Financial Accounting Theory 2e by Deegan 2006 Ch05 (1)

5/24/2018 Financial Accounting Theory 2e by Deegan 2006 Ch05 (1)

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Copyright 2006 McGraw-Hill Australia Pty Ltd

PPTs t/a Financia l Account ing Theory 2e by Deegan 5-1

Financial Accounting TheoryCraig Deegan

Chapter 5

Normative theories of accountingthe case

of accounting for changing prices

Slides written by Craig Deegan and MichaelaRankin


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PPTs t/a Financia l Account ing Theory 2e by Deegan

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 beenadopted


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Limitations of historical cost in times of

rising prices

Historical cost assumes money holds a constantpurchasing power

Three components of the economy which make

the assumption less valid than when historical cost

was developed specific price level changes (shifts in consumerpreference; 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 ofoperating 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 maintainsupport of profession

If not found useful business entities would have

abandoned it

Nevertheless, recent accounting standards beingreleased 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 equipmentwhere 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 consumedduring 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 torestate 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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Currentpurchasingpoweraccounting(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 pricelevel 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 theperiod

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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adjustments (cont.)

In times of inflation, holders of monetary assets willlose 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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adjustments (cont.)

No change in purchasing power arises fromholding 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 aresult 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 theyear 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 historicalcost 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 servicesincluded 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 historicalcost

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 representsthe 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 calculatingbusiness 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 gainsand 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 samefor 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 primefinancial 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 ofassets


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Capacity to adapt

Chambers approach focuses on new opportunities the ability of the entity to adapt to changingcircumstances

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 correctvaluation 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, whilemaintaining 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 accountof 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


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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


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Criticisms of CoCoA

If implemented CoCoA would involve afundamental 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 notexpect to sell the assets


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Criticisms of CoCoA (cont.)

Assets of a specific nature considered to have novalue 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 separatelyrather 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 tocurrent 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 corporatesupport 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 usersanything new

Findings interesting given the extent of voluntary

disclosure by corporations


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Reasons for lobbying

Watts and Zimmerman examined lobbying reactionto 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 draftrecommending disclosure of CCA


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Professional support for various

approaches

Current purchasing power accounting generally

supported by standard-setters from 1960s to mid-

1970s

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)

P i l f l k f i d


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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

P t ti l f l k f ti d


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PPT t/ Fi i l A t i Th 2 b D

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

Documents

Financial Accounting Theory 2e by Deegan 2006 Ch05 (1)