Fair value, historical cost and

accounting for changing prices

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Financial reporting
IFRS13 Fair value measurement

International financial reporting and analysis

(essential reading)
Chapters 5, 6, 7

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Financial reporting
IFRS Conceptual framework

What is measurement?

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Financial reporting
Selecting a measurement basis

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Financial reporting
 Historical cost accounting
All transactions are recorded at their original cost
(purchase price) and shown in the company’s
accounting reports at their historical (original)
price.

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Financial reporting
Historical cost principle: example

The Mona Lisa is having the highest insurance

value of any paintings in history:
1962 2015
$100,000,000 $782,000,000
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Financial reporting
Historical cost: non-financial

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Financial reporting
Historical (amortised) cost: financial

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Financial reporting
Advantages of HCA
It is more objective and verifiable and in this sense reliable.
Because of its relative objectivity, HCA may reduce conflicts over numbers.
It may be relevant to users’ legal needs, for example for legal/ contractual to
show what funds have been raised and how they have been spent.
It is relatively inexpensive to operate.
The historical cost convention has the advantage of familiarity. This probably
makes it cheaper to apply, because procedures for its implementation are well
established, and easier to use, because users too have established procedures for
interpreting it.
It enables comparability.
It is understandable for users.

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Financial reporting
 Disadvantages of HCA
It is still subjective in practice (e.g. it depends on depreciation policy and
inventory valuation).
It is unlikely to be relevant to the economic needs of users since it is unlikely to
reflect future cash flows to be earned by an asset/assets or the future cash flows
likely to replace it/them, and therefore may lack predictive value in times of
changing prices.
The balance sheet does not report a company’s value and that’s why has no
relevance.
Holding gains and operating gains are not distinguished and unrealised gains are
not reported which may result in fictitious profits from the perspective of
economic theory.
Some argue that HCA fails the ‘additivity’ test, because amounts of different
values are being added together to give a meaningless total.
Certain items are or have not been included under HCA: e.g. leases, financial
instruments executive share options.

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Financial reporting
 Alternatives to HCA

An approach An approach
concentrating on the concentrating on the
effects of general price effects of specific prices
changes (inflation) and the current values
of items

Current Purchasing Current Value

Power accounting Accounting (CVA)
(CPP)

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Financial reporting
Current Purchasing Power accounting (CPP)
Separation of monetary and non-monetary items

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Financial reporting
 Monetary/Non-monetary
Assets
Cash Monetary
Property, plant and equipment Non-monetary
Intangible assets (including goodwill) Non-monetary
Investments in associates Non-monetary
Equity investments (e.g. shares) Non-monetary
Investments in debt securities Monetary
Biological assets Non-monetary
Deferred tax asset Monetary
Inventories (including allowances) Non-monetary
Trade receivables (including allowances) Monetary
Other receivables to be settled in cash Monetary
Deposits and bank accounts Monetary
Advances and prepayments It depends
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Financial reporting
Equity and liabilities Monetary/Non-monetary

Share capital Non-monetary

Other components of equity Non-monetary
Provisions for employee benefits Monetary
Deferred tax liability Monetary
Bank and other loans Monetary
Accruals Monetary
Deferred income Non-monetary
Trade payables Monetary
Advances received It depends
Current tax liability Monetary

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Financial reporting
Converting from HCA to CPP

Step 1: Convert the income statement

Step 2: Calculate the losses or gains on monetary

items

Step 3: Convert the balance sheet

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Financial reporting
 Step 1: Convert the income statement

Example
The total sales in HCA are $50,000 and they took place evenly throughout the
year ending 31 December 2017.

The RPI at the dates:

1 January 2017 100
30 June 2017 (average for the year) 120
31 December 2017 135

What would the value of the sales be in the CPP income statement at 31
December 2017?

$50,000 * 135/120 = $56,250

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Financial reporting
Step 2: Calculate the losses or gains on monetary items
It may be calculated as separate gains/losses on holding each
monetary item (e.g. trade receivables, cash, creditors) or as combined
losses/gains on net short-term monetary items.
Example
During the year the company had trade receivable of $30,000 outstanding
from 31 March 2017 to 30 September 2017.

The RPI at the dates:

31 March 2017 105
30 September 2017 125
31 December 2017 135

What would be the holding gain/loss for this six months period at the year-
end?
$30,000 * (125 – 105) /105 = $5,714
$5,714 * 135/125 = $6,171
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Financial reporting
Step 3: Convert the balance sheet
closing balance sheet is converted into CPP based on closing RPI
only non-monetary items are converted
monetary items should not be converted; adjustments were already
made in Step 2 to capture holding gains and losses on these items
Example
The non-current assets in the HCA total $100,000 and they were all purchased
on 1 July 2017.
The RPI at the dates:
1 January 2017 100
01 July 2017 120
31 December 2017 135
What would be the value of non-current assets in the CPP accounts at the
year-end?
$100,000 * 135 / 120 = $112,500

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Financial reporting
 Example: HCA converting to CPP
Bell Ltd was established on 1 January 2017. On this date it has the following balance sheet:

Land $10,000
Premises $8,000
Inventory $12,000
Share capital $30,000

During 2017 Bell Ltd had the following transactions:

Purchased inventory for $5,000
Sold inventory with historical cost $8,000 for $10,000
Closing inventory on 31 December 2017 had historical cost of $9,000 and was bought when
RPI was 115 (average).
The buildings has an expected life of twenty years with nil residual value. The method of
depreciation is straight line.
The RPI at the dates:
1 January 2017 100
30 June 2017 110
31 December 2017 120

Assume that all purchase and receipts occur evenly throughout the year.
Prepare the CPP balance sheet as at 31 December 2017.
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Financial reporting
 Solution: HCA converting to CPP
Step 1: Converting the income statement
Sales $10,000 * 120/110 $10,909
Opening inventory $12,000 * 120/100 $14,400
Add purchase $5,000 * 120/110 $5,454
Closing inventory ($9,000 * 120/115) ($9,391)
($10,463)
$446
Less depreciation ($8000/20 *120/100) ($480)
($34)
Loss on holding monetary assets (cash) (step 2) ($455)
CPP profit / (loss) ($489)
Step 2: Calculate the losses or gains on monetary items
Cash: +$10,000 - $5,000 = $5,000
Loss on holding monetary assets (cash) = $5,000 *120 / 110 - $5,000 = ($455)
Step 3: Convert the balance sheet
Cash $5,000 Share capital $30,000*120/100 $36,000
Land $10,000 * 120/100 $12,000 CPP loss ($489)
Buildings $8,000 *120/100 $9,600
less depreciation $8,000/20 *120/100) ($480)
Inventory $9,000 * 120/115 $9,391
Total $35,511 Total $35,511
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Financial reporting
 Advantages of CPP
It is easy to convert HCA into CPP accounts.
The conversion is objective and verifiable as it is based on an inflation
measure applied universally.
It expresses all items in common purchasing power. It corrects time-lag
errors (particularly on inventories and depreciation) in the income
statement.
It facilitates comparison between companies and understanding of
trends (e.g. of sales and profit) if all years are expressed in the same
purchasing power.
It measures profit after maintaining shareholders’ capital in real terms.
As it shows real gains and losses on monetary items, users of the accounts
can assess the financial management policy.

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Financial reporting
 Disadvantages of CPP
CPP accounts are still based on HCA rather than current values. Any
subjectivity problems associated with HCA remain.
The difficulty of finding the appropriate index: Some argue that inflation is
unquantifiable
Some say the RPI is inappropriate because companies buy, for example,
things like plant and machinery not goods such as clothing, food and
television sets (which determine the RPI). But are we trying to measure the
income of the company as a separate entity, or the income of the
shareholders? If the latter, the RPI is relevant, because shareholders are
concerned with their ability to buy goods and services in general.
Others say the RPI is not representative of the effect of inflation on the
shareholder group.

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Financial reporting
Current value accounting (CVA)

Replacement cost
Net realisable values
Present value (“economic value”)
Deprival value (“value to the business”)

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Financial reporting
IFRS Conceptual Framework: Current
value

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Financial reporting
Replacement cost accounting (RCA)
Assets are entered in the financial statements at the cash-equivalent
value of what it would cost the company to replace them (so named
entry costs).

Three variants of RC:

Reproduction cost: the amount that would currently have to be paid
to purchase an asset identical to the one currently owned.

Cost of replacing with best alternative asset – the one best suited
to perform the function of the existing asset, adjusted for
depreciation.

Replacement of service potential tries to measure the cost of

replacing the services provided by the existing asset.

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Financial reporting
 Net realisable value (NRV)
The value of an asset is the estimated amount that could be raised from
its sale (net of selling expenses); this is also known as the exit value.

Example:
equipment with HC = $ 10,000,
expected life = 5 years
residual value = 0
straight-line depreciation
What is the net book value at the end of the first year?
$10,000 - $10,000 / 5 = $8,000
NRV of the equipment at the end of the year is $9,200.
The balance sheet carrying value is $9,200 and the depreciation charge is $800
instead of $2,000.
NRV of the equipment at the end of the year is $11,000.
The balance sheet carrying value is $11,000, no depreciation charge and “strange”
profit of $1,000…
Should we use it if the company has no intention of selling the asset?
What about “going concern” principle? 26
Financial reporting
 Present value (PV)
Assets are measured at the net present values of future cash flows from
the asset (the value in use).

This method is rather popular and used often.

The main problems:

the figures may lack reliability: to compute present values requires

estimation of all future cash flows together with an appropriate discount
rate;

sometimes it is very difficult to measure the cash flows from every

separate asset, only from the business as a whole.

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Financial reporting
 Deprival value (DV)
“The valuation of a property to its owners is identical in amount with the
adverse value of the entire loss, direct and indirect, that the owner might
expect to suffer if he were to be deprived of the property”.
DV of an asset is the amount of the loss which a business would suffer if that asset
was lost or destroyed, assuming that the owner takes optimal action on deprival. So
deprival value will either be RC or NRV or PV.

lower of

RC higher of

NRV PV
Let us assume you were going to attend an interview for a job paying $50,000 p.a.
and an hour before the interview someone spilt coffee down your business suit. The
cost of replacing your suit would be $1,000 and you don’t have time to get it
cleaned before the interview. What would be the best action to take and hence what
would be the deprival value of your suit? 28
Financial reporting
 Example: deprival value
CheapAir Ltd., a small airline company, has decided to account for assets
on a current value basis, using DV as current value. It has three airplanes:
001 002 003
Net book value $50,000 $1,400,000 $280,000
Net realisable value in market $60,000 $1,400,000 $340,000
CPP of an aircraft in similar condition $90,000 $1,500,000 $370,000
001 is rarely used, but is kept as a stand-by machine. If it were not available it is
estimated that average annual cash outlay on rental of $17,000 would have to be
spent on hire of a machine from another company. The annual expenditure on
keeping 001 airworthy is $10,000. Stand-by facilities will continue to be required as
long as can be foreseen.
002 if retained would have in its best use an expected flying life of 2 years with the
company, at the end of which its NRV would be $1,500,000. Its annual net
contribution to the cash flow over the 2 years would be $240,000.
003, if retained, would have in its best use an expected flying life of 3 years. It would
then sell for $200,000 net. Its cash contribution (revenue less operating and
maintenance costs) during the three years would be $60,000 p.a.
Discount rate is 10%. 29
Financial reporting
Solution: deprival value
001 002 003
NRV $60,000 $1,400,000 $340,000
PV $70,000 $1,656,120 $299,468
RC $90,000 $1,500,000 $370,000
DV $70,000 $1,500,000 $340,000

001 DV = PV
002 DV = RC
003 DV = NRC

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Financial reporting
Holding gains and current operating profit
You started business of trading tennis rackets. At the beginning of the
year you bought 100 rackets for $50 each. And at the end of the year
you sold them for $65 each.
What would be your HCA statement of income?

Sales $65 * 100 = $6,500

Cost of sales ($50 * 100 = $5,000)
Profit $1,500

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Financial reporting
If we move to current cost accounting what would be CCA income statement?
Let us assume that current cost equals RC. RC for the tennis rackets at the end
of the year was $60.

Sales $65 * 100 = $6,500

Cost of sales ($60 * 100 = $6,000)
Current operating profit $500

Where is the remaining $1,000?

While you were holding the rackets, you gained from the price increase. So
your holding gain totals ($60 - $50) *100 = $1,000

Sales $65 * 100 = $6,500

Cost of sales ($60 * 100 = $6,000)
Current operating profit $500
Holding gains $1,000
Profit $1,500
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Financial reporting
Holding gains or losses may be:
realised - the difference between the current value of an asset at
the time of consumption and its historical cost
unrealised - the difference between the current value of an asset
held at the balance sheet date and its historical cost (or the value at
the start of the period)
You started business of trading tennis rackets. At the beginning of the year you
bought 100 rackets for $50 each. And at the end of the year you sold 70 of
them for $65 each. RC for the tennis rackets at the end of the year was $60.
What would be your CCA statement of income?
Sales $65 * 70 = $4,550
Cost of sales ($60 * 70 = $4,200)
Current operating profit $350
Realised holding gains ($60 - $50)*70 = $700
Unrealised holding gains ($60 - $50)*30 = $300
Profit $1,350
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Financial reporting
You started business of trading tennis rackets. At the beginning of the year
you bought 100 rackets for $50 each. And at the end of the year you sold
70 of them for $65 each. RC for the tennis rackets at the end of the year
was $60.
What would be your CCA statement of financial position?
Assets Liabilities
Cash $4,550 Share capital $5,000
Inventory $1,800 Profit $1,350

Total asssets $6,350 Total liabilities $6,350

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Financial reporting
Is the unrealised holding gains a part of income?
CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE

FINANCIAL CONCEPT PHYSICAL CONCEPT

capital is synonymous with the capital is regarded as the

net assets or equity of the productive capacity of the
entity entity based on, for example,
units of output per day

should be adopted if the users

of financial statements are the main concern of users is
primarily concerned with the with the operating capability of
maintenance of nominal the entity
invested capital or the
purchasing power of invested
capital
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Financial reporting
Financial capital maintenance. Under this concept a profit is
earned only if the financial (or money) amount of the net assets
at the end of the period exceeds the financial (or money) amount
of net assets at the beginning of the period, after excluding any
distributions to, and contributions from, owners during the
period. Financial capital maintenance can be measured in either
nominal monetary units or units of constant purchasing power.

Physical capital maintenance. Under this concept a profit is

earned only if the physical productive capacity (or operating
capability) of the entity (or the resources or funds needed to
achieve that capacity) at the end of the period exceeds the
physical productive capacity at the beginning of the period, after
excluding any distributions to, and contributions from, owners
during the period.
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Financial reporting
Financial capital maintenance.
If the value of the assets rises, one is better off and the gain goes
to income.
Holding gains would form part of the income.

Physical capital maintenance.

The profit is measured after maintaining the company’s ability to
continue producing the same level of goods and services.
Holding gains would be excluded from the income.

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Financial reporting
You started business of trading tennis rackets. At the beginning of the year
you bought 100 rackets for $50 each. And at the end of the year you sold
all of them for $65 each.

Current operating profit & realised gains = ($65 – $50) * 100 = $1500

Under financial capital maintenance concept we can spend $1500 and still
maintain initial capital of $5,000.

Under physical capital maintenance concept if we spend $1500 we will be

able to sell no more than 83 rackets next period ($5000 / $60 = 83,3).
If you intend to maintain your operating capability, you will need capital
$60 * 100 = $6,000.
So your profit for the current year would be only $500.

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Financial reporting
What is useful in measuring income under physical capital
maintenance concept?
It is seen whether:
the company is maintaining operating capability,
the company planning to expand,
the company needs further finance.

But there are problems:

It is not suitable for all industries (financial companies, one-off ventures)
If the market prices have really risen, it is understandable that we should
reinvest our profit rather than suggest that our profit is lower
It is not necessary that you have capital enough to replace assets,
especially in case of non-current assets

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Financial reporting
 Thank you for attention!

Home assignment: loaded to ICEF online

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Financial reporting