be replace? The year of replacement is more realistic but none is ever certain of the exact time to fixed asset is to be replaced if current year’s replacement cost is taken for total depreciation (i.e. original cost plus additional cost of replacement) there is a real danger that the amount charged will be smaller or larger than the final replacement.
- Use of current cost accounting reduces the changeable profit and hence favours the companies more. This is because those companies will be paying less tax based on the profit calculated by considering current cost. When companies are taxed on profit arrived at by reference to historical cost then they are paying a level on part of the capital.
Furthermore, current cost accounting has the following disadvantages:
- The use of replacement cost does not really solve the problem of matching current cost of fixed asset to current prices. This is because with frequent technological change more advanced type of asset are used and you cannot match the cost of the old asset being replaced.
- Where revaluation accounting is used the profit, the depreciation change and the value of the assets are not acceptable to the taxing authorities for the purpose of determining tax liabilities. If the purpose of preparing accounts is for tax liability using revaluation accounting is unnecessary since the tax authorities will reject it.
- If revaluation accounting is carried to extremes all assets and liabilities are converted to common monetary units and this entails tremendous amount of work. In addition many complexities are introduced into an already complicated subject. Ezeugwu (1999:180).
1.2 STATEMENT OF PROBLEM
Historical cost accounting fails to adequately account for the impact of changing prices. Sometimes, this failure makes the statement misleading thereby leading to over statement of Net Profit and under valuation of Net Assets of companies.
The consequences of the above failure can be seen in the following areas:
- Value of Assets: The reported value of assets in the balance sheet will be unrealistic. This may lead to:
- Inadequate provision for replacement of assets.
- the real value of the firm may be understated
- Undervaluation of fixed assets with a long span.
- Cost of sales: The cost of sales will be understated since historical cost accounting fails to provide replacement of items sold.
The researcher want to investigate the impact current cost account will have on quoted companies if they start it against the normal historical cost accounting that have been in use.
Therefore, this study the Impact of current cost accounting on profit declaration and net asset valuation is an attempt to study:
- Whether historical cost accounting approach of preparing financial statement contributes to over statement of profit declared by companies.
- If the true and fair view of the financial statement is distorted by the use of historical cost accounting method and
- If the use of current cost accounting approach will present a more realistic picture of Net Asset at the end of each year.
1.3 HYPOTHESIS
- There is no significant difference between profit declared using historical cost accounting method and that declared using current cost accounting method.
- There is no significant difference between net asset value calculated using historical cost accounting method and that calculated current cost accounting method.
- SIGNIFICANCE OF THE STUDY
The significance of this study is to highlight the consequence of not taking into consideration the current cost accounting method in the accounting of an organization during rapid price rises. This is also intended to be of immense benefit to the following classes:
- Government, companies, Employees, shareholders, and students of accountancy will find this research useful as it will go a long way in solving some problems encountered by these group of people encountered by these groups of people in the area of study.
- Employees / Shareholders will understand better the report profit and how it reflects current price level. This will serve as a guide before agitating for higher wages as well as declaring of dividend.
- Management decision will be more meaningful if the perspective upon which financial statements are valued reflect current prices.
- SCOPE OF THE STUDY
This research is principally determine the impact of Current Cost Accounting (CCA) on profit declared in the profit and loss account and net assets value in balance sheets, the effects it will have on quoted companies. It will also touch on other inherent problems created in financial reports and attempts to proffer solutions. Some selected public companies (from quoted companies) in Enugu state will be covered in this work and four establishments will be studied.
Downwards trend of prices, otherwise known as deflation will not be considered in this work