1. Financial Accounting Theory Craig Deegan
Chapter 4
Normative theories of accounting - the case of accounting for changing prices
Slides written by Michaela Rankin

2. 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 methods of accounting that have been developed to address problems associated with changing prices
some of the strengths and weaknesses of the various alternative accounting methods
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

3. Learning Objectives
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
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

4. Limitations of historical cost in times of rising prices
Historical cost assumes money holds a constant purchasing power
three components 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

5. Limitations of historical cost in times of rising prices - continued
problem of relevance in times of rising prices
asset’s current value may be different from historical cost
problem of additivity
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 year’s income distorts the current year’s operating results
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

6. Support for historical cost accounting
Predominant method used today so tended to maintain support of profession
if not found useful business entities would have abandoned it
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

7. 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 upon a notion of capital maintenance
different notions of capital maintenance will provide different perspectives of income
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

8. 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

9. 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

10. Current purchasing power accounting
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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

11. 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)
eg. Australian Consumer Price Index (CPI)
can use a general or specific price index
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

12. 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

13. Performing current purchase power adjustments - continued
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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

14. Performing current purchase power adjustments - continued
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
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

15. 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

16. 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

17. 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
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

18. Current cost accounting
Based upon 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
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

19. 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
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

20. 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

21. 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

22. Adjustments using Edwards and Bell approach - continued
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
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

23. 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 management’s control
better comparability of various entities’ performance
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

24. 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

25. Criticisms of current cost accounting - continued
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
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

26. Continuously Contemporary Accounting (CoCoA)
Proposed by Chambers as well as others
based on valuing assets at net selling prices (exit prices) at balance 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

27. Continuously Contemporary Accounting (CoCoA) - continued
Statement of financial position (balance sheet) considered to be the prime financial statement
shows the net selling prices of the entity’s assets
profit directly relates to changes in adaptive capital
adaptive capital reflected by the total exit values of assets
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

28. 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’
assumes the objective of accounting is to guide future actions
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

29. 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 entity’s assets
no distinction between realised and unrealised gains - all gains are treated as part of profit
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

30. Definition of wealth under CoCoA - continued
Profit is the amount that can be distributed, while maintaining the entity’s 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
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

31. 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 period’s 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

32. 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

33. 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

34. Criticisms of CoCoA - continued
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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

35. Criticisms of CoCoA - continued
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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

36. 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

37. Demand for price adjusted accounting information- continued
Surveys of managers find limited corporate support for current cost accounting
cost, limited benefits from disclosure, lack of agreement as to approach are 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
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

38. 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

39. Reasons for lobbying - continued
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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

40. 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 © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan

41. 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
self-interest motives of corporations
limited relevance to decision makers
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan