Financial Accounting Theory

Craig Deegan

Chapter 5
Normative theories of accountingthe case
of accounting for changing prices
Slides written by Craig Deegan

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-1
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 been
adopted

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PPTs t/a Deegan, Financial Accounting Theory 3e 5-2
Limitations of historical cost in times
of rising prices
Historical cost assumes money holds a constant
purchasing power
Three aspects of the economy which make the
assumption less valid than when historical cost
was developed
specific price level changes (shifts in consumer
preference; technological advances)
general price level changes (inflation)
fluctuation in exchange rates

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-3
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 (adding together assets
bought at different times)
Can overstate profits in times of rising prices, with
distribution of profits leading to an erosion of
operating capacity
Including holding gains which accrued in previous
periods in current years income distorts the
current years operating results

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PPTs t/a Deegan, Financial Accounting Theory 3e 5-4
Support for historical cost
accounting
Predominant method used for many years so
tended to maintain support of profession
If not found useful business entities would have
abandoned it
Nevertheless, recent accounting standards being
released 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; property, plant and equipment where
the cost model and not the fair-value model has been
adopted; many intangible assets

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PPTs t/a Deegan, Financial Accounting Theory 3e 5-5
Definition of Income
The maximum amount that can be consumed
during 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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PPTs t/a Deegan, Financial Accounting Theory 3e 5-6
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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-7
Development of accounting for
changing prices
Research initially related to using price indices to
restate 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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-8
Current purchasing power accounting
(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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-9
Calculating indices
A price index is used when applying general price
level 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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-10
Performing current purchase power
adjustments
All adjustments are performed at the end of the
period
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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-11
Performing current purchase power
adjustments (cont.)
In times of inflation, holders of monetary assets will
lose 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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-12
Performing current purchase power
adjustments (cont.)
No change in purchasing power arises from
holding 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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PPTs t/a Deegan, Financial Accounting Theory 3e 5-13
Movements in net monetary assets
Must identify changes in net monetary assets as a
result 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 the
year as more cash required for expenses incurred
later in the year

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-14
Advantages of current purchasing
power adjustments
Relies on data already available under historical
cost accounting
No need to incur cost or effort to collect data about
current asset values
CPI data also readily available

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-15
Disadvantages of current purchasing
power adjustments
Movements in the prices of goods and services
included 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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PPTs t/a Deegan, Financial Accounting Theory 3e 5-16
Current cost accounting (CCA)
Based on actual valuations not adjusted historical
cost
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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PPTs t/a Deegan, Financial Accounting Theory 3e 5-17
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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PPTs t/a Deegan, Financial Accounting Theory 3e 5-18
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 represents
the maximum amount that can be distributed,
while maintaining operating capacity intact

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-19
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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-20
Adjustments using Edwards and Bell
approach (cont.)
BUT holding gains are included in calculating
business 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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PPTs t/a Deegan, Financial Accounting Theory 3e 5-21
Advantages of current cost
accounting
Differentiating operating profit from holding gains
and 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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PPTs t/a Deegan, Financial Accounting Theory 3e 5-22
Criticisms of current cost accounting
Replacement cost of assets may not be the same
for 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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-23
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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PPTs t/a Deegan, Financial Accounting Theory 3e 5-24
Continuously Contemporary
Accounting (CoCoA)
Proposed by Chambers as well as others

Based on valuing assets at net selling prices (exit

prices) at reporting 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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-25
Continuously Contemporary
Accounting (CoCoA) (cont.)
The balance sheet (statement of financial position)
considered to be the prime financial 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 of

assets

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PPTs t/a Deegan, Financial Accounting Theory 3e 5-26
Capacity to adapt
Chambers approach focuses on new opportunities
the ability of the entity to adapt to changing
circumstances

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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-27
Definition of wealth under CoCoA
Present (selling) price is seen as the correct
valuation 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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PPTs t/a Deegan, Financial Accounting Theory 3e 5-28
Definition of wealth under CoCoA
(cont.)
Profit is the amount that can be distributed, while
maintaining 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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PPTs t/a Deegan, Financial Accounting Theory 3e 5-29
Capital maintenance adjustment
Unlike CCA there is an adjustment to take account
of 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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-30
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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-31
Criticisms of CoCoA
If implemented CoCoA would involve a
fundamental 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 not

expect to sell the assets

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-32
Criticisms of CoCoA (cont.)
Assets of a specific nature considered to have no
value 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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-33
Criticisms of CoCoA (cont.)
CoCoA requires assets to be valued separately
rather than as a bundle
therefore would not recognise goodwill as an asset
value of assets sold together can be very different from
separate sale

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-34
Demand for price adjusted
accounting information
Limited evidence that stock markets react to
current 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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-35
Demand for price adjusted
accounting information (cont.)
Surveys of managers find limited corporate
support 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 users
anything new

Findings interesting given the extent of voluntary

disclosure by corporations

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PPTs t/a Deegan, Financial Accounting Theory 3e 5-36
Reasons for lobbying
Watts and Zimmerman examined lobbying reaction
to 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

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-37
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 draft
recommending disclosure of CCA

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-38
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)

Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e 5-39
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

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PPTs t/a Deegan, Financial Accounting Theory 3e 5-40
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

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PPTs t/a Deegan, Financial Accounting Theory 3e 5-41