Financial Accounting Theory Craig Deegan Chapter 5 Normative

Financial Accounting Theory Craig Deegan Chapter 5 Normative theories of accounting—the case of accounting for changing prices Slides written by Craig Deegan Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 5 -3

Limitations of historical cost in times of rising prices (cont. ) • Problem of relevance in times of rising prices – asset’s 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 year’s income distorts the current year’s operating results Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 management’s control • Better comparability of various entities’ performance Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 5 -24

Continuously Contemporary Accounting (Co. A) • 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 5 -25

Continuously Contemporary Accounting (Co. A) (cont. ) • The balance sheet (statement of financial position) 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 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 5 -27

Definition of wealth under Co. A • 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 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 5 -28

Definition of wealth under Co. A (cont. ) • 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 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 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 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 5 -30

Advantages of Co. A • 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 5 -31

Criticisms of Co. A • If implemented Co. A 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 5 -32

Criticisms of Co. A (cont. ) • Assets of a specific nature considered to have no value under Co. A because cannot be separately disposed of – Co. A 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 5 -33

Criticisms of Co. A (cont. ) • Co. A 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 5 -38

Professional support for various approaches • Current purchasing power accounting generally supported by standard-setters from 1960 s to mid 1970 s • From about 1975 preference shifted to current cost accounting • Late 1970 s and early 1980 s standard-setters issued recommendations which favoured a mixture of CPPA and CCA • From mid-1980 s support waned (time of falling inflation) Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 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 Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 5 -41