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)

3. Operating result – Historical cost accounting distorts the current year’s

operating results by including in the current year’s income holding gains
that actually accrued in previous periods. (page 86)

4. Capital maintenance – Two versions namely capital maintenance is

based on maintaining financial capital intact and maintaining
purchasing power intact. (page 87)

5. 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)
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.

b. 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.

c. 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.
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
Recognition represent actual economic
principle phenomena occur in the
(Holding gain of current period and should be
CCA) recognized if “there is
sufficient objective evidence
to support the price changes.
For items whose market prices
Objectivity are relatively easy to obtain,
of current the objectivity of their current
cost cost would be acceptable to
accountants
Technologica Edward and Bell believe that
l changes even if condition changes, the
(Current probability is great that the
operating profit existing production process
is primarily rep would generate a larger profit
of the long-term than alter processes if change
profit capability is due to external factor.
of the firm)
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.
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.
Lemke wonders why “these
long run prospects would be
indicated by the prospects of
present mode of production
when it is becoming
obsolete.
Topic 6 - Normative Accounting Theories

Exit price accounting - its support advocator (Deegan page 109 - 115)

 MacNeal’s 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.

 Chamber’s 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 owner’s 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
firm’s 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 firm’s net assets. He admits that every asset has, in
principle, a value in exchange (market value) and a value in use.

 Sterling’s 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 Chamber’s 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:

1. 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.

2. Using exit prices implies a short-term approach to business operation

since one is interested in disposition and liquidation values.

3. 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.

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 owner’s 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
firm’s 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 firm’s 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
price-level 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.