discuss why the historicalcost accoutning model may not prov

discuss why the historical-cost accoutning model may not provide descision-relevant information in an inflationary enviroment

Solution

First we should discuss the inflationary environment. Then we will understand the historical cost accounting model. After the understanding of both concepts, we will look into the compatibility of historical cost accounting model from decision making point of view in case of inflationary environment.

The inflationary environment is nothing but a situation where the value of nation’s currency goes down. Such reduction in currency value results into the increase in prices of products or services. That means you need to increase amount of money to get same level of services or quantity goods than that of earlier period.

Historical cost accounting which is also known as conventional accounting, is such method of accounting under which the recoding of transaction take place on prices that are generally the result of arm’s length transactions, i.e. historical amount of money exchanged for that transaction. As the recording of transaction takes place on original cost basis, the resulting Balance sheet, Profit and loss account are also represent the historical amount of money.

One of the basic assumption of historical cost method is Nil or very low rate of inflation. But in inflation environment the value of currency decrease, which leads to conflicting situation that of basic assumption. There is difference in current costs and historical cost like, depreciation charge for years is on historical cost basis, and the depreciation fund accumulated may not be equal to new asset requirement to purchase at the time of retirement of asset. The old stocks and assets utilization leads to under reporting of costs and overstatement of profit.   

These are the things which lead not to providing decision relevant information by historical cost accounting model in case of inflationary environment.