ACCA Financial Accounting (F3) Certification Practice Exam 2025 - Free Financial Accounting Practice Questions and Study Guide

The historical cost convention records assets at their original purchase price, which remains unchanged regardless of market price fluctuations. In times of falling prices, the market value of assets declines below their recorded historical cost. As a result, the asset values reflecting these historical costs appear overstated on the balance sheet because they do not represent the current market conditions.

Simultaneously, when it comes to profits, the historical cost convention does not account for the potential reductions in revenue that would occur in a declining price environment. Companies might be selling goods at lower prices leading to a reduction in future selling prices, but since the costs and the asset values remain recorded at historical costs, this might create an inflated perception of profitability based on the historical cost of goods sold. Therefore, profits reported could appear understated if companies are not considering the decrease in asset values that corresponds with market conditions.

In summary, the historical cost convention results in overstated asset values during periods of deflation or falling prices, as the recorded amounts of assets stray further from their fair values. Concurrently, this situation contributes to an understatement of profits due to an over-reliance on outdated cost figures without adjusting for current economic realities.