Measurement Model

Historical Cost

Current Cost (CAA) Prepared by:

Carly Wong Ingrid Yeung Carmen Wong Priscilla Wong

Historical Cost Model

Historical Cost Model

The model has been around since the 1400’s

Until after WWII, inflation was not really part of our economic environment

The essence of the model is that all transactions are recorded at their acquisition or original cost

Historical Cost Model (Cont’d)

Form of payment is irrelevantAssumes aggregation of monetary units

from different periods acceptableAcquisition cost of depreciable assets is

allocated over asset’s effective service life– Historical cost depreciation is matched against

current dollar revenue creating an illusory net income component

Argument for Historical Cost

Historical cost is relevant in making economic decisions

Decisions making concerning future commitments => need data on past transactions as the basis for judging

History cost is relevant for decision making1. Affecting evaluation and selection of decision rules

=> historical cost is directly related to past decisions => determine the quality of the past decision=> serve as a basis for the forecast

2. Providing input to the “satisficing” notion=> decision makers do not seek to optimizes but to satisfice => consider how much earned rather than how much can earn

Historical cost is relevant in making economic decisions

3. Imposing on the decision maker by their environment

=> employed many different contexts

e.g. taxable income , cost-plus contracts

Historical cost is based on actual, not merely possible transactions

Record of the actual transactions=>supporting documents are provided=>determining how effectively management has met its responsibilities=>increasing the accountability-primary objective under stewardship function

Current cost or exit price accountingBasis of year end market prices without

reference to actual transactions

Throughout history, financial statements based on historical cost have been found to be usefulFinancial reports based on historical cost useful

for over the yearsModern industrial and managerial accounting

practices based on trial and error for many years

=> not useful => changed

The best understanding concept of profit is the excess of selling price over historical cost Profit is accepted as a measure of successful

performance Profit requires sufficient use of time , place and form be

added to the materials, products or services purchased above the cost

Historical cost is the basis idea of profit E.g. decision on whether continue a product line or not

depends on the favorable spread between revenue and cost

Accountants must guard the integrity of their data against internal modification

Historical cost is less subjective to manipulation than current cost or selling price.

Littleton => these are still wholly outside the prior decisions and the recorded experience of the enterprise

Accountants must guard the integrity of their data against internal modification

Mautz => whom would you trust to value the assets of any major company, how are current values to be determined, how would an accountant ascertain that the values are a fair presentation, can an accountant withstand the pressure by managers to accept optimistically valued assets?

How useful is income information based on current cost or exist price

Is it useful to show as income an increase in the value of an asset that the firm has no intention of selling?

If the price of an asset at the end of the year is lower than it was during the year, this encourages criticism of management by shareholders for not having disposal of the asset earlier.

How useful is income information based on current cost or exist price

Current cost and exist price accounting induce a short-term view of profits.

In many cases, management may believe that disposing of assets is not the more profitable alternative – reasons for holding an asset other than realizing an immediate profit.

Changes in market prices can be disclosed as supplementary data

Historical cost does not differ materially from current cost.– Supplementary data on current prices are a practical

and sufficient way of dealing with such information without having to shift from historical cost to a current cost basis.

– Adopted by the Australian Accounting Standard setters in 1976.

• Supplementary statement in addition to their conventional financial statement

Changes in market prices can be disclosed as supplementary data

Based on studies of the relationship between accounting data and the market reaction to the data, the efficient markets hypothesis in semistrong form states that security prices always reflect publicly available information.– Implying that the method of disclosing any

information including current values, whether shown in the text of the financial statements, as a footnote, or as supplementary data, makes no difference to the market.

There is insufficient evidence to justify

rejection of historical cost accounting

Most of the research studies indicate that current cost data do not provide any more information than historical cost data

Traditional accountants argue that there is no persuasive empirical evidence that indicates that current cost or exist price accounting information is more useful than historical cost information

Criticisms of historical cost accounting

Objective of accounting

Provide useful information for economic decision making is taken to mean providing information to the stewardship function of management.– Historical cost accounting reveals that the

primary role of accounting is to meet the decision-making needs of users

– Forward-looking decision-usefulness approach

Objective of accounting

Information on the stewardship function does not necessarily restrict accountability to the original amounts invested directly or indirectly by equityholders.

Investors are interested in knowing about the increases or decreases in the value of their investments as represented by the net assets of the company

Objective of accounting

Historical cost system fails in its underlying function of providing objective information.– It is far from objective and is open to manipulation

– Monograph 10 questions the validity of the historical cost information and attacks a basic tenet of the system, which is that historical cost information ensures the maintenance of an entity’s capital base.

Information for decision making

Historical cost=> management needs historical cost data in order to evaluate their past decisions as they contemplate future commitments

Past decision was right or wrong must ultimately be ascertained by what happens in the marketplace

Historical cost has usefulness, but it is insufficient for the evaluation of business decisions.

Information for decision making

Historical cost accounting adopts a financial capital concept.

However, capital regarded as the nominal dollar investment in the firm rather than the purchasing power of the investment. After the year of acquisition, historical costs do not correlate with the events of the year.

Information for decision making (Cont’d)

Historical cost overstated income in a time of rising prices because it offsets historical cost against current inflated revenue.

Highly questionable for the relevance of historical cost for decision making.

Basis of historical cost

Historical cost is under the ‘going concern’ assumption

Sterling => questions the validity of the assumption– The high rate of business failure would make

it difficult to build an evidential case for a projection of continuity. No business has ever continued ‘indefinitely’ into the future.

Historical cost under attack

Balance sheets contain outdated cost prices or valuations => hardly to say to be true and fair

A lot of departures – All non-financial assets of GTEs be measured using

‘deprival value” concepts

– Liabilities be measured using present value

Departures provide more relevant information than historical cost

Notions of investor needs

Historical cost cause either a distortion or concealment of important company disclosures=> goal of conventional accounting are ill-conceived – Because accountant:

• Have naïve, simplistic view of investor and their needs• Accept old-fashioned, fundamentalist view

Share market analysis and corporate analysis are different– Market analysis mainly of trying to ascertain what other

investor are thinking– Corporate analysis not really concerned about corporate

facts but about the psychology of the market

Matching

Going concern assumption does not underlie the use of historical cost

Matching concept-when revenues are earned, the expenses incurred in earning those revenues are matched (offset) against the revenues to calculate income

Conventional accounting puts emphasis on deciding whether a cost should be deducted form revenues in the current period or be deferred to future periods=>responsible for deferred charges and that are not

assets and deferred credits that are nor liabilities

Matching

Decisions are based on the matching principle

=> in most cases the matching of costs and revenues is a practical impossibility

e.g. cost allocation- not capable of being verified or refuted because there is no way to select one method over another except arbitrarily

Current Cost Accounting (CCA)

Definition of current cost accounting

a cost calculated to take into consideration current circumstances of cost and performance levels

adjusting to constant purchasing power by using the average inflation rate in the current year

Business Profits

composes into 2 parts– current operating profit – realizable cost savings

Current operating profit:– excess of the current value of the output

sold over the current cost of the related inputs

 Realizable cost saving:– increase in the current cost of the assets

held by the firm in the current period– both realized and unrealized cost changes.

Business Profits

– realizable cost savings = holding gains/losses

– Holdings gains: • a saving attributable to the fact that the

input was acquired in advance of use• this savings is attributable to holding

activities.

Why we need to measure separately?

Holding assets and liabilities enhance the firm’s market position

managers and others want to know if these holding activities are successful

Under the conventional accounting gains are only recorded when the assets are disposed impossible to show it unless assets are bought and sold mislead the investor to determine which firm is more efficient

Assumption of the CCA

Without the measurement of the holding gains/losses

confuse the evaluation of management decision

hinders the allocation of resources in the economy

CCA suggest that separation of holding gains and operation profits gives credit to the appropriate managers

Financial Capital Concept vs. Physical Capital Concept

CCA provides more useful information than conventional accounting

supports can be divided into 2 camps– those who believe in the financial capital

concept

– those who believe in physical capital concept

Difference: “whether or not holding gains or losses are included in income” 

Financial Capital

firm invests financial resources with the expectations that the investment will create a higher level of cash inflow

recovery of the amount of financial resources invested is a return of capital

cash flows in excess of the amount financial resources invested are a return on capital

holding gains cost savings and the increases in future cash flow of the assets

Physical capital

physical units denoting the firm’s operating capability

emphasize on the need to know the firm’s operating capability has been maintained continue in businesses

the holding gains capital maintenance adjustment

Argument Against CCA

Realization principle– it violates the traditional realization principle– because the changes in market price of the

assets in use is irrelevant– fixed asset is not more valuable to a firm

simply because its current cost has risen– asset value lies in its service potential, not its

market value

Argument Against CCA (Cont’d)

Subjectivity– another problem is the subjectivity of

determining the amount of the increase in cost– if there is no reliable secondhand market,

current cost must be the new asset expected to replace the old one

– adjustment has to be made between the actual asset and the replacement

– it is difficult to calculate

Argument Against CCA (Cont’d)

Subjectivity– another problem is the subjectivity of

determining the amount of the increase in cost– if there is no reliable secondhand market,

current cost must be the new asset expected to replace the old one

– adjustment has to be made between the actual asset and the replacement

– it is difficult to calculate

Argument Against CCA (Cont’d)

viewpoint of exit price– cost implies opportunity cost or sacrifice of

the next best alternative– current sacrifice faced by a company is to sell

the asset rather than use it– but not to purchase the item because company

has already owned it – so current cost, which is the price to purchase,

is irrelevant

Argument Against CCA (Cont’d)

Allocation problem– allocation of current cost is arbitrary and lack

in real-world counterparts– backlog depreciation is charged to income or

to a capital account– cause difference in amount of income reported

Argument Against CCA (Cont’d)

Technological changes– improved assets will more than likely replace

existing assets– so current operating profits would be poor

predicators of future profits– investors would be misled by the current

operating profit as a basis for predicting future cash flows

Argument Against CCA (Cont’d)

Sum up:– current cost information is irrelevant to most

investment decisions– it does not focus on the firm’s ability to

command financial resources in the firm’s quest to adapt itself to the environment

Argument For CCA

Recognition principle– current cost accounting violates the conventional

principle of recognizing a holding gain only for unrealized holding gains from a financial capital view

– unrealized holding gains represent actual economic phenomena occurring in the current period

– therefore should be recognized if there is sufficient objective evidence to support the price changes

Argument For CCA (Cont’d)

Recognition principle (cont’d)– market price of fixed assets are not relevant – however, whether the firm intends to use or

sell a fixed asset is not pertinent – the change in the price of the asset is relevant– determination of periodic income should be

based on what actually happened in the current period, not on what might occur

Argument For CCA (Cont’d)

Subjectivity– current cost accounting lacks objectivity?– current cost is not based on actual transactions in

which the firm is a participant– however, objectivity is relative– even under conventional accounting, some figures are

more objective– therefore, the question is whether current costs meet a

certain minimum level of objectivity that the accounting profession is willing to accept

Argument For CCA (Cont’d)

Subjectivity (cont’d)– market prices are relatively easy to obtainthe objectivity of their current costs would be

acceptable– E.g current cost of fixed assets can be obtained

from secondhand dealers– No market prices are availableappraisals, calculations of reproduction costs

and use of index numbers

Argument For CCA (Cont’d)

Viewpoint of exit price– Value at exit price is unusual because the firm is

normally a buyer

– utilizing exit prices when liquidation is not contemplated is misleading

– e.g. a customized asset used by the company is of great value, but when a firm is under liquidation, the value of the asset is greatly reduced as it is customized for the company’s own use

Argument For CCA (Cont’d)

Viewpoint of exit price (cont’d)– however, the company decides to keep and use

its assets rather than sell the asset– because the management of the company

believes its value in use is greater than its exit value

Argument For CCA (Cont’d)

Allocation problem– allocation problem exists in most accounting

method, even the conventional historical cost accounting also has the allocation problem

Argument For CCA (Cont’d)

Technological changes– current operating profit = indication to make a

positive long-term contribution to the economy

– it also indicates that the production process in use by the firm is effective

– if profit > interest earned on the net assets at current cost

the existing production process is worth continuing

Argument For CCA (Cont’d)

Technological changes (cont’d)– current operating profit is primarily representative of

the long-term profit capability of the firm under the existing production process, assuming that existing conditions remain relatively the same

– the technological changes are not taken into account

– When a new machine changes the cost of production, the price of the old must adjust

the price of the old asset reflects the technological change

Conclusion

current cost accounting performs significantly better than historical cost income

because historical cost accounting fail to adjust for inflation

No doubt, CCA data provide useful information to managers

Conclusion (Cont’d)

Question: whether benefits exceed the cost of gathering the information?

On a cost-benefit basis– historical cost information are almost provided

in the capital marketsObjectivity:

– information obtained from genuine transaction that have occurred

– Information is capable of being verified

Conclusion: Historical Cost Accounting is better