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ACCA Applied Skills · Financial Reporting · Limitations of interpretation techniques

During a prolonged period of rising prices, which of the following is the most likely effect of using historical cost accounting on a company's reported return on capital employed (ROCE) when comparing it with a similar company that recently bought its assets?

ROCE is overstated for the company holding older assets. Historical cost leaves old assets at low carrying amounts and charges low depreciation, which inflates profit while shrinking capital employed. This makes the older-asset company look more profitable than a company with recently bought assets.

  1. AROCE is overstated for the company holding older assets, because carrying amounts are low and depreciation is low relative to current valuesCorrect
  2. BROCE is understated for the company holding older assets, because carrying amounts are low
  3. CROCE is unaffected, because profit and capital employed are inflated by the same proportion
  4. DROCE is understated for the company holding older assets, because depreciation is based on current cost

Explanation

Under historical cost, older assets sit at low carrying amounts and are depreciated on low costs. Profit is therefore higher and capital employed lower than on a current-value basis, so ROCE is overstated. The 'understated' options reverse the effect, and depreciation is not based on current cost under historical cost.

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