Summary — What This Chapter Covers
- Historic cost: assets are shown at what they cost, which may be far from what they are worth today.
- Difficulties of definition: terms such as profit and capital employed, and classifications of items, can be defined in more than one way.
- Non-financial aspects: staff, reputation, customers, location and competition do not appear in the figures.
- Statements also look backwards: they report past results, not the future.
1. Historic Cost
Syllabus 6.5 · Paper 1 & 2
Yesterday’s prices
Under the historic cost principle (Topic 7) assets are recorded at the price paid. Over time, inflation and market changes mean the figure no longer shows what the asset is worth. Premises bought twenty years ago may be worth several times their cost; equipment may be obsolete. Profit is also affected: depreciation is based on old costs, while revenue is at today’s prices.
Worked Example
A business made profit before interest of $36,000. Its capital employed is $240,000, which includes premises at their cost of $80,000. The premises are now worth $240,000. Calculate ROCE on the historic cost figures and on the current value of the premises, and comment.
2. Difficulties of Definition
Syllabus 6.5 · Paper 1 & 2
Same word, different numbers
Accounting terms are not always used in the same way, so two statements (or two analysts) may give different figures for the “same” thing.
- Profit could mean gross profit, profit before interest, or profit for the year.
- Capital employed can be defined with or without non-current liabilities.
- Classification: an item may be treated as capital or revenue expenditure, or a loan as current or non-current, depending on judgement.
- Estimates: depreciation, provision for doubtful debts and inventory value all rely on judgement and on the method chosen.
Practice Question 1
Two analysts calculate the ROCE of the same business and get different answers. Neither has made an arithmetical error. Explain how this could happen.
3. Non-financial Aspects
Syllabus 6.5 · Paper 1 & 2
What money cannot measure
Under the money measurement principle, only items that can be given a reliable money value are recorded. Many things that decide a business’s future are left out:
- the skill, experience and morale of the staff and managers;
- customer loyalty, the business’s reputation and the quality of its products;
- its location and the strength of competitors nearby;
- new technology, changes in the law and the state of the economy;
Memorise