International Developments in Accounting ACFI3217 Accounting for changes in price levels Dr. Samuel Owusu-Agyei HU 3.40

Historical cost accounting (HCA) The transaction-based HCA records transactions at cost. No further changes are made. HCA unchallenged until inflation became high, reaching an annual rate of increase of 20% in the mid 1970s. Then there were growing criticisms on HCA

Criticisms of HCA Profit overstated when inflationary changes in the value of assets ignored (e.g. inventory) Understatement of SoFP values Expenses (depreciation) understated as they are based on lower asset values

Criticisms of HCA Gains and losses on monetary assets are undisclosed. e.g. cash loses value in times of rising prices Comparability of business performance and growth becomes distorted. E.g. rise in profits versus inflation rates.

Review of the problems of HCA Financial reports confusing because revenue is mismatched with differing historical cost levels The decision-making process, the formulation of plans and the setting of targets may be suboptimal if underlying financial data is out of date.

Accounting for changing prices The limitations of HCA in inflationary times raise a need for current value accounting. Adjustments for changes after original entries.

Accounting for changing prices-IASB approach When inflation rates were high IAS 15 was issued in 1983 “Information reflecting the effects of changing prices” IAS 15 was withdrawn in 2003 when inflation rates were low IAS 29 still extant “Financial reporting in hyperinflationary economies”

Hyperinflationary indicators Qualitative indicators When people prefer non-monetary assets When people prefer prices to be stated in an alternative stable currency Quantitative indicators When the cumulative inflation rate over three years approaches 100%

Current value accounting disadvantages: It destroys the factual nature of HCA, which is transaction based: Transaction based historic values are replaced by judgmental values. It is not as objective as HCA because it is less verifiable. It entails recognition of unrealised profit. No improvement in comparability because of the degree of subjectivity in measuring current value. The lack of a single accepted method of computing current values.

Methods of accounting for changing price levels Current Purchasing Power (CPP) Current entry or replacement cost (RCA) Current exit or Net Realisable Value (NRVA)

Data to illustrate HCA method Transactions during January 20X3 1 January 20X3 Initial capital in cash 3,000 1 January 20X3 Purchased 6 computers for 500 each 15 January 20X3 Sold 3 computers for 900 each 31 January 20X3 Cash was 2,700 31 January 20X3 HCA Inventory was 1,500

HCA Income Statement and SOFP Sales 3x 900 2,700 Cost of sales 3x 500 1,500 Profit 1,200 Capital 3,000 Profit 1,200 4,200 Inventory 3x 500 1,500 Cash 2,700

Current Purchasing Power (CPP) CPP applies a general price index to HCA figures Such indices are often prepared by a government department e.g. Retail Price Index in the UK Holding monetary assets during periods of inflation leads to losses in the purchasing power of money

Current Purchasing Power (CPP) Transactions are restated from the date the transaction occurred to the closing SOFP date CPP accounts are expressed in units of Purchasing Power as CPP (not in £s)

CPP - Virtues An objective measure – transaction based A measure of shareholders’ capital with capital being maintained in terms of purchasing power units Introduces the concept of gains and losses on monetary items

CPP - defects General price indices may not reflect the effect of inflation on a particular business Creates an alien unit of measurement Its concept of profit is dangerous for decision making

Replacement cost accounting (RCA) Assesses income and value of assets by reference to current replacement costs of materials and other assets. Where asset values are increasing, a holding gain is recognised.

RCA – COSA RCA recognises a holding gain in the value of assets. The holding gain is the difference between the Replacement cost and Historic cost as at the date the transaction occurred. Thus, a holding gain is recognised because the cost to replace the asset has risen.

Illustration Assume that 3 units of inventory was purchased at £500 but can only be replenished at £700 per unit at the end of the period Cash balance is at £2700 How will this be presented in the SoFP using RCA? How does it compare to HCA?

RCA SoFP Asset section Inventory 3x 500 1,500 3 x 700 2,100 HCA RCA Inventory 3x 500 1,500 3 x 700 2,100 Cash 2,700 2,700 4,200 4,800 The significant information is Replacement cost at the SOFP date. Inventory is restated at its replacement cost. The Holding Gain is 600 which is recorded as a Gain in the SOFP.

RCA - virtues Its unit of measurement is the monetary unit It identifies and isolates holding gains and so maintains physical operating capability It introduces realistic current values

RCA - defects A subjective measure based on estimates of values often using index numbers It assumes replacement with similar assets which may not be the case

Net realisable value accounting (NRVA) Accounting based on the selling price of assets less necessary costs to sell. Based on the economist’s concept of opportunity cost Sometimes called current exit cost For many assets the value used would be the value that could be realised on a sale – this is the exit value

Illustration- NRVA Opening position 1.1.X3 Capital 3,000 1.1.X3 Purchased 6 items at 500 each 3,000 Transaction 15.1.X3 Sold 3 items for 900 each 2,700 Closing position 31.1.X3 Cash was 2,700 31.1.X3 Inventory was 3 at 500 each 1,500

NRVA – What is the significant date? The significant date is the selling price at the closing SOFP date. The difference between the Selling Price at the SOFP date and Historic Cost will be shown as a Holding Gain in the Income Statement.

NRVA Income Statement HCA NRVA Sales 3x 900 2,700 2,700 Cost of sales 3x 500 (1,500) (1,500) Holding gain 3 x (900-500) 1,200 Profit 1,200 2,400 This Holding Gain will be added to Inventory in the NRVA SOFP.

NRVA SOFP Capital 3,000 3,000 Profit 1,200 2,400 4,200 5,400 HCA NRVA Capital 3,000 3,000 Profit 1,200 2,400 4,200 5,400 Inventory 3x 500 1,500 3 x 900 2,700 Cash 2,700 2,700 4,200 5,400

NRVA - virtues Readily understood by users who think in terms of selling prices No need to estimate depreciation – rather it is the difference between NRV at the beginning and end of the period Based on opportunity cost and therefore more meaningful

NRVA - defects It is subjective and lacks prudence in calculating profit because unrealised profits are included NRVA is not relevant to assets that will be used rather than sold Hard to determine the NRV where there is no obvious market for the asset Violates the going concern concept Less reliable and verifiable than HC

Summary Traditional accounting using HC has many weaknesses Rising prices have led to three models CPP Replacement cost Realisable value