deeganfat3e ppt ch05-ed
TRANSCRIPT
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5-1Copyright 2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e
Financial Accounting TheoryCraig Deegan
Chapter 5
Normative theories of accountingthe case
of accounting for changing prices
Slides written by Craig Deegan
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5-2Copyright 2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e
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 beenadopted
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Limitations of historical cost in timesof rising prices
Historical cost assumes money holds a constantpurchasing power
Three aspects of the economy which make the
assumption less valid than when historical cost
was developed specific price level changes (shifts in consumerpreference; technological advances)
general price level changes (inflation)
fluctuation in exchange rates
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5-4Copyright 2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e
Limitations of historical cost in timesof 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, withdistribution of profits leading to an erosion of
operating capacity
Including holding gains which accrued in previous
periods in current years income distorts thecurrent years operating results
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Support for historical costaccounting
Predominant method used for many years sotended to maintain support of profession
If not found useful business entities would have
abandoned it
Nevertheless, recent accounting standards beingreleased 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 wherethe cost model and not the fair-value model has been
adopted; many intangible assets
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Definition of Income
The maximum amount that can be consumedduring 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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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
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Development of accounting forchanging prices
Research initially related to using price indices torestate 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
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Currentpurchasingpoweraccounting(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
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Calculating indices
A price index is used when applying general pricelevel 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
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Performing current purchase poweradjustments
All adjustments are performed at the end of theperiod
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
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Performing current purchase poweradjustments (cont.)
In times of inflation, holders of monetary assets willlose 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
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Performing current purchase poweradjustments (cont.)
No change in purchasing power arises fromholding 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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Movements in net monetary assets
Must identify changes in net monetary assets as aresult 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 theyear as more cash required for expenses incurred
later in the year
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Advantages of current purchasingpower adjustments
Relies on data already available under historicalcost accounting
No need to incur cost or effort to collect data about
current asset values
CPI data also readily available
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Disadvantages of current purchasingpower adjustments
Movements in the prices of goods and servicesincluded 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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Current cost accounting (CCA)
Based on actual valuations not adjusted historicalcost
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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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 capitaladjustments
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2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e
CCA under physical capitalmaintenance 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 representsthe maximum amount that can be distributed, while
maintaining operating capacity intact
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2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e
Adjustments using Edwards and Bellapproach
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
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2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e
Adjustments using Edwards and Bellapproach (cont.)
BUT holding gains are included in calculatingbusiness 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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2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e
Advantages of current costaccounting
Differentiating operating profit from holding gainsand 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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2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e
Criticisms of current cost accounting
Replacement cost of assets may not be the samefor all firms
some firms may not choose to replace the asset
If the entity requires replacement assets it may bemore efficient and less costly to acquire different
assets
Replacement cost does not reflect what the assetwould be worth if sold
C i i i f i
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2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e
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
C ti l C t
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Continuously ContemporaryAccounting (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
C ti l C t
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Continuously ContemporaryAccounting (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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2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e
Capacity to adapt
Chambers approach focuses on new opportunities the ability of the entity to adapt to changingcircumstances
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
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2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e
Definition of wealth under CoCoA
Present (selling) price is seen as the correctvaluation 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
D fi iti f lth d C C A
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Definition of wealth under CoCoA(cont.)
Profit is the amount that can be distributed, whilemaintaining the entitys adaptive ability (adaptive
capital)
Abandons notion of realisation in terms ofrecognising 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
Capital maintenance adjustment
Unlike CCA there is an adjustment to take accountof 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
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PPTs t/a Deegan, Financial Accounting Theory 3e
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 fordepreciation as gains or losses on assets are
based on movements in exit price
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PPTs t/a Deegan, Financial Accounting Theory 3e
Criticisms of CoCoA
If implemented CoCoA would involve afundamental 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
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Criticisms of CoCoA (cont.)
Assets of a specific nature considered to have novalue 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 assetsintroduces subjectivity into accounts
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Criticisms of CoCoA (cont.)
CoCoA requires assets to be valued separatelyrather than as a bundle
therefore would not recognise goodwill as an asset
value of assets sold together can be very different from
separate sale
Demand for price adjusted
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PPTs t/a Deegan, Financial Accounting Theory 3e
Demand for price adjustedaccounting information
Limited evidence that stock markets react tocurrent 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
Demand for price adjusted
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Demand for price adjustedaccounting information (cont.)
Surveys of managers find limited corporatesupport 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
Reasons for lobbying
Watts and Zimmerman examined lobbying reactionto release of FASB Discussion Memorandum on
general price level accounting
Found that political visibility a major factor inexplaining lobbying positions
large firms favour general price level accounting as leads
to lower reported profits
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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 firmsmore likely to lobby in support of exposure draft
recommending disclosure of CCA
Professional support for various
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PPTs t/a Deegan, Financial Accounting Theory 3e
Professional support for variousapproaches
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)
Potential reasons for lack of
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PPTs t/a Deegan, Financial Accounting Theory 3e
Potential reasons for lack ofcontinued 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
Potential reasons for lack of
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Potential reasons for lack ofcontinued support (cont.)
Self-interest motives of corporations
Limited relevance to decision makers
Nevertheless, in recent years there have beenmovements towards the use of fair values as new
accounting standards are being released