Ermine commenced trading on 1 July 20X4 with a capital of £100,000 cash. During the year ended 30 June 20X5, he operated from rented premises and at the end of the year he had sold all his inventory. His statement of financial position at 30 June 20X5 was:

During the year there was inflation of 10 per cent in the country in which he operates.

Required
a. Using this simple example where appropriate, define the terms ‘financial capital’ and ‘physical capital’, and explain why it may be dangerous for an enterprise if it maintains financial capital but does not maintain physical capital.
b. List and briefly explain three ways in which the use of historical cost accounting may cause financial statements to be misleading.
c. List three advantages of historical cost accounting. Author’s note: the term ‘financial capital’ is used here to refer to money financial capital.

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Cash at bank Capital at 1 July 20X4 Profit for year to date Less: drawings £ 100,000 40,000 140,000 40,000 £ 100,000 100,000 100,000 100,000