Financial Accounting Theory Craig Deegan

Chapter 5 Normative theories of accountingthe case of accounting for changing prices Slides written by Craig Deegan and Michaela Rankin

Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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Learning objectives
In this chapter you will be introduced to
some particular limitations of historical cost accounting in terms of its ability to cope with various issues associated with changing prices a number of alternative accounting methods developed to address problems associated with changing prices some of the strengths and weaknesses of the various alternative accounting methods evidence that the calculation of income pursuant to a particular method of accounting will depend on the perspective of capital maintenance that has been adopted

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Limitations of historical cost in times of rising prices

Historical cost assumes money holds a constant purchasing power Three components of the economy which make the assumption less valid than when historical cost was developed
specific price level changes (shifts in consumer preference; technological advances) general price level changes (inflation) fluctuation in exchange rates

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Limitations of historical cost in times of rising prices (cont.)

Problem of relevance in times of rising prices
assets current value may be different from historical cost

Problem of additivity Can overstate profits in times of rising prices, with distribution of profits leading to an erosion of operating capacity Including holding gains which accrued in previous periods in current years income distorts the current years operating results

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Support for historical cost accounting

Predominant method used so tended to maintain support of profession If not found useful business entities would have abandoned it Nevertheless, recent accounting standards being released have embraced fair values as the basis of measurement. However, various assets are still measured on an historical cost basis
e.g. inventory, which is measured at the lower of cost and net realisable value, and property, plant and equipment where the cost model and not the fair-value model has been adopted
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Definition of Income
The maximum amount that can be consumed during the period while still expecting to be as well off at the end of the period as at the beginning of the period (Hicks 1946) Consideration of well-offness relies on a notion of capital maintenance Different notions of capital maintenance will provide different perspectives of income

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Capital maintenance perspectives

Financial capital maintenance
perspective taken in historical cost accounting

Purchasing power maintenance

historical cost accounts adjusted for changes in the purchasing power of the dollar

Physical operating capital maintenance

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Development of accounting for changing prices

Research initially related to using price indices to restate historical costs to account for changing prices Literature then moved towards current cost accounting
the basis of measurement changed to current values not historical values

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Current purchasing power accounting (CPPA)

Also called general purchasing power accounting; general price level accounting; constant dollar accounting Based on the view that in times of rising prices, if an entity were to distribute unadjusted profits based on historical costs, in real terms the entity could be distributing part of its capital

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Calculating indices
A price index is used when applying general price level accounting A price index is a weighted average of the current prices of goods and services related to a weighted average of prices in a prior period (base period)
e.g. Australian Consumer Price Index (CPI)

Can use a general or specific price index

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Performing current purchase power adjustments

All adjustments are performed at the end of the period Adjustments are applied to historical cost accounts Monetary and non-monetary assets considered separately
values of monetary assets do not change as a result of inflation liabilities generally considered monetary items

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Performing current purchase power adjustments (cont.)

In times of inflation, holders of monetary assets will lose in real terms
the assets have less purchasing power at the end of the period relative to the beginning of the period

Holders of monetary liabilities gain, given the amount they have to repay at the end of the period is worth less than at the beginning

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Performing current purchase power adjustments (cont.)

No change in purchasing power arises from holding non-monetary assets
non-monetary assets are restated to current purchasing power so no gain or loss is recognised

Purchasing power gains or losses are included in income for the period

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Movements in net monetary assets

Must identify changes in net monetary assets as a result of revenues or expenses In times of rising prices there will be a loss in purchasing power of cash received during the year More expenses are able to be paid earlier in the year as more cash required for expenses incurred later in the year

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Advantages of current purchasing power adjustments

Relies on data already available under historical cost accounting No need to incur cost or effort to collect data about current asset values CPI data also readily available

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Disadvantages of current purchasing power adjustments

Movements in the prices of goods and services included in a general price index (CPI) may not reflect specific price movements in different industries Information generated under CPPA may be confusing to users Studies of share price reactions failed to find much support for decision usefulness of CPPA data

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Current cost accounting (CCA)

Based on actual valuations not adjusted historical cost Differentiates between profits from trading and holding gains Holding gains can be realised or unrealised Income perspective adopted will determine whether holding gains or losses treated as income

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Treatment of holding gains or losses

Financial capital maintenance perspective
holding gains or losses can be treated as income

Physical capital maintenance perspective

holding gains or losses can be treated as capital adjustments

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CCA under physical capital maintenance approach

Advocated by Edwards and Bell Valuations based on replacement costs Operating income represents realised revenues less the replacement cost of assets in question Generates a measure of income that represents the maximum amount that can be distributed, while maintaining operating capacity intact

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Adjustments using Edwards and Bell approach

Adjustments usually made at year end Historical cost accounts used as basis of adjustments Operating profit calculated by using replacement costs Holding gains excluded in calculating current cost operating profit
not available for dividends

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Adjustments using Edwards and Bell approach (cont.)

BUT holding gains are included in calculating business profit Business profit shows how the entity has gained in financial terms from the increase in cost of its resources Depreciation of non-current assets based on the replacement cost As with CPPA no restatement of monetary assets required

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Advantages of current cost accounting

Differentiating operating profit from holding gains and losses can enhance the usefulness of information provided
holding gains different to trading income as due to market-wide movements that are often beyond managements control

Better comparability of various entities performance

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Criticisms of current cost accounting

Replacement cost of assets may not be the same for all firms
some firms may not choose to replace the asset

If the entity requires replacement assets it may be more efficient and less costly to acquire different assets Replacement cost does not reflect what the asset would be worth if sold

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Criticisms of current cost accounting (cont.)

Often difficult to determine replacement costs Allocating replacement cost via depreciation is still arbitrary as with historical cost accounting Chambers (1995) claimed products of CCA were irrelevant and misleading

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Continuously Contemporary Accounting (CoCoA)

Proposed by Chambers as well as others Based on valuing assets at net selling prices (exit prices) at balance dates on the basis or orderly sales
referred to as current cash equivalent

Chambers argued that key information for decision making relates to capacity to adapt

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Continuously Contemporary Accounting (CoCoA) (cont.)

The balance sheet considered to be the prime financial statement
shows the net selling prices of the entitys assets

Profit directly relates to changes in adaptive capital Adaptive capital reflected by the total exit values of assets

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Capacity to adapt
Chambers approach focuses on new opportunities
the ability of the entity to adapt to changing circumstances

The ability of the firm to go into the market with cash for the purposes of adapting oneself to contemporary conditions (Chambers 1966, p.91) Assumes the objective of accounting is to guide future actions

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Definition of wealth under CoCoA

Present (selling) price is seen as the correct valuation of wealth at a point in time
past prices are a matter of history so not relevant to current actions

Profit is tied to the increase (or decrease) in the current net selling prices of the entitys assets No distinction between realised and unrealised gainsall gains are treated as part of profit

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Definition of wealth under CoCoA (cont.)

Profit is the amount that can be distributed, while maintaining the entitys adaptive ability (adaptive capital) Abandons notion of realisation in terms of recognising revenue
revenues are recognised at point of purchase or production rather than sales

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Capital maintenance adjustment

Unlike CCA there is an adjustment to take account of changes in general purchasing power (inflation adjustment) Capital maintenance adjustments form part of the periods income with a corresponding credit to a capital maintenance reserve (part of owners equity) Calculated by multiplying net assets by the proportional change in a general price index over the period

Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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Advantages of CoCoA
By using one method of valuation for all assets (exit values) the resulting numbers can be logically added together (additivity) No need for arbitrary cost allocation for depreciation as gains or losses on assets are based on movements in exit price

Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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Criticisms of CoCoA
If implemented CoCoA would involve a fundamental shift in financial accounting
revenue recognition points and asset valuations could lead to unacceptable social and environmental consequences

Relevance of exit prices questioned if we do not expect to sell the assets

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Criticisms of CoCoA (cont.)

Assets of a specific nature considered to have no value under CoCoA because cannot be separately disposed of
CoCoA ignores the value in use of an asset

Questioned whether appropriate to value all assets at exit prices if the entity is a going concern Determining exit prices for unique assets introduces subjectivity into accounts

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Criticisms of CoCoA (cont.)

CoCoA requires assets to be valued separately rather than as a bundle
therefore would not recognise goodwill as an asset value of assets sold together can be very different from separate sale

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Demand for price adjusted accounting information

Limited evidence that stock markets react to current cost and CPPA information
little or no share price reaction to price adjusted accounting information found results may have been due to limitations with research methods used
reaction to other information released at the same time could not be distinguished users may have obtained information from other sources prior to release of annual reports

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Demand for price adjusted accounting information (cont.)

Surveys of managers find limited corporate support for current cost accounting
cost, limited benefits from disclosure and lack of agreement as to approach are all considerations

Surveys of users indicate information not helpful, not used and information does not tell users anything new Findings interesting given the extent of voluntary disclosure by corporations

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Reasons for lobbying

Watts and Zimmerman examined lobbying reaction to release of FASB Discussion Memorandum on general price level accounting Found that political visibility a major factor in explaining lobbying positions
large firms favour general price level accounting as leads to lower reported profits

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Reasons for lobbying (cont.)

Supported in New Zealand by Wong (1988)
corporations adopting CCA during period of rising prices had higher effective tax rates and larger market concentrations than those that did not

In UK Sutton (1988) found politically sensitive firms more likely to lobby in support of exposure draft recommending disclosure of CCA

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Professional support for various approaches

Current purchasing power accounting generally supported by standard-setters from 1960s to mid1970s From about 1975 preference shifted to current cost accounting Late 1970s and early 1980s standard-setters issued recommendations which favoured a mixture of CPPA and CCA From mid-1980s support waned (time of falling inflation)

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Potential reasons for lack of continued support

May question the relevance of current cost information in times of falling inflation Drastic change to accounting conventions could cause disruption and confusion in capital markets New method of accounting could have taxation consequences

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Potential reasons for lack of continued support (cont.)

Self-interest motives of corporations Limited relevance to decision makers Nevertheless, in recent years there have been movements towards the use of fair values as new accounting standards are being released

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