Question

× A specific issue raised relates is that of ‘additivity’ specifically in the context of measurement in accounting. Discuss this issue and indicate why it may be a problem in the measurement of a business’s wealth? Illustrate by reference to the Balance Sheet. × Does this then have implications for the quality of information available to the user, and the ability to compare performance reports both across time for an entity and between entities? Discuss. × Alternative models to historical cost have been suggested by a number of accounting academics overtime. Discuss one of these models and indicate why you believe this model has not replaced historical cost, and why, in accounting, the historical cost model (or a modified historical cost model) continues to be preferred.

Answer 1

Solution:

Let's First understand why the problem of "Additivity" arises. Additivity Problem arise when different items added together in financial terms when the purchasing power of the currency in question was changing over period of time. For Example: if in the balance sheet we sum total all the fixed assets to reach at the value of the total fixed assets (which we do in general) is quite misleading because different assets were purchased at different level of time (inflation) and hence they are not comparable. So , it arises the problem of "additivity".

"Additivity" is definitely a problem while measuring a business wealth. Because if the numbers shown in the finacial statements does not reflect the true picture of the business , . For Eg An asset worth $50000 two years back will not be of the same amount as off today and the same goes with the liabilities. This is the biggest problem with the historical concept of accounting.

Again it will affect the quality of infomation to users Because whatever shows in the financial statement is not comparative as it does not take into account the effect of inflation or change in purchasing power of the currency in question.

There are many alternatives available to Historical costs like:

1. Replacement Cost

2. Net Reliazable Value

3. Fair Value

4. Accural Cost concept.

Replacement Cost method can be replaced by Historical cost Approach. Under Replacement cost method assets and liabilities will be measured at the current market price of the different items. However , even after resolving the biggest drawback of historical cost , Historical cost method is still preferred due to following reasons:

1. It takes into account actual profits and losses i.e. when they actually happen. but in replacement cost method it takes into account irrespective of actual gain and loss.

2. It provides certainity when there is high rate of inflation, as in case of replacement cost method numbers can be highly deviated from previous years.

3. Since Historical cost is widely used ,people generally hesitate to use any other method.