Chapter 6: Analysis and Interpretation — Part 5

01 Historic Cost

• Definition: Assets and expenses are recorded at their original purchase price, not current market value.
• Example: Premises bought in 2015 for $200,000 remain at $200,000 in the accounts even if the market value is now $500,000.
• Limitation: During inflation, profits may appear healthy while replacement costs for assets and inventory have risen sharply. The Statement of Financial Position understates the true worth of property and understates the cost of replacing worn-out equipment.

02 Application of Accounting Policies

• Definition: Businesses choose methods permitted by accounting standards (depreciation method, inventory valuation, doubtful debt provision). Different choices produce different profit and asset figures.
• Example — Depreciation: Firm X uses straight-line depreciation ($10,000 per year on a $50,000 machine). Firm Y uses reducing balance (20% on written-down value). Year 1 depreciation differs, so profit and non-current asset values are not comparable even with identical cash flows.
• Example — Inventory: FIFO during rising prices gives lower cost of sales and higher profit than weighted average for the same physical stock.
• Limitation: Users may think they are comparing like with like when policies differ. The Consistency concept requires disclosure when policies change.

03 Non-Financial Aspects

Financial statements ignore qualitative factors that may be critical to real performance:

• Skill of the workforce: A loyal, experienced team is valuable but is not recorded as an asset. Losing key staff is not shown as an expense until recruitment and training costs arise.
• Location of the business: A shop on a busy high street has competitive advantage over a remote rival, but both premises may appear at similar historic cost in the accounts.
• Economic climate: A recession, rising interest rates, or supply-chain disruption can threaten survival without appearing as a line item in last year’s published accounts.
• Brand reputation and customer loyalty: Non-monetary assets excluded under the money measurement concept.

04 Other Recognised Limitations

• Use of estimates: Depreciation, doubtful debts, and accruals rely on judgement. Incorrect estimates distort profit and asset values.
• Time lag: Published accounts reflect past performance; current trading may already have changed.
• Window dressing: Management may time transactions (e.g. delay purchases until after year-end) to flatter the current ratio or profit.

05 Worked Example 1: Historic Cost and Inflation

Scenario: A warehouse bought for $80,000 in 2018 is shown at $64,000 net book value after depreciation. Replacement cost today is $150,000. Profit for the Year is $40,000.

Analysis: Accounts suggest a profitable, adequately asset-backed business. In reality, replacing the warehouse would consume more than the reported profit and net asset value imply. Historic cost overstates real return during inflation and may mislead owners considering expansion.

06 Worked Example 2: Non-Financial Factors

Scenario: Two cafés report identical profit margins of 18%. Café A is on a university campus with a 10-year lease; Café B is in a declining industrial estate and loses its best barista to a competitor.

Analysis: Ratio analysis alone suggests equal performance. Non-financial factors — location, workforce quality, and economic climate of the area — indicate Café A has stronger prospects. A lender relying only on last year’s accounts might underrate the risk at Café B.