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

ABSTRACT

This study evaluates the effect of historical cost accounting on the reported profit of a company: An evaluation of current cost accounting as an alternative reporting method. In a high – inflationary and distorted economy like Nigeria with high uncertainties, the conventional historical cost method of profit reporting has misled many companies into liquidation since it has been found inadequate in accounting for the uncertainties. The persistent nature of this phenomenon has called for a fair and suitable reporting method of profits in times like this. The profits retained by the company are affected by costs and appropriations of income. A higher cost will leave little income for appropriation and to be retained in the company. The amount of profit will depend on the reported method in operation. The historical cost method makes low depreciation to be charged while leaving high profit for tax and dividends payments. In the light of the above, the objectives of the study were to determine the nature of relationship between historical cost methods and reported profits of manufacturing companies in Nigeria, ascertain the extent to which current cost method affects the overstated profits made by manufacturing companies in Nigeria and to determine how current cost accounting can be used to remedy the inherent deficiencies in the historical cost methods. An ex post facto research design was adopted in this study. The population of the study comprises forty-eight ( 48) manufacturing companies in Nigeria under 24 industrial classifications. Financial statements of these companies are published annually for public consumption. But due to time lag, ten(10) manufacturing  companies quoted  in  the  first  tier  securities  market  were    randomly selected . Secondary sources of data were used in the study. The data were obtained from the statistical bulletin of the Central Bank of Nigeria and Annual Reports of the Nigerian Stock Exchange. Depreciation charge served as the independent variables while Profits of the firm served as the dependent variables and were used to measure the profitability, capital adequacy ratio and improvement of shareholders` equity in the selected sampled manufacturing companies. The Pearson Product Moment Correlation Coefficient was employed to test the hypotheses one while Chi-Square were employed to test the hypotheses two and three. These were done at the alpha level of 5% with the aid of the SPSS 17.0 statistical software. The results of the study discovered that there is a positive significant relationship between historical cost method and the reported profits of companies  in Nigeria , Current cost methods does not significantly affects the overstated profits made by these companies and the study recommended that: there should appropriate decision for current cost accounting method to be adopted so as to improve their capital maintenance level, and there should be further research on the causes of further research on the effect on historical cost accounting on the reported profits of companies in Nigeria.

1.1      Background to the Study

CHAPTER ONE INTRODUCTION

The major objective of any business organization is to make profits and continue in business, but what they face in the course of doing their business and the method of accounting they use  in reporting their  profits may  make this  noble objective to  be unrealistic particularly during the inflationary period.

Inflation in Nigeria in the last one decade has seriously distorted and created uncertainties in the economy to the extent that there has been economic and productivity decline, infrastructural and institutional decay, high poverty level, low investors confidence, wide spread of corruption, high exchange rate, depreciation of domestic currency, high rate of unemployment, high debt profile, general fall in the purchasing power of naira, high level of crime rate leading to cost of business operations, fall in industrial capacity utilization to about 20 percent, price instability, decline in GDP and growth and general increase in cost of living. Inflation rate  in the  last  14  years shows thus: 1997: 8.5, 1998:10.0, 1999:6.6, 2000:6.9, 2001:18.9, 2002:12.9, 2003: 14.0, 2004:15.0, 2005:16.5, 2006:13.5, 2007:10.5, 2008:5.4,  2009:11.6, 2010:11.5,  2011:13.9. Federal Office  of Statistics  ( 2005), Central Bank of Nigeria Annual Report (2006), and www.indexmundi.com/Nigeria/inflation-rate-CIAworldfactbook(2011).

The economic and  environmental uncertainties in the Nigerian economy have  made business in Nigeria to be constantly under serious threat especially the inflationary trend which has now become a noticeable phenomenon. This has also called for; or caused changes in the value of our currency in which accountants and even the accounting bodies find difficult to agree. Operating costs of business in the economy keep rising thereby making the  existence and  survival of the  business organizations to  become difficult  which  eventually  lead  to  insolvency  and  winding  up  of  many  of  them (Ola:2001). Doubt has a serious role to play in this, but more serious is a situation where the environment makes it difficult to report the actual profit of the business at a given period resulting in the pay outs from the business to be based on subjective (assumed) profit. The method of profit reporting during the period of changing prices is another case in point. Whereas the reporting method does not  change frequently for the sake of principle of consistency but the reporting units in the accounts keeps on changing. The question now is how can these two be reconciled to arrive at the actual profit made for the period? The use of historical cost accounting for profit reporting makes past costs to be charged against current revenue resulting in overstatement of the reported profits. Not only charging past cost, but also the past costs being under charged make the accounts to be misleading.

This situation was aggravated throughout the 1990s by the accelerated rate of inflation; as a consequence, products and services were under- rated, thus producing fictitiously high” paper” profits which the company   shared out between the employees as wages, its shareholders as dividends and  the  taxation authorities as corporate tax.  The  rate of liquidation of business during this period was a great concern to the accountants, professional bodies and the Government to the extent that it generated a lot of debates. The relevance of the financial reports is based on historical reports of accounting practice has  continued  to  generate  intensive  debate  at  different  for  a  in  the  world.  This  is especially true in a high – inflationary and distorted economy like Nigeria.  Except for few items (Assets revaluation, a major example), financial information reported by many Nigerian companies are stated under the historical cost convention. This policy is clearly stated in the annual reports and accounts of these companies as part of the significant accounting policies adopted in the preparation of financial statements.

This method has led many businesses into liquidation in the last one decade and has caused a great concern to the accountants, professional bodies and the Government. The Nigerian government in collaboration with the CBN in order to find solution to this in 2001 directed her fiscal policy towards bringing inflation rate to a single digit figure while the CBN primary objective of monetary policy is to ensure price stability. The focus on price stability derives from the over whelming empirical evidence that it is only in the midst of price stability that sustainable growth can be achieved (Ola: 2001).

Debates on inflation have subsided, but the issue is not dead. Debates on this issue are as perennial as the grass; as soon as they are continuous and significant increase in the level of prices, the debates will be resumed with much vigor. Therefore, the issue has to be addressed in spite of the cessation of debate at this time. Williamson (1980) and Jennings (1993), in their argument against the continuous use of historical cost accounting, concluded that it includes the fact that historical cost accounting values can relate to transactions that could be a year old, 10 years old and as much as 100 years old. It is true that  some  businesses have  old  equipment  and  old  stocks (Inventories) that  are  still working but out of date and so the balance sheet is showing out date values.          It      is readily apparent that financial statements prepared in accordance with the historical cost concept have always been defective to the extent that:

a)        They fail to reflect the impact of changing price level:

b)        Assets are disclosed in the balance sheet at unrealistic values.

c)         The profit and loss account does not bear proper charges, particularly for depreciation and cost of materials consumed (Jennings 1993).

According to Ola (2001), the method of historical cost accounting does not make provision for the changes in the purchasing power and as such, the continuous usage of the system leaves these questions unanswered:

a)  How are we affected by the steeply rising cost of Assets replacement?

b)  How much lower is our profit if we take into account the cost of replacing the base stocks we need to remain in business?

c)  What money do we need to set aside to finance our higher values of work-in- progress?

d)  To  what  extent  can  we  sensibly  rely  upon  supplies  to  share  the  burden  of inflation?

e)  To what extent is the erosion of our capital resources mitigated in the longer term by the repayment of loans and over draft in depreciated currency? And

f)   Is the real wealth of shareholders reflected in the account?

These are some of the questions that the current cost accounting is trying to answer. The existence of inflation and its persistent nature calls for an alternative to the historical cost accounting method of profit reporting. One of the feasible alternatives to the historical cost accounting is the current cost accounting method. Current cost accounting method has as a basic principle, that operating profits should only be measured and reported after the capital the capital of the firm has been maintained (Dean, 1994).The emphasis on capital maintenance is highly imperative in today’s business environment if the business must survive and succeed. (Glanter and Under down, 1987).

However, Capital cannot  be  maintained in  isolation of the principles, Concepts and postulates employed in the measurement of business income. Since the income of the business directly affects the shareholders’ capital, it therefore follows that the method employed in measuring the income may equally and directly influence the value of the shareholders’ capital. Traditionally, accounting measures profits by comparing sales with cost of sales and overheads measured at  their historical costs Goudeket, 1990. This method is often referred to as the historical cost accounting method. The method is objective and in times of relatively stable price level works well.

However in recent years when a rise in the general price level of over 25% is experienced (CBN,  2005)  the  profession  has  recognized the  need  for  some  amendments to  the historical cost accounts. The basic problem with the historical method is that dividends, taxes and depreciation are based on profits measured by sales (which are at  current values)   less   cost   of   sales   and   expenses   measured   on   historical   cost   values (Berliner.1993).This  measurement   approach  reduces  the   operating   ability  of  the company’s assets and does not maintain the capital of the firm (Baxter 1984).       The basic objective of current cost accounting is to provide management and shareholders with more useful information about financial viability, returns on investment, pricing policy, cost control, distribution and gearing decision.

The rate of inflation over the years as published by the Federal Office of Statistics (FOS) and  www.Indi exmundi.Com (Nigeria/Inflation-rate-CIA World  fact  book)  keeps on rising thereby introducing complexities into the simple profit measurement of revenue less cost. Among the many methods used in profits reporting during price changing period  are:   Replacement   cost   Accounting  (RCA),  Revaluation  of   Assets  (RA), Accelerated  depreciation  and  LIFO,  Current  Purchasing  power  Accounting  (CPP).

Replacement price Accounting (RPA), Current cost Accounting (CCA), and Continuous Contemporary Accounting (COCOA).Despite these stipulation and legislation and in the light of inflationary trends, published financial statements over the years have failed to comply with the professional codes and legal standards. The studies empirically examines the deficiencies of the historical cost accounting on reported profit during inflationary period and suggest modified current accounting as an alternative method of profit measurement in a distorted economy like Nigeria.

1.2      Statement of the Problem

Corporate financial reports rest upon the assumption that management is reporting to absentee investors who have no independent means of learning how their representatives are discharging their stewardship. Therefore the need to furnish them with useful and guided accounting information cannot be over-emphasized. Thus, the method used in the preparation of accounting information becomes an important consideration in the analysis of such information to meet users’ needs.

In an economy such as Nigeria, what method of reporting should be adopted or used so as to present a true and fair view of the state of affairs of the businesses of a company? Nigerian economy has experienced different inflationary rates in recent times, and it is doubtful if the historical cost accounting serves adequately in reporting a true and fair view of the affairs of the company. This has posed a great challenge to the accounting profession, government and management of businesses to effectively measure and report the operating results of companies. In order to guarantee the going concern concept, the historical cost which is the traditional reporting method does not accommodate price changes. Selling prices are stated at  current prices while the cost of assets used in generating the sales are stated at historical cost; that is acquisition cost. This results in overstated profit leading to overpayment of tax and dividends.

Fixed assets and stock of goods also face the same problem. The conventional practice is to  record  the  fixed  assets  at  their  acquisition  cost  throughout  their  useful  life. Depreciation is also charged based on the acquisition cost of the assets irrespective of the current replacement cost of such assets. This equally leads to overstated profits and overstated value of assets which may make replacement difficult. The main problem of rising prices is that the financial statements prepared on historical cost basis do not show true and fair view of the results of operations as shown in the income statement and financial position as shown in the balance sheet shown in the statement. The consequence is that the cost of goods sold does not approximate the actual goods sold neither does distributed income relate to actual current profit instead ,dividend payout turns to capital reduction. Similarly, the annual depreciation charge may not represent the true proportion of assets used up in the proportion of the income for the period. The continuous use of historical  cost  accounting  method  during  the   period  of  changing  prices  makes performance analysis to be misleading. Moreover, investment decision is hampered because both local and foreign investors do not have a real picture of actual operation of the organization. Taking these deficiencies of historical cost method into consideration, necessary adjustment to accommodate the effect of price changes became paramount.

1.3 Research Questions

In the course of this study, the following research questions were formed:

1.  What is the relationship between historical cost method and reported profits of manufacturing companies in Nigeria?

2.  To what extent does current cost method overstate profits made by manufacturing companies in Nigeria?

3.  How could current cost accounting be used to remedy the inherent deficiencies in the historical cost methods?

1.4      Objective of the Study

The broad objective of this study is to examine the impact of inflation on reported profit of financial statements of Nigerian quoted companies. In order to achieve this purpose, the following specific objectives are:

1.         To  determine  the  nature  of  relationship  between  historical  cost  method  and reported profits of manufacturing companies in Nigeria.

2.         To ascertain the extent to which current cost method affects the overstated profits made by manufacturing companies in Nigeria.

3.         To determine how current cost accounting can be used to remedy the inherent deficiencies in the historical cost methods.

1.5      Research Hypotheses:

The following are the research hypotheses:

1. Ho:  There is no positive significant relationship between historical cost method and the reported profits of manufacturing companies in Nigeria.

2. Ho: Current cost method does not significantly affect the overstated profits made by manufacturing companies in Nigeria.

3. Ho:  Current cost accounting cannot be used to remedy the inherent deficiencies in the historical cost methods.

1.6      Scope of the Study

In accordance with the Nigerian stock exchange classification of companies listed on the exchange,  there  were  48  companies  listed  on  the  Nigerian  Stock  Exchange  as  at December 2005 (Cashcraft, 2010).  For this researches.10 firms were randomly selected each from these sub sectors;-  Livestock feed plc, Dunlop plc, Guinness Breweries plc, Nigerian Wire Company plc, Cap plc, Unilever plc, Niger Flour Mills plc, Glaxo SmithKline plc, First City Aluminum plc, Avon Crown Caps and Containers  plc all in manufacturing sectors, thus the sample size is 10 companies.

The technique adopted in this research is the stratified random sampling method. This method involve the selection of the sample based on classes or groups with each group or stratum having some definite characteristics or features (Onwumere, 2005; Douglas, William and Robert 2002).  10 companies was selected based on this techniques from 48 manufacturing companies in the Nigerian Stock Exchange classification of firms quoted on the exchange excluding the Banking, Insurance, Foreign listings and other Financial Servicing subsectors.  The exclusion of these subsectors was based on them representing the lending end of the Nigerian financial system as well as the desire of the researcher to localize the research to Nigeria.

In furtherance to the study, 10 manufacturing companies quoted in the first tier securities market (Financial Times, 2005), under 24 industrial classifications, publish their annual financial statements for public consumption. Financial  statements  of  these  companies published in the year 2001,2002,2003,2004, 2005, 2006 and 2007 are used as the basis of analysis. The base year of 2001 is chosen because the International Financial Report Standard (IFRS) (2004) requires that or states that “Accounts of companies should be adjusted for effects of price changes when the country is experiencing inflation – rate of 16 percent, and above. The inflation rate in 2001 was 18.9 percent and it was that year that the government expressed genuine intention to curb inflation rate to a single digit figure. Historical financial statements for 2001 were adjusted for effects of price level changes using the Consumer Price Index (CPI) for 2001. Previous studies by Peterson (1993) and Baran (1996) indicated that the CPI is a reliable deflator in the restatement procedure.  Davidson  and  Weil  (1995)  equally  used  CPI  in  adjusting  the  historical financial statements for effects of price changes in a study carried out in United Kingdom (UK).

1.7   Significance of the Study

The relationship between historical cost accounting method and current cost accounting method on the reported profits of companies is a relatively new area of study although gaining ground due to  greater  interest  amongst  government, management, investors, scholars, academia etc. The study will lend support to the government, management, investors, financial institution, as well as add to the literature. This research work is imperatively expected to significantly fill the lacuna in Nigeria and beneficial to the following:

1.      The Government

The end result of this study is expected to benefit policy makers in government and its agencies in understanding better, the impact of operating profit of companies in manufacturing  sector  in  Nigeria.  This  will  help  in  formulating  policies  on  how  to maintain production, sales and distribution indices high. It will equally help government have more focus on the areas to intensify reforms to attract investment which boost our economy and move towards redirection of strategies, programmes and policies that will enhance managers, shareholders, public and private participation, income generation, employment and infrastructural development.

2.  The Academia

The result of this study to the body of academic world, will form part of the needed information, motivation will be geared towards widening the scope of the knowledge of historical  cost  accounting  method  and  current  cost  accounting  methods  on  profit reporting and to other researchers in same area. And will thus serve as a spring board for further researchers in the vital area of study with regards to manufacturing sector.

3.   The investors:

The end result of this study is expected to benefit investors greatly in the sense that the annual financial statements published in the first tier of the Nigerian stock exchange market is solely to attract and encourage investors in Nigeria for instance. So, these manufacturing companies whose shares are traded and are requested by the law to always publish their financial statement for the public’s consumption were measures agreed and adopted by the stock market commission to serve investors with useful information about companies.

1.8      Limitation of the study

In the course of carrying out this research work, the researcher encountered a lot of difficulties in gathering of necessary materials. To achieve this purpose, materials were sourced  from  the  internet,  CBN  annual  and  statistical  report  among  others.  The constraints of a single –digit inflation rate of 18.9 in 2001 of the country and the period (2001-2007) financial statements under study (time-lag) limits the researcher’s scope of knowledge in various ways which cannot be enumerated here. The manipulatable nature of secondary data equally imposes limitations on the findings of the work. Notwithstanding the undeserved constraints, this study utilized the relevant available data gathered from the internet and other sources to carry out the research. Apparently, the reliability and validity of the sources of data significantly determine the outcome of the study.

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