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Theory in Action 6.

2 Outsourcing and costs


Identify the potential problems associated with allocating costs that attach to
services provided by firms such as Infosys Technologies.

The allocation of costs to a service provided by a firm can be problematic. While direct costs
can normally be easily traced to a particular service, indirect costs such as depreciation and
overheads may not be so easily determined for a particular service. The allocation of these
costs may require the use of an arbitrary allocation method or the determination of cost
drivers in order to allocate the costs over multiple services.

What criteria would management use when deciding to expense or capitalise

expenditures associated with its services?

Under the historical cost approach, management would need to determine which costs have
expired as these will need to be matched (expensed) against income. Any unexpired costs
will be capitalised and carried forward as unmatched assets on the balance sheet. Ready to be
matched against future revenue as it flows in.

Why is the decision to expense or capitalise expenditures so important to the costs

attach principle which underlies the historical cost system?

The historical system of accounting relies on the correct matching of expenses against
revenues in determining profit. Expenditures under the historical system are broken into
expense and asset components, with the asset component transferred progressively from the
statement of financial position to the income statement as the future economic benefit of
revenue is received. The reliability of this system relies on costs being measured and attached
correctly and the correct allocation of these costs to expenses or assets. However, the decision
to capitalise or expense is not always straight-forward and often judgement may need to be
made on whether the expenditures have expired and what the probability is of that asset
generating future revenue.

Theory in Action 5.2 Capital or income?


Why is the measurement distinction between capital and income important?

In theory (and practice) income is the incremental increase in beginning period capital.
Therefore income cannot be measured unless the beginning period capital amount is known.

What do you think is real financial capital maintenance and what is physical
capital maintenance?

Financial capital maintenance is having the same amount of financial resources (or net assets
valued in money terms) at the end of the period as at the beginning of the period. Real
financial capital maintenance means maintaining the same purchasing power (so an
adjustment for inflation is needed). Physical capital is the ability to produce the same level of
goods and services at the end of the period.

Is the increase in the value of a house you live in income or capital?

If you wish to continue to live in the same level of housing then any increase in value is
capital. If you sell then you have to purchase a similar house that provides accommodation
services at a similar price. However, some students will argue that you will eventually sell so
it is some form of future income or increase in value.

Does your answer to question 3 change if your house is an investment property?

Then you may legitimately use a financial (or real financial) concept of capital. Students
should now realise some of the complexity of the arguments about measuring income and