ACCOUNTING FOR PRICE CHANGES Flashcards
HISTORICAL COST
Assets are recorded at the amount paid to acquire them i.e. Acquisition cost
CURRENT COST
Assets shown (carried) at the amount to be paid to acquire an asset currently (i.e. now) - this is replacement cost.
REALISABLE VALUE
Assets would be shown at the amount that could be received if the asset were sold.
VALUE IN USE
OR PRESENT VALUE / ECONOMIC VALUE
Assets are shown at the present value of future cash flows expected to be generated from using the asset.
FINANCIAL CAPITAL
This is the owners interest (net assets/equity)
PHYSICAL CAPITAL
This is the productive capacity of the business (i.e. the asset base of the business)
CAPITAL MAINTENANCE
Important because it impacts on the measurement of profit.
FINANCIAL CAPITAL MAINTENANCE
Profit is earned only if the financial amount of net assets at the end of a period is greater than that at the beginning.
PHYSICAL CAPITAL MAINTENANCE
Profit is earned only if the physical operating capability at the end of a period is greater than that at the beginning.
Why is measurement of income important?
It is important to measure income because:
It is an important requirement for financial statements.
Basis for taxation and dividends.
Sometimes basis for decision making.
Plays a role in the stewardship function.
What is the problem of the income statement?
Many ways to derive net income.
Different views on how income is to be measured.
No real use in decision making.
Does not give any information about physical resources of the business.
INCOME
Operationally: application of measurement rules.
Conceptually: Personal view of income: what it means to individuals.
Its to do with well-offness.
Definition by Hicks:
“we ought to define a man’s income as the maximum value which he can consume during a week, and still expect to be as well off at the end of the week as he was in the beginning.”
Has been adapted to apply to companies:
“the maximum value which the company can distribute during the year and still expect to be as well off at the end of the year as it was in the beginning”.
VALUE
At its more theoretical and possibly in its most relevant sense, value is a totally subjective and individualistic concept.
However, it may have a meaning as an objective concept.
Car and boat example to define value.
Mr A owns a boat and Mrs B owns a car.
Mr A agrees to exchange his boat for Mrs B’s car.
Are they of equal value?
In a subjective sense (i.e. directly involved sense) the car and the boat are not of equal value because if the two objects were of equal value in all senses, why would individuals go to the bother of exchanging the items?
In an objective sense (third party looking in), the two objects must be of equal value since no further consideration was required by either party. So, the boat and the car can be said to be of equal value in exchange.
Which is the most relevant? Subjective or objective value?
From a theoretical point of view, subjective value is the most relevant because:
It is this value which motivates economic activity.
Economic activity which accountants report on, and it i the directly involved individuals that accountant report to.
What are the four accounting models for price changes?
- Historical cost accounting (HCA)
- Net Replacement Cost (NRCA)
- Current Purchasing Power Accounging (CPPA)
- Net Realisable Value Accounting (NRVA)
HISTORICAL COST ACCOUNTING
Transactions are recorded at their historical (original) monetary cost.
Assets and liabilities are stated in the SoFP at their historical cost less any amounts written off (e.g. accumulated depreciation)
Income and expenses are recorded at their historical amount.
Merits of Historical cost accounting (HCA)
Objective/ free from bias. Easy to understand. Straightforward to produce. Reliable as original values can be confirmed. Does not record gains until realised.
Problems of historical cost accounting.
HC basis of measuring performance, particularly in periods of significant price changes, potentially overstates profit and understates carrying values of non-current assets.
Overstatement of profit and understatement of assets prevent meaningful calculation/interpretation of ROCE.
Inventory reflects historic prices (i.e. at date of purchase/manufacture) rather than those current at year end.
In periods of inflation, monetary assets lose general purchasing power while liabilities gain general purchasing power.
These relationships are reversed during periods of deflation.
However, HC basis does not reflect this.
NET REPLACEMENT COST ACCOUNTING
The basis for this model comes from the work of Edwards and Bell. Income based on replacement cost = business income.
Business income recognises operating and holding gains for the current and prior periods.
Since measurement is based on replacement cost it recognises income for the current period whether realised or not.
i.e. unrealised gains are recognised (conflict with prudence?)
EXAMPLE HCA V NRCA
Company bought 1,000 items on 1 Jan Year 0 for £1,000.
At 31 Dec Year 0, the cost of these items had increased to £1,500.
At 31 Dec Year 1, these items were sold for £2,000.
On 31 Dec Year 1, it would cost £1,800 to replace those items.
How much profit has the company made?
When will the profit be recognised?
HCA:
In Year 0, no income will be measured. This is because none of the items were sold during the year to 31 Dec Year 0.
In Year 1, income will be measured as follow:
Sales: £2,000
Cost of Sales: £(1,000)
Income (Profit): £1,000
NRCA:
The profit of £1,000 is made up of different parts because there is a mixture of gains.
i) REALISED OPERATING GAIN at the time of sale:
This is the profit received over and above the current replacement cost (i.e. at 31/12/y1):
Sales: £2,000
Replacement cost: (£1,800)
Realised operating gain: £200
ii) REALISED HOLDING GAIN at the time of sale:
This is the increase in replacement cost during the period the items were held prior to sale (i.e. from 1/1/Y1 to 31/12/y1)
Replacement cost Y1: £1,800
Historic cost: (£1,000)
Realised holding gain: £800
REALISED OPERATING GAIN AT THE TIME OF SALE (NRCA)
Profit received over and above the current replacement cost. REALISED HOLDING GAINS CAN BE FURTHER SUBDIVIDED INTO: Those which accrued, and were realised during the current period: Replacement cost Y1 £1,800 Replacement cost Y0 £1,500 Realised holding gain Y1 £300 Those which accrued in a prior period and which were realised in the current period: Replacement cost y0 £1,500 Historic cost (£1,500) Realised holding gain Y0 £500 From 1 Jan Y0 to 31 Dec Y0: Income = £1,500 - £1,000 = £500 THIS IS UNREALISED INCOME AT END OF Y0. Income - £500. SUBDIVIDED: Current operating gain: (£2,000 - £1,800) = £200 Realised holding gain: (£1,800 - £1,500) = £300 BREAKDOWN OF ACCOUNTING INCOME IN PERIOD 1 UNDER NRCA: Current operating profit £200 Realised holding gains: Current period £300 Prior period £500 Total profit (recognised in P1) £1,000 SUMMARY OF INCOME RECOGNITION: HCA: Period 0 £0 Period 1 £1,000 NRCA: Period 0 £500 Period 1 £500
REALISED HOLDING GAIN AT THE TIME OF SALE (NRCA)
This is the increase in replacement cost during the period the items were held prior to sale.
HOLDING GAINS
the view of the supporters of the replacement cost model is that all holding gains recognised in the period should be included in income.
Alternative view is that unrealised gains should not be part of income (profit) as this would lack prudence.
Thus, all holding gains (whether realised or not) should be excluded.
EXAMPLE 2
NRCA- THE DEPRECIATION PROBLEM
A non-current asset is bought at the beginning of Year 1 for £100. The asset is to be depreciated at 25% p.a.
The replacement cost of a new asset increases by £20 each year.
Since the asset increases in value each year by £20 the replacement cost will be (at the end of each year) as follows: Year 1 (100 + 20) £120 Year 2 (120 + 20) £140 Year 3 (140 + 20) £160
Position at end of Year 1: HC Depreciation (£100 x 25%) = £25 RC Depreciation (£120 x 25%) = £30
Position at end of Year 2: HC Depreciation (£100 x 25%) = £25 RC Depreciation (£140 x 25%) = £35
At the end of year 2 total depreciation in the RC model will be £30 + £35 = £65
But, total depreciation ought to be (£140 x 25%) for 2 years = £70
Depreciation has not kept up with the change in replacement cost.
There is a shortfall of (£70 - £65) = £5
Referred to as BACKLOG DEPRECIATION
BACKLOG DEPRECIATION
Shortfall in depreciation when it has not kept up with replacement cost.
Usually deducted from the total amount of holding gains.
ADVANTAGES OF NRCA
Provides more information. Total profit into holding gains and operating gains. Better appraisal of earlier actions possible, and provides more useful data for decision making.
Allows proper maintenance of operating capacity (capital maintenance)
Provides a statement of financial position based on current value which is more relevant.
Holding gains are recognised and reported as they occur.
PROBLEMS OF NRCA
More subjective requiring arbitrary choices to be made.
It requires the replacement cost of assets that the firm does not intend, or may not be able to replace.
It does not give any indication of the current market value of most assets in their present state, or of the business as a whole.
It fails to take account of general price level movements.
Which replacement cost is to be applied? That of an identical asset or an “equivalent asset”.
CURRENT PURCHASING POWER
Value tends to be expressed in money terms.
However, money by itself has no intrinsic value.
The value of money is thus related to what it can buy.
CPPA is a general purchasing power concept.
The concern is with general price rises usually expressed in terms of the average rise in the cost of living, measured by general price index (e.g. RPI or CPI)
How are price changes shown (CPPA)?
All £’s have to be dated since £’s at different dates can no longer be regarded ass the same.
In order to have common measuring unit, it is necessary to convert £’s from the purchasing power at one point in time to purchasing power at another point in time.
EXAMPLE:
Consider a situation where a business purchases two assets as follows:
1st purchase on 1st Jan Year 1 for £200 cash
2nd purchase on 31 Dec Year 1 for £350 cash.
From traditional accounting viewpoint the total cost of the purchases would be £550.
However, each purchase is being measured against the scale of money values at its transaction date.
In other words, two different measurement scales are being used.
By using general purchasing price indices, each individual purchase can be measured at a specific point in time.
Financial statements at 31st Dec year 2 relating to the following purchases:
1 Jan Y1 £200
31 Dec Y2 £350
Assume the general price index was as follows:
1st Jan Year 1: 100
31st Dec Year 1: 105
31st Dec Year 2: 112
in order to restate in CPP terms:
£HC x (Index at SoFP date / GPL index at date of original transaction)
Date of purchase: 1st Jan Year 1 £HC: 200 HC Index: 112/100 CPP at 1/2/2: 224
Date of purchase: 31 Dc Year 2 £HC: 350 HC Index: 112/105 CPP at /12/2: 373
Then total.
MONETARY ITEMS
Those items fixed in terms of number of £’s regardless of changes in the purchasing power of money.
E.g. Cash, accounts receivable, bank overdraft, accounts payable, loan capital.
Holders of monetary assets will lose general purchasing power in times of rising prices.
Holders of monetary liabilities will gain
NON-MONETARY ITEMS
All items not so fixed in terms of number of £’s.
E.g. Land, machinery, inventories
EXAMPLE:
A purchases an item costing £1,000 from B on credit at a time when the general price index is 100.
The debt is settled by A later when the general price level index is 110.
Identify the purchasing power gain/loss arising.
Need to update to point in time when debt is settled:
£1,000 x 110/100= £1,100
Debt is fixed at = £1,000
=£100
From the point of view of A, there will be a gain in purchasing power of £100
From the point of view of B there will be a loss in purchasing power of £100.
OVERSIMPLIFIED in that it is based on one single monetary item.
In practice the monetary position of a company will fluctuate on a daily basis.
The gain or loss on holding net monetary items is one of the more important features of CPPA.
CPP accounts attempt to show the final position of the company from the point of view of the equity shareholders.
TREATMENT OF GPL GAIN AND LOSS
There is no general agreement on how such a gain or loss is to be treated.
Early accounting practice suggested that any general price level gain or loss should be included in current income.
This has become the accepted position.
NRVA
NRV model is based on the economist’s concept of “opportunity cost”.
the concept of realisable income is concerned with the periodic change in the realisable value of capital.
DIFFERENT MEASURES OF REALISABLE VALUE
Realisable values arising on: -Assumed liquidation - Normal course of business Realisable values of resources in: -Their existing state -Their finished state -Generally agreed that exit values should refer to assets: In their existing state -Sold in an orderly manner in the normal course of business.
What does exit value (NRV) of capital at any particular time show?
Shows the amount the amount of money that the business could get from its assets.
This implies the economic concept of opportunity cost.
It is expressed in terms of command over goods: what the firm could acquire with the cash if it sold its existing assets.
How does the NRV model work?
This approach revalues all assets and liabilities at their net realisable value.
NRV is the current market value (adjusted for selling costs)
Completely abandons the principle of realisation for revenue recognition.
When all non-monetary assets are valued at current exit prices means that all gains are recognised immediately.
ASSETS HELD FOR RESALE
e.g. inventory
Assets held for resale give rise to operating gains.
These operating gains can be either realised or unrealised.
E.g. opening inventory (as part of cost of sales) will give rise to a realised operating gain.
Closing inventory will give rise an unrealised operating gain.
ASSETS HELD FOR USE
This will give rise to non operating gains which will be realised or unrealised.
Depreciation is no longer a process of allocation under the matching principle.
Depreciation becomes the loss in value of the asset over the period.
HOLDING GAINS AS INCOME
Similar to business income (or NRC) model:
Non operating gains are included as income
Based on the argument that in the NRV model, capital is the expression of “command over goods” a firm has.
CAPITAL MAINTENANCE UNDER NRVA
NRV model does not maintain capital in terms of physical operating capacity.
If there has been an increase in the potential realisable proceeds of existing resources, then the company has potentially more to invest - so wealth has increased.
Income may be said to exist, because if the value change was used up by way of dividend, then capital (in terms of command over goods) would still be maintained.
