Revise lecture 8

Historical cost accounting

• Under historical cost accounting, assets are recorded at the amount of cash or cash equivalents paid, or the fair value of the consideration given for them

• Liabilities are recorded at the amount of proceeds received in exchange for the obligation.

Historical cost accounting

1. Another, similar asset might be purchased. Management need to know the current replacement cost which might have changed substantially since the present asset was purchased at its historical cost.

2. The asset might be sold. Management need to know the amount which would be realised from sale, less any costs involved in disposal, i.e. the NRV. Again this may bear no relationship to historical cost.

Historical cost accounting

3. The asset might be used in the business. Management need to estimate the future cash flows arising from the asset and discount these to their present value, i.e. their economic value. Clearly there is no direct link with historical cost in this case.

Historical cost accounting

Advantages of historical cost accounting1. Easy to understand2. Straightforward to produce3. Historical cost accounts are objective and free from

bias4. Historical cost values are reliable and original values

can be confirmed based on original invoices / accompanying documents

5. Historical cost accounts do not record gain until they are realised

Historical cost accounting

Disadvantages of historical cost accountingIn periods in which prices change significantly,

historical cost accounts have grave deficiencies:1. Carrying value (CV) of non-current assets is

often substantially below current value2. Stock in the SFP reflects prices at the date of

purchase or manufacture rather than those current at the year end

Historical cost accounting

3. Income statement expenses do not reflect the current value of assets consumed so profit in real terms is exaggerated

4. No account is taken of the effect of increasing prices on monetary items

5. The overstatement of profits and the understatement of assets prevent a meaningful calculation of return on capital employed (ROCE)

•Alternative to historical cost accounting

Alternative to historical cost accounting

The alternative to historical cost accounting is a form of current value accounting, either:

1. Constant purchasing power (CPP) or

2. Current cost accounting (CCA)

Alternative to historical cost accounting

Constant purchasing power accounting

1. Accounts figures are adjusted to show all figures in terms of money with the same purchasing power

2. A general price index is used for this3. Figures in the IS and SFP are adjusted by the CPP

factor4. CPP factor = Index at the reporting date / Index

at the date of entry in accounts

Alternative to historical cost accounting

In converting the figures in the basic historical cost accounts into those in the CPP statement, a distinction is drawn between:

1. Monetary items

2. Non-monetary items

Alternative to historical cost accounting

Monetary items• Are those whose amounts are fixed by

contract or otherwise in terms of numbers of dollars, regardless of change in general price level. Examples of monetary items are cash, receivable, payables and loan capital

Alternative to historical cost accounting

Holders of monetary asset lose general purchasing power during a period of inflation to the extent that any income from the assets does not adequately compensate for the loss in purchasing power. The converse applies to those having monetary liabilities

Alternative to historical cost accounting

Non-monetary items• Include such assets an stock and non-current assets.

Retaining the historical cost concept requires that holders of non-monetary assets are assumed neither to gain nor to lose purchasing power reason only of changes in the purchasing power of the unit of currency

• The owners of the company’s equity capital have the residual claim on its net monetary and non-monetary assets. The equity interest is therefore neither a monetary nor a non-monetary item.

Alternative to historical cost accounting

Advantages of CPP accounting1. CPP accounting is both simple and objective.

It relies on the standard index2. It adjusts for changes in the unit of

measurement and therefore is a true system of inflation accounting

3. It measures the impact on the company in terms of shareholders purchasing power

Alternative to historical cost accounting

Disadvantages of CPP1. Its fails to capture economic substance when

specific and general price movements diverge2. The unfamiliarity of information stated in terms

of current purchasing power units3. CPP does not show the current values (value to

the business) of assets and liabilities4. The general price index used is not necessarily

appropriate for all assets in all businesses

Alternative to historical cost accounting

Current cost accounting (CCA)1. It is based on deprival values or value to the business2. Stock and non-current assets are valued at deprival

value3. Monetary assets (cash, receivables, payables, loans) are

not adjusted4. Assets are stated at their value to the business5. Holding gains are eliminated from profit6. Users will be able to assess the current state or recent

performance of the business

Alternative to historical cost accounting

Disadvantages of CCA1. Possibility greater subjectivity and lower

reliability than historical cost2. Lack of familiarity3. Complexity4. CCA only adjust values for non-monetary

asset not all assets and liabilities

Current cost accounting - CCA

Q:Describe the types of business that would be most heavily affected by the replacement of historical cost accounting with a system based on current values.

Solution

• Businesses with the following characteristics will be most heavily affected by the change to current value accounting.

1. Large quantities of stock held for long periods of time, the resulting adjustments will impact heavily on the income statement

Solution

2. High levels of non-current assets acquired a long time ago, the resulting depreciation adjustment will adversely affect profit

3. Large reserves of monetary assets, a charge is made to the income statement to reflect their fall in value when prices are rising

4. Large borrowing, a credit is made in the IS to reflect the beneficial effect of holding borrowing in inflationary times.

Fair presentation

Q: When do financial statements show fair presentation?

Solution

There is no absolute definition of fair

presentation (known as the true and fair view in the UK). It is felt that its meaning evolves over time and with changes in generally accepted accounting practice (GAAP)

Solution

• Financial statements will generally show a fair presentation when:

1. They conform with accounting standards2. They conform with the any relevant legal

requirements3. They have applied the qualitative

characteristics from the framework

True and fair override

• IAS 1 states that an entity whose FS comply IFRSs should disclose that.

• However in extremely rare circumstances management may conclude that compliance with an IFRSs or interpretation would be misleading

• In this case an entity should depart from the requirement of the standard provided the relevant regulatory framework permits such departure.