Chapter 4 - Normative Accounting Theories The case of accounting for changing price There are various prescriptive theories

of accounting that were advanced by various people on the basis that historical cost accounting has too many shortcomings, particularly in times of rising prices. Page 83 Chapter 4 1. Historical cost accounting in times of rising prices Historical cost accounting assumes that money holds a constant purchasing power. (Page 84) As Elliot states: An implicit and troublesome assumption in the historical cost model is that the monetary unit is fixed and constant over time. Argument for the limitation:However, there are three components of the modern economy that makes this assumption less valid than it was at the time the model was developed. One component is specific price-level changes, occasioned by such things a technological advances and shifts in consumer preferences; Second component is general price-level changes(inflation); and

Third component is the fluctuation in exchange rates for currencies. Thus, the book value of a company, as reported in financial statements, only coincidental reflects the current value of assets. (Page 84 of Financial Accounting Theory Deegan) As we would appreciate, the method of accounting predominantly used today is based on historical cost accounting. The very fact that historical cost accounting has continued to be applied by business entities has been used by a number of academics to support its continued use.

Chapter 4 - Normative Accounting Theories 1. Historical cost accounting in times of rising prices (cont)

Point to note: 1. It has been argued that historical cost accounting information suffers from problems of relevance in times of rising prices. At issue is whether it is really logical to add together assets acquired in different periods when those assets were acquired with dollars of different purchasing power. (page 85) 2. There is also an argument that methods of accounting that do not take account of changing prices, such as historical cost accounting, can tend to overstate profits in times of rising price, and that distribution of H.C. profits can actually lead to an erosion of Operating capacity purchasing power remain intact.(page 86) Operating result Historical cost accounting distorts the current years operating results by including in the current years income holding gains that actually accrued in previous periods. (page 86) Capital maintenance Two versions namely capital maintenance is based on maintaining financial capital intact and maintaining purchasing power intact. (page 87) Use of actual current value is made under another approach to accounting which seeks to provide a measure of profits which, if distributed, maintains physical operating capital intact. They based on present values, entry or exit prices. (page 88)

3.

4.

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Chapter 4 - Normative Accounting Theories 2. Current purchasing power accounting (page 88 to 101) Purchasing power and capital maintenance CPPA was developed on the basis of a view that in times of rising prices, if an entity were to distribute unadjusted profits based on historical costs, the result could be a reduction in the real value of an entity that is in real terms the entity could otherwise distribute part of its capital. Current purchase power accounting with its reliance on the use of indices is generally accepted as being easier and less costly to apply than methods that rely upon current valuations of particular assets. Performing current purchase power adjustments When applying CPPA, all adjustments are done at the end of the period, with the adjustments being applied to accounts prepared under the historical cost convention. a. Non-monetary assets can be defined as those assets whose monetary equivalents will change over times as a result of inflation, and would include such things as plant and equipment and inventory. Net monetary assets would be defined as monetary assets less monetary liabilities. It is stressed that under CPPA, no change in the purchase power of entity is assumed to arise as a result of holding non-monetary assets. Under general price level accounting, non-monetary assets are restated to current purchasing power and no gain or loss is recognized. Purchasing power losses arise only as a result of holding net monetary assets. Possible limitation the information generated under CPPA might actually be confusing to users. Another potential limitation that no support of CPPA as it is irrelevant for decision making.

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c.

Chapter 4 - Normative Accounting Theories 3. Current cost accounting (page 102 107) Current cost accounting (CCA) is one of the various alternatives to historical cost accounting that has tended to gain the most acceptable. Edwards and Bell decided to reject historical cost accounting and current purchasing power accounting in favor of a method that considered actual valuation. CCA differentiates between profits from trading, and those gains that result from holding an asset. Edwards and Bell adopt a physical capital maintenance approach to income recognition. In this approach, which determines valuations on the basis of replacement cost, operating income represents realized revenues, less the replacement cost of the assets in question. Edwards and Bell believe operating profit is best calculated by using replacement costs as the approach to profit calculation operating profit is derived after ensuring that the operating capacity of the organization is maintained intact. (Page 103 Chapter 4) The current cost operating profit before holding gains and losses, and the realised holdig gains, are both tied to the notion of realisation, and hence the sum of two equates to histoical cost profit. Holding gains are deemed to be different to trading income as they are due to market-wide movements, most of which are beyond the control of Management. Some of the criticism relate to its reliance (CCA) on replacement costs but what is the rationale for replacement cost?

Topic 6 - Normative Accounting Theories 3. Current cost accounting (Page 168 170) Chapter 7 Current cost accounting) Business profits Concept 2 components of current cost accounting are Current operating profit (COP) and Realizable cost savings (RCS). COP is the excess of the current value of the output sold over the current cost of the related inputs. RCS are the increase in the current cost of the assets held by the firm in the current period. The term we use for realizable cost saving is holding gains /losses which can be realized or unrealized. (IAS Investment property holding gain of revaluation surplus is unrealized but is treated as business profit in income statement). For example two companies with different set up years Company A 10 years earlier than others. The operating profit of A will be larger because of lower depreciation expenses, thus giving the impression that A is more efficient than the others. In fact, the larger profit of Company A is not due to the efficiency of the managers in operating the firm in the current years. Rather, it reflects the efficiency of the manager of 10 years ago in starting the business and purchasing the assets at that time. Holding gain is a component of income Revsine suggests that the inclusion of holding gains as income may be justified on the ground that changes in the current cost of the given asset reflects changes in the future cash flow expected to be generated from the use of assets.

Topic 6 - Normative Accounting Theories Support vs. Criticism of current cost accounting Argument Support of current cost CCA Proponent points out that the unrealized holding gains represent actual economic phenomena occur in the current period and should be recognized if there is sufficient objective evidence to support the price changes. Criticism of current cost CCA violates the traditional realization principle. A fixed asset is not more valuable to a firm simple because its current cost has risen. Its value lies in its service potential. Subjective as current cost to be used is not based on actual transactions in which the firm is a participant.

Recognition principle
(Holding gain of CCA)

For items whose market prices Objectivity of are relatively easy to obtain, the objectivity of their current current cost cost would be acceptable to accountants Technological changes
(Current operating profit is primarily rep of the long-term profit capability of the firm)

Edward and Bell believe that even if condition changes, the probability is great that the existing production process would generate a larger profit than alter processes if change is due to external factor.

Lemke wonders why these long run prospects would be indicated by the prospects of present mode of production when it is becoming obsolete.

Page 183 to 186 Chp 7 Grofferd Chambers, an advocate of current cost accounting based on exit value was particularly critical of the Edwards and Bell model of accounting.

Topic 6 - Normative Accounting Theories

Exit price accounting - its support advocator (Deegan page 109 - 115) MacNeals argument He contended that conventional accounting principles do not serve the decision-oriented investor well; they provide financial statements that may be misleading or false. Accountant should report all profits and losses and values as determined in competitive markets. MacNeal suggested that a. Marketable assets should be valued at market price (exit price), b. Non marketable reproducible assets at replacement cost and c. Occasional no marketable, non reproducible assets at original cost d. Income should include all profit and loss, whether realized or not. Chambers argument CoCoA (Continuously contemporary accounting) Chambers sees the business firm as an adaptive entity engaged in buying and selling goods and services. It is governed by the decision of its managers who are cognisant of the owners objectives. The notion of adaptive behavior implies a continual attempt to adjust to the competitive business environment for the sake of survival. He argued that the purchase price, or current cost, does not reveal the firms capability to go into the market with cash for the purpose of adapting itself to present conditions Current cash equivalent is the price of the assets. The concept of adaptive behavior sees the firms as always being ready to dispose of the asset if this action is in its best interest. Adaptive behavior, therefore, calls for knowledge of the cash and current cash equivalents of the firms net assets. He admits that every asset has, in principle, a value in exchange (market value) and a value in use. Sterlings argument He believed that there is one method to determine income that is superior to all others. He concluded that the present price of wheat is the one item of information relevant to all the decisions.

Other advantages are Additive, Allocation, Reality and Objectivity Topic 6 - Normative Accounting Theories Exit price accounting - its criticism (Page 230 234 of Chapter 7 Current cost

accounting) 1. Profit concept Bell, a current cost advocate, asserts that an evaluation of the expected plans against the actual outcome must be made and a meaningful profit is the measurement of performance in terms of what was originally intended. Rationale: Accounting is to measure the profitability of the firm in a given period and it means the effectiveness of the actual performance of the company in utilizing the resources entrusted to it. Argument against Exit price: Using exit price (the opportunity cost), however, does not provide the relevant data to match against revenues to measure the relevant success or failure, this is, the performance of the firm. Accounting must measure past events, those that actually happened, rather than those that might happen if a firm does something other than what was planned. Weston concluded that the exit price accounting does not supply useful profit information. 2 Value in use versus value in exchange Both historical cost and current cost advocates accuse exit price proponents of ignoring the concept of value in use. The former (HCA) believes such value is represented by acquisition cost and the later (CCA) current cost. Rationale: An asset that is held rather than sold out must be worth more to its owner than its exit price, otherwise, it would be sold. It is argued that exit price represents the opportunity cost but this may not always be justified. The opportunity cost of using an asset in the company is derived by the value foregone of the next best alternative, which is not necessarily to sell it. A firm can consider an asset to have value because of its use in the business rather than its sale Topic 6 - Normative Accounting Theories Exit price accounting - its criticism (Page 230 234 of Chapter 7 Current cost

accounting)

3. Additivity Exit price proponent claims that accounting measurements, if they are to be objective, must only be based on past and present events. Anticipatory calculations cannot be added together with current figures. Critics point out, however, that Chambers current cash equivalent of assets s to be determined on the assumption of a gradual and orderly liquidation. The concept of current cash equivalent, with its emphasis on sever ability of assets, does not recognize the possibility of selling assets as one package. Finally, exit price accounting, as proposed by both Chambers and Sterling, does not give adequate consideration to intangible factors. Current Cost versus exit price Edward and Bells are favor of Current cost and concluded that an entry price, current cost is the normal method of valuation for the following reasons: Using exit prices leads to anomalous revaluations on acquisition. Immediately after the purchase of a new machine, its value usually falls so that it is less than acquisition cost. 1. Using exit prices implies a short-term approach to business operation since one is interested in disposition and liquidation values. 2. Using exit price for finished goods inventory leads to anticipation of operating profit before the point of sale because the inventory is valued in excess of current cost. 3.

Topic 6 - Normative Accounting Theories Question

Currently there is little support for the various normative approaches to accounting for changing prices. Discuss the reason for this. In the discussion please consider the relevance of the various theories for regulation to the lack of regulation for accounting changing prices. Point to answer: 1. Who recommended the normative approaches to accounting for changing prices and what is the normative approach? 2. Any regulator / regulated supported the changing prices accounting perspective during the past thirty years? 3. What is the regulation theory applicable to the accounting approach Public interest, capture or Private interest? Current Purchase Power Accounting (CPPA) CPPA was developed on the basis of a view that in times of rising prices, if an entity were to distribute unadjusted profits based on historical costs, the result could be a reduction in the real value of an entity that is in real terms the entity could otherwise distribute part of its capital. Current cost accounting (CCA) CCA is one of the various alternatives to historical cost accounting that has tended to gain the most acceptances. CCA differentiates between profits from trading, and those gains that result from holding an asset. Edwards and Bell adopt a physical capital maintenance approach to income recognition. In this approach, which determines valuations on the basis of replacement cost, operating income represents realized revenues, less the replacement cost of the assets in question. Edwards and Bell believe operating profit is best calculated by using replacement costs as the approach to profit calculation operating profit is derived after ensuring that the operating capacity of the organization is maintained intact. (Page 103 Chapter 4) Topic 6 - Normative Accounting Theories Point to answer Continuously contemporary accounting - CoCoA

Chambers sees the business firm as an adaptive entity engaged in buying and selling goods and services. It is governed by the decision of its managers who are cognizant of the owners objectives. The notion of adaptive behavior implies a continual attempt to adjust to the competitive business environment for the sake of survival. He argued that the purchase price, or current cost, does not reveal the firms capability to go into the market with cash for the purpose of adapting itself to present conditions Current cash equivalent is the price of the assets. The concept of adaptive behavior sees the firms as always being ready to dispose of the asset if this action is in its best interest. Adaptive behavior, therefore, calls for knowledge of the cash and current cash equivalents of the firms net assets. He admits that every asset has, in principle, a value in exchange (market value) and a value in use.

Changing price development - From CPPA, CCA to CoCoA It was generally favored by accounting standard-setters from the 1960s to the mid-1970s with a number of countries. The AICPA supported general pricelevel restatement in Accounting Research Study no.6 release in 1961. From about 1975, preference tended to shift to current cost accounting as certain large organization is required to provide supplementary information about the estimated current replacement cost of inventories and productive capacity at the end of the fiscal year for which a balance sheet is required and the approximate amount of cost of sale and depreciation based on replacement cost for the two most recent full fiscal years. In the late 1970s and early 1980s, many accounting standard setters issued recommendation that favored disclosure based on a mixture of current purchasing power accounting and current cost accounting. E.g. The FASB released SFAS 33 which required a mixture of information.