THE EFFECT OF HISTORICAL COST ACCOUNTING ON THE REPORTED PROFIT OF A COMPANY: AN EVALUATION OF CURRENT COST ACCOUNTING AS AN ALTERNATIVE REPORTING METHOD

CHAPTER ONE: INTRODUCTION

1.1 Background to the Study

Historical cost accounting (HCA) is the traditional method of valuing assets and recording transactions based on their original acquisition cost. Under this system, assets are recorded on the balance sheet at the price paid at the time of acquisition, and depreciation is calculated based on that historical cost. Similarly, revenues and expenses are recorded at their transaction prices. Historical cost accounting has been the dominant accounting method for centuries due to its objectivity, verifiability, and reliability. The historical cost principle is deeply embedded in accounting standards, including International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP), although these standards also permit or require other measurement bases for certain assets and liabilities (Kieso, Weygandt, and Warfield, 2019; Horngren, Sundem, and Stratton, 2018).

The primary advantage of historical cost accounting is its objectivity and verifiability. Historical cost is based on actual transactions supported by invoices, receipts, and other documentary evidence, making it difficult to manipulate. Auditors can easily verify historical cost, enhancing the credibility of financial statements. Historical cost also provides consistency and comparability across time periods and across companies, as all entities use the same cost basis (Drury, 2020; Penman, 2018).

However, historical cost accounting has significant limitations, particularly during periods of inflation (rising prices). Under historical cost accounting, assets are reported on the balance sheet at outdated, low values, while their economic value (current replacement cost) may be much higher. Depreciation is calculated based on historical cost, leading to understated depreciation expense and overstated profit. Cost of goods sold (COGS) is based on historical purchase costs (often using FIFO or weighted average), which may be significantly lower than current replacement costs, leading to understated COGS and overstated profit. As a result, reported profit under historical cost accounting may not reflect the true economic profit of the company, leading to misleading financial statements (Edwards and Bell, 1961; Chambers, 1966; Sterling, 1970).

The overstatement of profit under historical cost accounting during inflation has several adverse consequences. Companies may pay taxes on illusory (fictitious) profits (tax on holding gains, not real operating profits). Dividends may be paid out of capital (since reported profit exceeds real economic profit), eroding the company’s capital base. Managers may make suboptimal decisions based on distorted profit figures. Investors may be misled into overvaluing the company (Penman, 2018; Tweedie and Whittington, 1984).

Current cost accounting (CCA) was developed as an alternative to historical cost accounting to address the limitations of HCA during inflation. Under current cost accounting, assets are valued at their current replacement cost (the cost of acquiring an equivalent asset today) rather than historical cost. Depreciation is calculated based on current replacement cost, providing a more realistic measure of asset consumption. Cost of goods sold is based on current replacement cost of inventory, providing a more realistic measure of the cost of goods sold. Holding gains (gains from holding assets during periods of price increases) are separately identified and disclosed, often in a separate statement (current cost income statement) or in equity (revaluation reserve). The objective of CCA is to report “operating profit” (profit from trading activities after maintaining operating capability) separately from “holding gains” (gains from price changes that could be distributed without eroding capital) (Edwards and Bell, 1961; Chambers, 1966; Sandilands Committee, 1975).

The theoretical justification for current cost accounting is based on the concept of capital maintenance. Under historical cost accounting, capital is maintained if the nominal amount of net assets at the end of the period equals or exceeds the nominal amount at the beginning of the period (financial capital maintenance). However, during inflation, maintaining nominal capital does not maintain the physical productive capacity of the business (physical capital maintenance). Under physical capital maintenance (current cost accounting), profit is recognized only after maintaining the operating capability of the business (i.e., after providing for replacement of assets at current prices). This concept of profit is considered more relevant for assessing the long-term viability of a business (IFRS Foundation, 2021; IASB, 2018).

Several countries have experimented with current cost accounting or inflation accounting. The United Kingdom required large companies to disclose current cost accounts as supplementary information from 1980 to 1988 (SSAP 16). The United States required large companies to disclose current cost information as supplementary data from 1979 to 1986 (FAS 33). However, both requirements were later abandoned due to complexity, cost of preparation, and lack of user demand. In Nigeria, there has been no mandatory requirement for current cost accounting, although companies may voluntarily revalue assets under IAS 16 (Property, Plant and Equipment) (Whittington, 1988; Tweedie and Whittington, 1984).

The debate between historical cost and current cost accounting has resurfaced in recent years due to concerns about asset valuation (relevance vs. reliability) and the impact of inflation on financial statements. IFRS permits (but does not require) the revaluation of property, plant, and equipment (IAS 16), investment property (IAS 40), and intangible assets (IAS 38), which brings some elements of current cost accounting into financial reporting. IFRS also requires fair value measurement for financial instruments (IFRS 9) and investment property under the fair value model. However, most assets (inventory, trade receivables, most property, plant and equipment) remain at historical cost (IFRS Foundation, 2021).

The effect of historical cost accounting on reported profit is particularly significant during periods of high inflation. Nigeria has experienced periods of high inflation (double-digit annual rates) over the past several decades. During such periods, historical cost accounting significantly overstates reported profit because: (a) depreciation is understated (based on old low costs), (b) cost of goods sold is understated (based on old low purchase costs), and (c) holding gains on inventory and fixed assets are not recognized as a separate component (they are included in operating profit). This overstatement of profit leads to higher tax liabilities, potential capital erosion (dividends paid out of capital), and misleading performance metrics (Adebayo and Oyedokun, 2019; Okafor and Udeh, 2020).

The evaluation of current cost accounting as an alternative reporting method requires consideration of several factors:

Advantages of CCA:

• Reports profit after maintaining operating capability (physical capital maintenance), giving a more realistic measure of sustainable profit.
• Depreciation based on current replacement cost provides a more realistic measure of asset consumption.
• Cost of goods sold based on current replacement cost provides a more realistic measure of the cost of sales.
• Holding gains are separately identified, allowing users to distinguish between operating profit (from trading activities) and price changes.
• Provides better information for decision-making (pricing, dividend policy, investment decisions).
• Results in more realistic asset values on the balance sheet.

Disadvantages of CCA:

• Subjectivity: Current replacement cost may be difficult to determine, especially for unique assets or assets no longer available in the market.
• Less verifiable: Current replacement cost is not based on actual transactions, making it harder for auditors to verify.
• Volatility: Current replacement costs may fluctuate significantly, leading to volatile reported profits.
• Complexity: Preparing current cost accounts is more complex and costly than historical cost accounts.
• Lack of comparability: If not all companies adopt CCA, comparability across companies is reduced.
• Potential for manipulation: Management may have discretion in determining current replacement costs, creating opportunities for earnings management (Whittington, 1988; Tweedie and Whittington, 1984).

The evaluation of current cost accounting as an alternative reporting method is an empirical question. This study will examine the effect of historical cost accounting on reported profit and compare it to current cost accounting for a sample of Nigerian companies.

1.2 Statement of the Problems

Historical cost accounting has been the dominant accounting method for centuries due to its objectivity and verifiability. However, during periods of inflation, historical cost accounting significantly overstates reported profit because depreciation and cost of goods sold are understated. This overstatement leads to several problems:

1. Tax on illusory profits: Companies pay taxes on holding gains (gains from price increases) that are not real operating profits. This reduces the company’s capital base and ability to reinvest.
2. Dividends paid out of capital: If companies distribute reported profits (which include holding gains) as dividends, they may be returning capital to shareholders, eroding the company’s ability to replace assets.
3. Misleading performance metrics: Investors and managers may be misled by inflated profit figures, leading to suboptimal investment and operational decisions.
4. Understated depreciation and COGS: Depreciation is based on historical cost, which may be much lower than current replacement cost. COGS based on historical cost (especially FIFO) may be much lower than current replacement cost. This understates expenses and overstates profit.
5. Distorted asset values: Assets on the balance sheet are reported at outdated, low historical costs, not reflecting their current economic value.
6. Lack of distinction between operating profit and holding gains: Historical cost accounting does not separately identify holding gains (gains from price increases). Users may mistake holding gains for operating profit.
7. Limited adoption of current cost accounting: Despite its theoretical advantages, current cost accounting has not been widely adopted due to concerns about subjectivity, complexity, and cost.
8. Lack of empirical evidence in Nigeria: Limited empirical research exists on the effect of historical cost accounting on reported profit and the feasibility of current cost accounting as an alternative in Nigeria.

This study addresses these problems by: (a) analyzing the effect of historical cost accounting on reported profit for Nigerian companies, (b) comparing historical cost profit to current cost profit for a sample of companies, (c) evaluating the advantages and disadvantages of current cost accounting as an alternative reporting method.

1.3 Objectives of the Study

The specific objectives of this study are:

1. To examine the conceptual and theoretical differences between historical cost accounting and current cost accounting.
2. To analyze the effect of historical cost accounting on reported profit during periods of inflation, focusing on depreciation and cost of goods sold understatements.
3. To compute and compare historical cost profit and current cost profit for a sample of Nigerian companies.
4. To determine the magnitude of overstatement (or understatement) of profit under historical cost accounting compared to current cost accounting.
5. To evaluate the advantages and disadvantages of current cost accounting as an alternative reporting method for Nigerian companies.
6. To assess the feasibility of adopting current cost accounting (or elements thereof) in Nigeria.
7. To provide recommendations for companies, regulators, and standard-setters on the use of current cost accounting as a supplementary reporting method.

1.4 Statement of Hypotheses

The following hypotheses are formulated in null (H₀) and alternative (H₁) forms:

Hypothesis One (Depreciation Understatement)

• H₀: Depreciation under historical cost accounting is not significantly lower than depreciation under current cost accounting for Nigerian companies.
• H₁: Depreciation under historical cost accounting is significantly lower than depreciation under current cost accounting for Nigerian companies.

Hypothesis Two (Cost of Goods Sold Understatement)

• H₀: Cost of goods sold under historical cost accounting is not significantly lower than cost of goods sold under current cost accounting for Nigerian companies.
• H₁: Cost of goods sold under historical cost accounting is significantly lower than cost of goods sold under current cost accounting for Nigerian companies.

Hypothesis Three (Profit Overstatement)

• H₀: Reported profit under historical cost accounting is not significantly higher than profit under current cost accounting for Nigerian companies.
• H₁: Reported profit under historical cost accounting is significantly higher than profit under current cost accounting for Nigerian companies.

Hypothesis Four (Dividend Sustainability)

• H₀: Dividends paid by Nigerian companies are not significantly influenced by the overstatement of profit under historical cost accounting.
• H₁: Dividends paid by Nigerian companies are significantly influenced by the overstatement of profit under historical cost accounting.

1.5 Significance of the Study

This study is significant for several stakeholders:

Companies (Management and Boards) : The findings will help companies understand the limitations of historical cost accounting during inflation and the potential benefits of current cost accounting for internal decision-making (pricing, dividend policy, capital investment). Companies may consider preparing supplementary current cost information for internal use.

Investors and Financial Analysts: The study will help investors and analysts adjust financial statements for inflation effects and understand the difference between historical cost profit and current cost profit, enabling better valuation and investment decisions.

Regulators (Financial Reporting Council of Nigeria, SEC) : The findings will inform regulators on the potential need for supplementary current cost disclosures or the adoption of revaluation accounting for certain assets in Nigeria.

Standard-Setters (IASB) : The study contributes to the ongoing debate on measurement bases (historical cost vs. current value) by providing evidence from a high-inflation emerging market.

Tax Authorities (Federal Inland Revenue Service) : The study highlights the potential overtaxation of companies under historical cost accounting during inflation, informing tax policy (e.g., inflation-adjusted tax allowances).

Academics and Researchers: The study contributes to the literature on inflation accounting, current cost accounting, and the relevance of historical cost in high-inflation environments.

Professional Bodies (ICAN, ANAN) : The findings will inform training and CPD programs on inflation accounting and current cost accounting.

The Nigerian Economy: Improved understanding of the limitations of historical cost accounting and the benefits of current cost accounting will lead to better capital allocation, more sustainable dividend policies, and enhanced corporate performance.

1.6 Scope of the Study

This study focuses on the effect of historical cost accounting on reported profit and an evaluation of current cost accounting as an alternative reporting method. The scope is limited to:

Geographical Scope: Nigeria, with a sample of Nigerian companies from various sectors (manufacturing, banking, consumer goods, oil and gas, conglomerates).

Time Period: The study period covers recent years (e.g., 2018-2023) when Nigeria experienced significant inflation (double-digit rates). Historical data from earlier periods may also be used for inflation adjustment.

Companies: A sample of listed companies on the Nigerian Exchange Limited (NGX) and potentially unlisted companies with available data.

Assets: Focus on property, plant and equipment (PPE) and inventory (the two major asset classes most affected by inflation). Financial assets and liabilities are excluded unless fair value measurement is relevant.

Inflation Measurement: Inflation rates from the National Bureau of Statistics (NBS) or other sources are used to adjust historical costs to current costs.

Performance Measures: Focus on reported profit (operating profit, profit before tax, profit after tax), depreciation, cost of goods sold, and dividends.

Reporting Method: Comparison of historical cost accounting and current cost accounting, but does not include other inflation accounting methods (e.g., general price level accounting, CPP) except for comparison.

1.7 Limitations of the Study

This study acknowledges several limitations:

1. Data Availability: Access to detailed historical cost data (purchase dates, original costs, useful lives) for property, plant, and equipment may be limited. Companies may not disclose sufficient detail to compute current cost depreciation accurately.
2. Replacement Cost Estimation: Determining current replacement cost for unique assets (e.g., specialized machinery) or assets no longer available in the market may require estimates and assumptions, introducing subjectivity.
3. Inflation Indices: The choice of inflation index (consumer price index CPI, producer price index PPI, industry-specific indices) may affect the results. Different indices may produce different current cost estimates.
4. Sample Size: The sample may be limited by data availability; not all listed companies may provide sufficient disclosures.
5. Time Period: The study period may not capture the full effect of inflation if inflation rates vary significantly over time.
6. Generalizability: Findings may not be generalizable to all Nigerian companies (e.g., small private companies, companies in low-inflation periods).
7. Complexity of CCA: Full current cost accounting requires adjustments for many asset and liability categories; this study may focus on major categories (PPE, inventory) and may not fully implement all aspects of CCA.
8. Lack of Mandatory CCA in Nigeria: Since CCA is not mandatory, companies do not prepare current cost accounts; the study will compute current cost profit based on available data and reasonable assumptions.

Despite these limitations, the study aims to provide robust, meaningful insights into the limitations of historical cost accounting and the potential benefits of current cost accounting for Nigerian companies.

1.8 Definition of Terms

Historical Cost Accounting (HCA) : An accounting method where assets are recorded on the balance sheet at their original acquisition cost, and depreciation and cost of goods sold are based on historical cost. Revenues and expenses are recorded at transaction prices.

Current Cost Accounting (CCA) : An accounting method where assets are valued at their current replacement cost (the cost of acquiring an equivalent asset today), and depreciation and cost of goods sold are based on current replacement cost. Holding gains are separately identified.

Reported Profit (Historical Cost Profit) : Profit reported in the income statement under historical cost accounting, calculated as revenue minus expenses (including depreciation and COGS based on historical cost).

Current Cost Profit (Operating Profit) : Profit calculated under current cost accounting, where depreciation and COGS are based on current replacement cost. Holding gains are excluded from operating profit.

Holding Gain: The gain (increase in value) from holding assets (inventory, property, plant, and equipment) during a period of price increases. Holding gains are not realized (operating) profits; they represent an increase in the replacement cost of assets.

Realized Holding Gain: A holding gain that is realized when the asset is sold. Under current cost accounting, realized holding gains are often transferred from revaluation reserve to retained earnings.

Capital Maintenance: The concept that profit should be recognized only after maintaining the capital of the business. Under financial capital maintenance (historical cost accounting), capital is maintained if nominal net assets at the end of the period equal or exceed nominal net assets at the beginning. Under physical capital maintenance (current cost accounting), capital is maintained if the operating capability (productive capacity) of the business is maintained.

Depreciation: The systematic allocation of the cost (or revalued amount) of property, plant, and equipment over its useful life. Under HCA, depreciation is based on historical cost; under CCA, depreciation is based on current replacement cost.

Current Replacement Cost: The cost of acquiring an equivalent asset at current prices (at the balance sheet date or average for the period). For inventory, it may be the purchase cost of the same goods; for PPE, it may be the cost of a similar new asset adjusted for age and condition.

Cost of Goods Sold (COGS) : The direct costs attributable to the production of goods sold, including materials, labor, and overhead. Under HCA, COGS is based on historical purchase costs (FIFO, weighted average, etc.); under CCA, COGS is based on current replacement cost of inventory.

Inflation: A sustained increase in the general price level of goods and services in an economy over time. High inflation significantly affects the relevance of historical cost accounting.

Revaluation of Assets: An accounting policy permitted under IAS 16 (PPE) and IAS 40 (investment property) where assets are carried at revalued amount (fair value) less subsequent depreciation. Revaluation brings elements of current cost accounting into financial statements.

Revaluation Reserve: An equity account (other comprehensive income) where unrealized holding gains from asset revaluation are recorded. When the asset is sold or depreciated, the revaluation reserve is transferred to retained earnings (realized).

Physical Capital Maintenance (Operating Capability) : The concept that profit is recognized only after maintaining the physical productive capacity (operating capability) of the business. This is the basis for current cost accounting.

Financial Capital Maintenance (Nominal Capital) : The concept that profit is recognized after maintaining the nominal amount of net assets (financial capital). This is the basis for historical cost accounting.

Inflation Accounting: A broad term encompassing various methods (current cost accounting, general price level accounting, constant purchasing power accounting) that adjust financial statements for the effects of inflation.

Constant Purchasing Power (CPP) Accounting : An alternative inflation accounting method that restates historical cost financial statements in terms of a constant purchasing power unit (e.g., end-of-period Naira) using a general price index (e.g., CPI). Unlike CCA, CPP does not use replacement costs.

Relevance: A qualitative characteristic of financial information; information is relevant if it can make a difference in users’ decisions. Current cost accounting is considered more relevant during inflation because it provides current values.

Reliability (Faithful Representation) : A qualitative characteristic of financial information; information is reliable if it is verifiable, neutral, and free from material error. Historical cost accounting is considered more reliable because it is based on actual transactions.

Verifiability: The ability of different knowledgeable observers to reach consensus that information is faithfully represented. Historical cost is more verifiable than current cost.

Subjectivity: The degree to which information depends on management estimates and judgments. Current cost accounting involves more subjectivity than historical cost accounting.

IAS 16 (Property, Plant and Equipment) : The IFRS standard that permits (but does not require) the revaluation of property, plant, and equipment to fair value, with revaluation gains recognized in other comprehensive income (revaluation reserve).

FIFO (First-In, First-Out) : A cost flow assumption for inventory where the earliest (oldest) costs are assigned to cost of goods sold, and the latest (newest) costs are assigned to ending inventory. During inflation, FIFO results in lower COGS and higher reported profit.

Weighted Average Cost: A cost flow assumption for inventory where the average cost of all units available for sale is used for both COGS and ending inventory. During inflation, weighted average produces results between FIFO and LIFO.

LIFO (Last-In, First-Out) : A cost flow assumption for inventory where the latest (newest) costs are assigned to cost of goods sold, and the earliest (oldest) costs are assigned to ending inventory. During inflation, LIFO results in higher COGS and lower reported profit. LIFO is prohibited under IFRS (IAS 2) but permitted under US GAAP.

REFERENCES

Adebayo, K. and Oyedokun, G. (2019). Inflation accounting and financial reporting in Nigeria. Nigerian Journal of Accounting and Finance, 11(2), 45-68.

Chambers, R. J. (1966). Accounting, evaluation and economic behavior. Prentice-Hall.

Drury, C. (2020). Management and cost accounting (11th ed.). Cengage Learning.

Edwards, E. O. and Bell, P. W. (1961). The theory and measurement of business income. University of California Press.

Horngren, C. T., Sundem, G. L., and Stratton, W. O. (2018). Introduction to management accounting (17th ed.). Pearson Education.

IASB. (2018). Conceptual framework for financial reporting. International Accounting Standards Board.

IFRS Foundation. (2021). IFRS standards and interpretations. International Financial Reporting Standards Foundation.

Kieso, D. E., Weygandt, J. J., and Warfield, T. D. (2019). Intermediate accounting (17th ed.). John Wiley and Sons.

Okafor, E. and Udeh, S. (2020). Historical cost accounting and profit overstatement in Nigerian manufacturing companies. African Journal of Accounting and Finance, 8(3), 44-62.

Penman, S. H. (2018). Financial statement analysis and security valuation (6th ed.). McGraw-Hill.

Sandilands Committee. (1975). Inflation accounting: Report of the Inflation Accounting Committee. HMSO.

Sterling, R. R. (1970). Theory of the measurement of enterprise income. University of Kansas Press.

Tweedie, D. and Whittington, G. (1984). The debate on inflation accounting. Cambridge University Press.

Whittington, G. (1988). The introduction of current cost accounting in the UK. Accounting and Business Research, 18(72), 371-384.

CHAPTER TWO: LITERATURE REVIEW

2.1 Introduction

This chapter reviews the literature relevant to the effect of historical cost accounting on reported profit and the evaluation of current cost accounting as an alternative reporting method. The review is organized into two main sections: theoretical framework and alternative approaches to historical cost accounting. The theoretical framework discusses seven key theories: wealth, income and capital maintenance theory; realization hypotheses; value differential theory; matching theory; asset theory; value theory; and depreciation theory. The alternative approaches section examines various methods proposed to address the limitations of historical cost accounting, including provision for increased cost of asset replacement, revaluation of assets, accelerated depreciation and LIFO, current purchasing power accounting, constant purchasing power (CPP) accounting, current cost accounting, replacement price accounting, basic disclosure, current cost profit and adjustments, current profit and loss account, current cost balance sheet, current account, and group account.

2.2 Theoretical Framework

The theoretical framework for this study is anchored on several theories that explain the limitations of historical cost accounting and justify alternative approaches. These theories provide the conceptual foundation for understanding why historical cost accounting distorts reported profit during inflation and why current cost accounting is a theoretically superior alternative.

2.2.1 Wealth, Income and Capital Maintenance Theory

The concepts of wealth, income, and capital maintenance are fundamental to the measurement of business profit. Wealth (or capital) is the stock of economic resources controlled by an entity at a point in time. Income (or profit) is the flow of economic benefits generated by the entity over a period of time. The relationship between wealth and income is that income increases wealth (or reduces wealth if negative). The measurement of income depends critically on the concept of capital maintenance (Hicks, 1946; Edwards and Bell, 1961).

Hicksian Income: John Hicks (1946) defined income as “the maximum amount that can be consumed during a period while still being as well off at the end of the period as at the beginning.” This definition requires a clear specification of “being as well off” – i.e., capital maintenance. There are two main concepts of capital maintenance (IASB, 2018):

Financial Capital Maintenance (Nominal Capital) : Under financial capital maintenance, profit is earned only if the nominal amount of net assets at the end of the period exceeds the nominal amount of net assets at the beginning of the period, after excluding contributions from and distributions to owners. This is the concept underlying historical cost accounting. However, during inflation, maintaining nominal capital does not maintain the purchasing power or operating capability of the business.

Physical Capital Maintenance (Operating Capability) : Under physical capital maintenance, profit is earned only if the physical productive capacity (operating capability) of the business is maintained. This requires that assets be measured at current replacement cost, and that profit is recognized only after providing for the replacement of assets at current prices. This is the concept underlying current cost accounting (Edwards and Bell, 1961).

Wealth Measurement: Wealth (net assets) can be measured using different valuation bases:

• Historical Cost: Wealth is measured at original acquisition cost less depreciation.
• Replacement Cost: Wealth is measured at current cost of acquiring equivalent assets.
• Net Realizable Value (Exit Value) : Wealth is measured at the amount that could be obtained from selling assets.
• Present Value (Discounted Cash Flow) : Wealth is measured at the present value of expected future cash flows.

Each valuation base leads to a different measure of wealth and income. Historical cost accounting uses historical cost for wealth measurement and financial capital maintenance. Current cost accounting uses replacement cost for wealth measurement and physical capital maintenance (Sterling, 1970).

2.2.2 Realization Hypotheses

The realization concept is a fundamental principle in accounting that revenue (and gains) should not be recognized until it is realized (or realizable). Realization generally occurs when: (a) the earnings process is substantially complete, (b) the amount of revenue can be measured reliably, and (c) collectibility is reasonably assured. Under historical cost accounting, holding gains (increases in the value of assets while held) are not recognized until the asset is sold (realized). This results in the deferral of holding gains, which are recognized in the period of sale (Kieso, Weygandt, and Warfield, 2019).

The realization hypothesis has been criticized because it delays the recognition of holding gains, which may be economically significant. During inflation, holding gains are large but are not recognized until assets are sold, giving an incomplete picture of economic performance. Current cost accounting addresses this by recognizing holding gains (in a separate component, often in other comprehensive income or a revaluation reserve) as they accrue, even before the asset is sold (Chambers, 1966; Edwards and Bell, 1961).

There are two main approaches to realization:

Transaction-Based Realization: Revenue and gains are recognized only when an external transaction (sale) occurs. This is the approach under historical cost accounting.

Value-Based Realization (Economic Realization) : Gains are recognized as value increases occur, even without a transaction. This is the approach under current cost accounting (for holding gains) and fair value accounting (Edwards and Bell, 1961).

2.2.3 Value Differential Theory

Value differential theory addresses the difference between the historical cost of an asset and its current value (replacement cost, net realizable value, or present value). This difference (value differential) consists of two components: (a) holding gain (gain from holding the asset during a period of price increase), and (b) changes in the asset’s condition (depreciation, wear and tear). Value differential theory suggests that financial statements should separately report these components to provide users with a complete picture of economic performance (Sterling, 1970; Chambers, 1966).

Under historical cost accounting, the value differential is not recognized until the asset is sold (for holding gains) or is systematically recognized as depreciation (for wear and tear). Under current cost accounting, the holding gain component is separately identified and reported, while the depreciation component is based on current replacement cost rather than historical cost.

The value differential can be decomposed as:

Current Replacement Cost – Historical Cost = Holding Gain + (Change in Asset Condition)

Current cost accounting recognizes the holding gain as it accrues (in other comprehensive income or revaluation reserve), while historical cost accounting defers recognition until sale.

2.2.4 Matching Theory

The matching concept is a fundamental principle in accounting that expenses should be recognized in the same accounting period as the revenues they help generate. Proper matching is essential for the determination of accurate periodic profit. Under historical cost accounting, depreciation is based on historical cost, and cost of goods sold is based on historical purchase costs (using FIFO, weighted average, or LIFO). During inflation, historical cost depreciation and COGS do not match current revenues, which are expressed in current prices. This leads to mismatch: revenues are in current (higher) prices, while expenses are in historical (lower) prices, resulting in overstated profit (Paton and Littleton, 1940; Kieso et al., 2019).

Current cost accounting addresses this mismatch by basing depreciation and COGS on current replacement costs. This ensures that expenses are expressed in the same price level as revenues (current prices), providing a better matching of costs with revenues. The resulting profit (current cost profit) is a more accurate measure of periodic performance (Edwards and Bell, 1961).

The matching concept is also relevant to the treatment of holding gains. Under historical cost accounting, holding gains (which are not expenses) are implicitly included in operating profit because they reduce COGS and depreciation (since lower historical costs are used). This violates the matching concept because holding gains are not matched with any revenue. Current cost accounting separately identifies holding gains, removing them from operating profit (Edwards and Bell, 1961).

2.2.5 Asset Theory

Asset theory addresses the definition, recognition, and measurement of assets. An asset is a resource controlled by the entity as a result of past events, from which future economic benefits are expected to flow to the entity. The measurement of assets directly affects the measurement of profit (since profit is the change in net assets, adjusted for contributions and distributions) (IASB, 2018).

Under historical cost accounting, assets are measured at historical cost less accumulated depreciation (or impairment). This measurement basis does not reflect the current economic value of the asset. As a result, the balance sheet reports outdated, low values, and profit (the change in net assets) is understated during inflation (because the increase in asset values is not recognized). Under current cost accounting, assets are measured at current replacement cost, which reflects their economic value more accurately. The balance sheet provides more relevant information, and profit includes holding gains as they accrue (Chambers, 1966; Sterling, 1970).

Asset theory also addresses the concept of asset valuation bases. The choice of valuation base (historical cost, replacement cost, net realizable value, present value) affects both the balance sheet and the income statement. Proponents of current cost accounting argue that replacement cost is the most appropriate valuation base for operating assets because it reflects the cost of maintaining operating capability (physical capital maintenance) (Edwards and Bell, 1961).

2.2.6 Value Theory

Value theory addresses the concept of value and how it should be measured in accounting. There are several concepts of value:

Historical Cost Value: The original transaction price. This is objective and verifiable but may become outdated.

Replacement Cost Value: The current cost of acquiring an equivalent asset. This reflects the cost of maintaining operating capability.

Net Realizable Value (Exit Value) : The amount that could be obtained from selling the asset. This reflects the asset’s liquidation value.

Present Value (Discounted Cash Flow) : The present value of expected future cash flows from the asset. This reflects the asset’s economic value to the entity (Penman, 2018).

The debate between historical cost and current cost accounting reflects different concepts of value. Historical cost accounting emphasizes reliability (verifiability) and uses historical cost value. Current cost accounting emphasizes relevance (current values) and uses replacement cost value. Value theory suggests that the appropriate value concept depends on the objective of financial reporting. If the objective is to report profit after maintaining operating capability, replacement cost is the appropriate value concept. If the objective is to report profit after maintaining financial capital (nominal), historical cost is appropriate (Sterling, 1970).

2.2.7 Depreciation Theory

Depreciation is the systematic allocation of the cost (or revalued amount) of a tangible asset over its useful life. Depreciation theories address: (a) the basis of depreciation (historical cost vs. current value), (b) the pattern of allocation (straight-line, reducing balance, units of production), and (c) the relationship between depreciation and asset replacement (Edwards and Bell, 1961).

Under historical cost accounting, depreciation is calculated based on historical cost. During inflation, historical cost depreciation is understated relative to the economic cost of asset consumption (which is based on current replacement cost). This leads to understated expenses and overstated profit. It also means that the provision for depreciation (accumulated depreciation) is insufficient to replace the asset at current prices. As a result, the company may not have sufficient funds to replace the asset when it wears out (unless it retains additional earnings) (Anthony and Govindarajan, 2018).

Under current cost accounting, depreciation is calculated based on current replacement cost. This provides a more realistic measure of the economic cost of asset consumption. It also ensures that the provision for depreciation is sufficient to replace the asset at current prices (if the company retains the additional depreciation). This is consistent with the physical capital maintenance concept (maintaining operating capability) (Edwards and Bell, 1961).

Depreciation theory also addresses the concept of “backlog depreciation” – the additional depreciation that would be required if historical cost depreciation were adjusted to current replacement cost. Backlog depreciation represents the cumulative effect of past under-depreciation (due to using historical cost during inflation). Under current cost accounting, backlog depreciation is recognized as an adjustment to the revaluation reserve (or retained earnings) (Sandilands Committee, 1975).

2.3 Alternative Approaches to Historical Cost Accounting

Various alternative approaches have been proposed to address the limitations of historical cost accounting during inflation. These range from partial adjustments (e.g., accelerated depreciation, LIFO) to full inflation accounting systems (e.g., current purchasing power accounting, current cost accounting). This section reviews these alternative approaches.

2.3.1 Provision for Increased Cost of Asset Replacement

One of the simplest alternatives to historical cost accounting is to create a provision for the increased cost of asset replacement. This involves estimating the additional amount needed to replace assets at current prices and charging this amount as an additional expense (or transferring it from retained earnings to a special reserve). This provision is not a charge against profit (since it is not an expense under historical cost accounting), but it reduces distributable profit. Companies may voluntarily create such provisions to avoid distributing holding gains as dividends (Whittington, 1988).

Limitations of this approach: (a) it does not adjust the balance sheet (assets remain at historical cost), (b) it does not adjust depreciation or COGS, (c) it is not based on systematic measurement of replacement costs, and (d) it is not required by accounting standards.

2.3.2 Revaluation of Assets

Revaluation of assets (property, plant and equipment) is permitted (but not required) under IAS 16. Under the revaluation model, assets are carried at revalued amount (fair value) less subsequent depreciation. Revaluation increases (gains) are recognized in other comprehensive income (revaluation reserve), while revaluation decreases (losses) are recognized in profit or loss (to the extent they reverse previous revaluation gains) (IFRS Foundation, 2021).

Revaluation brings elements of current cost accounting into financial statements, but it is not a complete current cost system because: (a) revaluation is optional, (b) not all assets may be revalued, (c) revaluation may not be performed every period (revaluations are required to be kept up-to-date but not necessarily performed annually), (d) inventory is not revalued, and (e) cost of goods sold is not adjusted (Kieso et al., 2019).

2.3.3 Accelerated Depreciation and LIFO

Accelerated depreciation (e.g., reducing balance method, sum-of-the-years’-digits) allocates more depreciation in the early years of an asset’s life and less in later years. This results in higher depreciation expense and lower reported profit in the early years. While accelerated depreciation does not adjust for inflation per se, it provides a partial hedge against inflation by recognizing more expense earlier (when prices are lower) (Drury, 2020).

LIFO (Last-In, First-Out) is an inventory cost flow assumption where the latest (newest) costs are assigned to cost of goods sold, and the earliest (oldest) costs are assigned to ending inventory. During inflation, LIFO results in higher COGS and lower reported profit than FIFO or weighted average. LIFO is prohibited under IFRS (IAS 2) but permitted under US GAAP. The use of LIFO provides a partial hedge against inflation by matching current costs with current revenues. However, LIFO does not adjust for inflation in other areas (depreciation, holding gains) (Kieso et al., 2019).

2.3.4 Current Purchasing Power Accounting

Current Purchasing Power (CPP) accounting (also known as Constant Purchasing Power accounting or General Price Level accounting) adjusts historical cost financial statements for changes in the general price level (inflation). Under CPP, all items in the financial statements (assets, liabilities, revenues, expenses) are restated in terms of a constant purchasing power unit (e.g., end-of-period Naira) using a general price index (e.g., Consumer Price Index, CPI). The objective of CPP is to measure profit after maintaining the general purchasing power of capital (financial capital maintenance adjusted for inflation) (Chambers, 1966; Sterling, 1970).

CPP accounting differs from current cost accounting in two important respects: (a) CPP adjusts for general inflation (using a general price index), while CCA adjusts for specific price changes (using specific indices or replacement costs), and (b) CPP does not change the valuation basis (assets remain at historical cost, restated for inflation), while CCA uses replacement cost.

CPP accounting was required in the US (FAS 33) and UK (SSAP 16) in the 1970s and 1980s but was later abandoned due to complexity and lack of user demand. CPP is not currently required under IFRS, although IAS 29 (Financial Reporting in Hyperinflationary Economies) requires restatement of financial statements in hyperinflationary economies using a general price index (IFRS Foundation, 2021).

2.3.5 CPP – Converting the Accounts

The process of converting historical cost accounts to CPP accounts involves several steps:

1. Select a general price index: Typically the Consumer Price Index (CPI) published by the National Bureau of Statistics.
2. Restate non-monetary items: Non-monetary items (inventory, property, plant, equipment, equity) are restated to end-of-period purchasing power using the ratio of the end-of-period index to the index at the date of acquisition (or last revaluation).
3. Monetary items: Monetary items (cash, receivables, payables, debt) are already expressed in current purchasing power and are not restated (but a purchasing power gain or loss is recognized).
4. Restate income statement items: Revenues and expenses are restated to end-of-period purchasing power using the average index for the period (or index at transaction date if more accurate).
5. Calculate purchasing power gain or loss: The gain or loss from holding monetary assets and liabilities during inflation is calculated as the difference between the nominal amount and the inflation-adjusted amount.
6. Prepare CPP financial statements: A CPP balance sheet and CPP income statement are prepared, with a separate line for purchasing power gain/loss (Chambers, 1966; Sterling, 1970).

Limitations of CPP accounting: (a) general price index may not reflect specific price changes affecting the company, (b) does not provide current replacement cost information, (c) complex and costly to prepare, (d) less relevant for assessing operating capability than CCA.

2.3.6 Current Cost Accounting

Current Cost Accounting (CCA) is a comprehensive inflation accounting system that values assets at current replacement cost (or net realizable value for assets held for sale). Depreciation and cost of goods sold are based on current replacement cost. Holding gains are separately identified (often in a revaluation reserve or in other comprehensive income). The objective of CCA is to measure profit after maintaining the operating capability (physical capital) of the business (Edwards and Bell, 1961; Sandilands Committee, 1975).

Key features of CCA:

• Current replacement cost: Assets are valued at the cost of acquiring equivalent assets at current prices (at the balance sheet date or average for the period). For inventory, replacement cost is the purchase cost of the same goods. For property, plant, and equipment, replacement cost may be the cost of a similar new asset adjusted for age and condition (depreciated replacement cost).
• Depreciation based on replacement cost: Depreciation is calculated by applying the depreciation rate to the current replacement cost of the asset (or to the depreciated replacement cost).
• Cost of goods sold based on replacement cost: COGS is calculated as the replacement cost of inventory at the time of sale (or average replacement cost for the period). The difference between historical cost COGS and replacement cost COGS is a holding gain (or loss) on inventory.
• Holding gains: Holding gains (gains from holding assets during periods of price increases) are separately identified and reported. Holding gains are not included in operating profit (realized profit) but are often shown in other comprehensive income or as a separate component of profit (revaluation reserve). Realized holding gains (when assets are sold) are transferred from revaluation reserve to retained earnings.
• Current cost profit (operating profit) : Operating profit under CCA is calculated as revenue minus operating expenses (including depreciation and COGS at replacement cost). This represents the profit from trading activities after maintaining operating capability.
• Current cost balance sheet: Assets are reported at current replacement cost. Liabilities are reported at historical (or amortized) cost, unless fair value is required. Equity includes share capital (at historical cost), retained earnings (adjusted), and revaluation reserve (cumulative holding gains) (Edwards and Bell, 1961).

2.3.7 Replacement Price Accounting

Replacement price accounting is a simplified version of current cost accounting that focuses on replacement cost for inventory and property, plant, and equipment. It is similar to CCA but may not include the full range of adjustments (e.g., may not adjust depreciation on a current cost basis). Replacement price accounting was used in some countries (e.g., the Netherlands) and by some individual companies (e.g., Philips) (Whittington, 1988).

2.3.8 Basic Disclosure

Basic disclosure refers to the minimum disclosure requirements for supplementary inflation-adjusted information. During the 1970s and 1980s, standard-setters required companies to disclose supplementary current cost information in the notes to the financial statements (e.g., UK SSAP 16, US FAS 33). These disclosures typically included: (a) current cost profit (operating profit), (b) current cost adjustments (depreciation adjustment, COGS adjustment), (c) current cost balance sheet data (net assets at current cost), and (d) holding gains (revaluation surplus). Basic disclosure allowed users to adjust historical cost financial statements to a current cost basis (Tweedie and Whittington, 1984).

2.3.9 Current Cost Profit and Adjustment

Under current cost accounting, the calculation of current cost profit involves adjusting historical cost profit for two main items:

1. Depreciation Adjustment: The difference between depreciation based on current replacement cost and depreciation based on historical cost. This adjustment increases (or decreases) depreciation expense, thereby increasing (or decreasing) profit.

Depreciation Adjustment = Current Cost Depreciation – Historical Cost Depreciation

During inflation, current cost depreciation > historical cost depreciation → negative adjustment (reduces profit).

2. Cost of Goods Sold (COGS) Adjustment: The difference between COGS based on current replacement cost and COGS based on historical cost. This adjustment increases (or decreases) COGS, thereby decreasing (or increasing) profit.

COGS Adjustment = Current Cost COGS – Historical Cost COGS

During inflation, current cost COGS > historical cost COGS (if FIFO or weighted average is used) → negative adjustment (reduces profit).

Current Cost Profit = Historical Cost Profit – Depreciation Adjustment – COGS Adjustment

(Assuming both adjustments are negative during inflation.)

The sum of the depreciation adjustment and COGS adjustment is sometimes called the “current cost operating adjustment” or the “cost of sales adjustment” (Edwards and Bell, 1961; Sandilands Committee, 1975).

In addition to these adjustments, holding gains are calculated as:

Holding Gain on Inventory = Current Replacement Cost of Inventory – Historical Cost of Inventory

Holding Gain on PPE = Current Replacement Cost of PPE – Historical Cost of PPE (net of depreciation)

Holding gains are not included in operating profit; they are recognized in other comprehensive income or revaluation reserve.

2.3.10 Current Profit and Loss Account

The current cost profit and loss account (income statement) has a different structure from the historical cost profit and loss account. A typical current cost income statement includes:

Revenue (same as historical cost)
Less: Cost of Goods Sold (at current replacement cost) = Current Cost COGS
Gross Profit (at current cost)
Less: Operating Expenses (including depreciation at current replacement cost, other operating expenses at historical cost or adjusted for inflation)
Operating Profit (Current Cost Profit before interest and tax)
Less: Interest (same as historical cost)
Profit before Tax (Current Cost)
Less: Tax (same as historical cost)
Profit after Tax (Current Cost)
Add: Realized Holding Gains (transferred from revaluation reserve)
Add: Unrealized Holding Gains (recognized directly in equity or OCI)
Total Comprehensive Income (Edwards and Bell, 1961)

Some current cost income statements also show a “current cost operating adjustment” line, which reconciles historical cost profit to current cost profit:

Historical Cost Profit
Less: Current Cost Operating Adjustment (Depreciation + COGS adjustments)
= Current Cost Profit (Sandilands Committee, 1975)

2.3.11 Current Cost Balance Sheet

The current cost balance sheet (statement of financial position) values assets at current replacement cost (or depreciated replacement cost) rather than historical cost. A typical current cost balance sheet includes:

ASSETS:

• Non-Current Assets: Property, Plant, and Equipment at current replacement cost (or depreciated replacement cost). The revaluation reserve (cumulative holding gains) is shown as a separate component of equity.
• Current Assets: Inventory at current replacement cost (or net realizable value, if lower). Trade receivables, cash, and other monetary assets at historical (or nominal) amount.

LIABILITIES: Usually at historical (or amortized) cost, unless fair value is required.

EQUITY:

• Share Capital (at historical cost)
• Share Premium (at historical cost)
• Revaluation Reserve (cumulative unrealized holding gains on non-current assets and inventory)
• Retained Earnings (cumulative realized profits) (Edwards and Bell, 1961)

The relationship between the current cost balance sheet and the historical cost balance sheet can be summarized as:

Current Cost Net Assets = Historical Cost Net Assets + Revaluation Reserve (Holding Gains)

2.3.12 Current Account

In the context of inflation accounting, the “current account” may refer to:

1. Current Cost Operating Account: A supplementary account that tracks the adjustments made to convert historical cost profit to current cost profit. This account includes the depreciation adjustment and COGS adjustment.
2. Monetary Working Capital Adjustment: An adjustment for the effect of inflation on monetary working capital (trade receivables, trade payables). This adjustment is sometimes included in current cost profit calculations (Sandilands Committee, 1975).
3. Current Account (Balance of Payments analogy) : Not directly relevant to corporate inflation accounting.

For the purpose of this study, the current account refers to the ledger or worksheet used to track current cost adjustments.

2.3.13 Group Account

In the context of inflation accounting, “group account” refers to the consolidation of current cost financial statements for a group of companies (parent and subsidiaries). When a group prepares consolidated financial statements under current cost accounting, the following issues arise:

1. Different measurement bases: Subsidiaries may use different measurement bases (historical cost vs. current cost) if they are in different countries with different inflation rates. Consistency is required for consolidation.
2. Foreign currency translation: Assets and liabilities of foreign subsidiaries must be translated into the group’s reporting currency at current exchange rates, then restated for inflation (or vice versa). The interaction between inflation and exchange rates is complex.
3. Intercompany transactions: Intercompany transactions (sales, loans) may be affected by inflation; unrealized holding gains should be eliminated.
4. Goodwill: Goodwill arising from business combinations may need to be restated for inflation (or measured at current cost) (Edwards and Bell, 1961).

Group accounts under current cost accounting are more complex than under historical cost accounting and were a factor in the abandonment of mandatory CCA in the UK and US (Whittington, 1988).