Chapter 12

Current-value accounting

Arguments in favour of measuring income – I

• Income is a basis for the taxation and redistribution of wealth among individuals

• Income is perceived as a guide to a firm’s dividend and retention policy

• Income is viewed as an investment and decision-making guide in general

The AAA’s normative shareholders’ valuation model• The American Accounting Association’s

Committee on External Reporting defined a normative shareholders’ valuation model centring on:– the future dividend-per-share flows to be

derived from an investment– the risk associated with these flows

• The Committee on External Reporting also suggested that a firm’s ability to pay dividends is a function of the following variables:– net cash flows from operations– non-operating cash flows

The AAA’s normative shareholders’ valuation model (cont’d)

– cash flows from changes in the levels of investment by stockholders and creditors

– cash flows from investment in assets– cash flows from priority claims– cash flows from random events– management attitudes regarding stocks of

resources– cash dividend policy

Arguments in favour of measuring income – II

• Income is perceived as a predictive device that aids in the prediction of future incomes and future economic events

• Income may be perceived as a measure of efficiency

Accounting income

Accounting income is operationally defined as the difference between the realised revenues arising from the transactions of the period and the corresponding historical costs

Attributes of accounting incomeThere are at least five attributes of accounting income:1. accounting income is based on the

actual transaction entered into by the firm (primarily revenues arising from the sales of goods or services minus the costs necessary to achieve these sales)

2. accounting income is based on the revenue principle and requires the definition, measurement, and recognition of revenues

Attributes of accounting income (cont’d)

3. accounting income requires the measurement of expenses in terms of historical cost to the enterprise, constituting a strict adherence to the cost principle

4. accounting income requires that the realised revenues of the period be related to appropriate or corresponding relevant costs

5. accounting income is also based on the period postulate and refers to the financial performance of the firm during a given period

Advantages of accounting income

• Accounting income has survived the test of time

• Because it is based on actual, factual transactions, accounting income is measured and reported objectively and is therefore basically verifiable

• By relying on the realisation principle for the recognition of revenue, accounting income meets the criterion of reliability

• Accounting income is considered useful for control purposes, especially in reporting on stewardship

Disadvantages of accounting income

• The arguments against the use of accounting income question its relevance in decision making

• The most serious problem with accounting income is that it is predicated on the assumption of a stable monetary unit, which means that as a result it fails to recognise increases in the values of assets and liabilities held in a given period

Disadvantages of accounting income (cont’d)

• A host of authors have observed that, because the monetary unit is unstable in modern economies, accounting income can easily give a mistaken and misleading impression of an entity’s earnings, financial strength and performance

• Accounting income effectively allows entities to ‘manage’ results

Disadvantages of accounting income (cont’d)

• The reliance of accounting income on the historical-cost principle makes comparability difficult, given the different acceptable methods of computing ‘cost’ and the different acceptable methods of cost allocation deemed arbitrary and incorrigible

The nature of the economic concept of income

The concept of income has always been an important point of interest to economists:• Adam Smith was the first economist to

define income as an increase in wealth• most classicists followed Smith’s concept of

income and linked its conceptualisation to business practices

• towards the end of the nineteenth century, the understanding that income is more than cash was expressed in Von Bohm Bawerk’s theories on capital and income

FisherFisher defined economic income as a series of events that correspond to different states – the enjoyment of psychic income, real income and money income:• psychic income is the actual personal

consumption of goods and services that produce a psychic enjoyment and satisfaction of wants … it cannot be measured directly, but it can be approximated by real income

• real income is an expression of the events that give rise to psychic enjoyment and is best measured by the cost of living

• money income represents all the money received and intended for use in consumption to meet the cost of living

Lindahl • Lindahl introduced the concept of income

as interest, referring to the continuous appreciation of capital goods over time

• The differences between the interest and consumption anticipated for a given period are perceived as saving

• This idea led to the generally accepted concept of economic income as consumption plus saving expected to take place during a certain period, the saving to being equal to the change in economic capital

Hicks

Hicks used the concepts introduced by Fisher and Lindahl to develop a general theory of economic income, defining a person’s personal income as: ‘the maximum amount he can

consume during a week and still expect to be as well-off at the end of the week as he was at the beginning’

Capital maintenance• The concept of capital maintenance

implies that income is recognised after capital has been maintained or costs have been recovered

• Return on capital (income) is distinguished from return of capital (cost recovery)

• SAC 4 identified two concepts of capital maintenance: financial and physical

Financial and physical capital maintenance

• Financial and physical capital maintenance can be in the form of units of money or general purchasing power

• This gives rise to four concepts of capital maintenance:1. money maintenance, being financial

capital measured in units of money2. general purchasing-power money

maintenance, being financial capital measured in units of the same purchasing power

Financial and physical capital maintenance (cont’d)

3. productive-capacity maintenance, being physical capital measured in units of money

4. general purchasing-power, productive-capacity maintenance, being physical capital measured in units of the same purchasing power

Capitalisation (present value)• Under the capitalisation method for calculating

current value, the capitalised value of an asset, group of assets or total assets is the net amount of the discounted expected cash flows of such assets during their useful lives

• To compute the capitalised value, four variables must be known:1. expected cash flows from asset use or

disposal2. the timing of those expected cash flows3. the number of years of the asset’s remaining

life4. the appropriate discount rate

Capitalisation (present value) (cont’d)

• The present-value income is the total pure-profit income expected to be accrued up to the firm’s planning horizon

• It is an ex ante income, or economic income, that reflects expectations about future cash flows

Economic income versus accounting income

• Economic income is an ex ante income based on cash-flow expectations

• Accounting income is an ex post or periodic income based on historical values

Current entry price • Current entry price can be defined as the amount

of cash or other consideration that would be required to obtain the same asset or its equivalent

• The following interpretations of current entry price have been used:– replacement cost – used is equal to the amount

of cash or other consideration that would be needed to obtain an equivalent asset on the second-hand market, having the same remaining useful life

– reproduction cost is equal to the amount of cash or other consideration that would be needed to obtain an asset identical to the existing asset

Current entry price (cont’d)

– replacement cost – new is equal to the amount of cash or other consideration needed to replace or reproduce the productive capacity of an asset with a new asset that reflects changes in technology

• The common characteristic of the three notions of current entry prices is that they all correspond to the costs of replacing or reproducing an asset held

Measurement of current entry prices

• The issue that remains to be solved is the choice of method of measurement of current entry prices

• The three most-advocated methods use:– quoted market prices– specific price indexes– appraisals

Holding gains and losses• The valuation of assets and liabilities at current

entry prices gives rise to holding gains and losses as entry prices change during a period of time when they are held or owed by a firm

• Holding gains and losses may be divided into two elements:1. the realised holding gains and losses that

correspond to the items sold or to the liabilities discharged

2. the holding gains and losses that correspond to the items still held or to the liabilities owed at the end of the reporting period

Backlog depreciation• Three methods have been suggested to

account for backlog depreciation:1. charge or credit to retained earnings2. charge or credit to current income3. adjust holding gains and losses by the

amount of backlog depreciation• The three methods result from two

fundamentally different interpretations of depreciation:– that depreciation should provide a reserve

for the future replacement of assets so that backlog depreciation should be treated according to either of the first two methods

Backlog depreciation (cont’d)

– that depreciation is a current cost of operations, so that backlog depreciation should be treated according to the third method

Advantages of current-entry-price-based accounting

The primary advantage of current-entry-price-based accounting results from the breakdown and segregation of current-value income into current operating profit and holding gains and losses:• as noted by Edwards and Bell, the dichotomy

between current operating profit and holding gains and losses is essential for evaluating the past performance of managers

• the dichotomy between current operating profit and holding gains and losses is useful in making business decisions

Advantages of current-entry-price-based accounting (cont’d)

• current operating profit corresponds to the income that contributes to maintaining physical productive capacity – that is, the maximum amount that the firm can distribute and maintain its physical productive capacity

• the dichotomy between current operating profit and holding gains and losses provides important information that can be used to analyse and compare inter-period and inter-company performance gains

• the current-entry-price method allows a distinction between realised holding gains and losses and unrealised holding gains and losses

Disadvantages of the current-entry-price system

• Each claim about the benefits to be derived from dichotomising current-value income into current operating profit and holding gains and losses has been contested

• The current-entry-price system is based on the assumptions that the firm is a going concern and that reliable current-entry-price data may be obtained easily

• There is also the difficulty of correctly specifying what is meant by ‘current entry price’

Disadvantages of the current-entry-price system (cont’d)

• There have been other conceptual criticisms of replacement-cost accounting

• There have been suggestions that the current-entry-price system recognises current value as a basis of valuation but does not account for changes in the general price level, and gains and losses on holding monetary assets and liabilities

Current exit price – I• Advocates of exit value accounting

emphasise the notion of opportunity costs

• Opportunity cost means the value of the next best alternative

• In order to know the next best alternative, it is relevant to know the market value or the selling price of an asset

Chambers’ model• One of the most popular exit-value models was

developed by Chambers in 1966• His model is better known as continuous

contemporary accounting, or CoCoA• According to Chambers, a firm must continually

make adjustments to stay in tune with its environment and the marketplace, in order to survive and prosper

• Capacity for adaptation necessitates that entities can quickly modify, replace or redeploy an existing asset base as the need arises

• Decisions relating to changes in the composition of resources require knowledge of selling prices, not buying prices

Continuous Contemporary Accounting (CoCoA)

According to Chambers (1975), CoCoA is based on three key ideas:1. a statement of financial position is only

understandable and significant in relation to financial dealings if its components are amounts of money and prices expressed in money

2. no reasonable action can be taken on the basis of a statement of financial position unless the statement corresponds reasonably well with the actual financial position of a firm as at the date the statement bears

Continuous Contemporary Accounting (CoCoA) (cont’d)

3. specific price movements in a period affect both the income of the period and the financial position at the end of the period

Current exit price – II • Current exit price represents the

amount of cash for which an asset might be sold or a liability might be refinanced

• The current exit price is generally agreed to correspond to:– the selling price under conditions of

orderly rather rather than forced liquidation

– the selling price at the time of measurement

Advantages of current-exit-price-based accounting

• The current exit price and the capitalised value of an asset provide different measures of the economic concept of opportunity costs

• Current exit price provides relevant and necessary information on which to evaluate the capacity for adaptation and liquidity of a firm

• Current exit price provides a better guide for the evaluation of managers in their stewardship function because it reflects current sacrifices and other choices

Disadvantages of current-exit-price-based accounting

• The current-exit-price-based system is relevant only for assets that are expected to be sold for a determined market price

• The current-exit-price-based system is not relevant for assets that the firm expects to use

• Some writers have questioned the relevance of operating profit as determined under the exit-value model

• The valuation of certain assets and liabilities at the current exit price has not yet been adequately resolved

Disadvantages of current-exit-price-based accounting (cont’d)

• The abandonment of the realisation principle at the point of sale and the consequent assumption of liquidation of the firm’s resources contradict the established assumption that the firm is a going concern

Other interpretations of current values

Other proposals for the implementation of current-value accounting have been made, such as:• essential versus non-essential assets• value to the firm• SEC replacement-cost proposal• combination of values• the concept of business income

Essential versus non-essential assets

• The Australian Accounting Standards Committee published a preliminary exposure draft ‘A Method of Current-Value Accounting’ in June 1975

• The exposure draft introduced a form of current-value accounting that uses different treatments for essential assets and non-essential assets

• Essential assets are determined on the basis of ‘the expected role of particular assets in the entity’s operations in the immediately forseeable future’

Essential versus non-essential assets (cont’d)

• A non-essential asset is valued at its current exit price

• An essential asset is valued at its current entry price

Essential versus non-essential assets

• The holding gains and losses on essential assets are credited or debited to a revaluation account

• The holding gains and losses on non-essential assets are included in income

• The distinction between essential and non-essential assets represents a modification of the current-entry-price-based system to reflect economic realities

The Sandilands Report• In the UK, the ‘Report of the Inflation Accounting

Committee’, which was chaired by F. E. P. Sandilands, was issued in 1975:– the Report’s most important recommendation

is the use of the value to the firm as a valuation base

– accounting based on the value to the firm is also described as current-cost accounting (CCA)

– according to this approach, assets are valued at an amount that represents the opportunity cost to the firm

The Sandilands Report (cont’d)

• The Sandilands Report also recommends that:– all holding gains and losses be excluded

from current-cost profit– a ‘summary statement of total gains and

losses for the year’ appear immediately after the income statement

SEC replacement-cost proposal

• The Securities Exchange Commission (SEC) cited replacement cost as the mandatory method of disclosure for large corporations

• Replacement cost is defined as the lowest amount that would have to be paid in the normal course of business to obtain a new piece of equipment operating at productive capacity

• The regulation requires that designated firms:– estimate the current replacement cost of

inventories and productive capacity

SEC replacement-cost proposal (cont’d)

– restate the cost of goods sold and services, depreciation, depletion and amortisation for the two most recent full fiscal years on the basis of the replacement cost of equivalent productive capacity

• The SEC proposal was a timid attempt to show the impact of inflation on fixed assets and inventory, rather than on all monetary and non-monetary assets

The combination of values• The combination-of-values approach avoids

some of the disadvantages of the current-exit-price, current entry price and capitalisation methods

• The Canadian Accounting Research Committee’s preliminary position favours a combined use of current entry and current exit prices

• Although the combination-of-values approach may appear to be based on arbitrary rules, advocates of this approach have suggested specific decisions rules for the choice of a valuation method based on the market-opportunity costs of assets

The concept of business income• Edwards and Bell have introduced the

concept of business income• We have defined accounting income as the

difference between the realised revenues arising from the transactions of the period and the corresponding historical costs

• Business income differs from accounting income in two ways:1. business income is based on

replacement-cost valuation 2. business income recognises only the

gains accrued during the period