Accounting theory.

• Criticism against historical cost include:

1. Despite being useful, historical cost is insufficient for the meaningful evaluation of business decisions since it needs to predict behaviour not look at where they’ve been.
2. Since the objective of financial reporting is providing relevant business information to users for effective decision-making, the more current the information the better.  Historical costs are therefore not relevant.
3. The matching concept is flawed.
4. Since historical cost financial reports are based upon the going concern concept, the high rate of business failures rejects the concept of continuity.  
5. Historical cost accounting, with its focus on determining net profit often causes either a distortion or concealment of important corporate disclosure.

5. Current Cost Accounting

Whereas traditional accounting convention values assets (and liabilities) at original cost, current cost accounting utilises current replacement prices, with profits being determined by allocations based upon current costs.  

Management often have to decide on whether to hold assets and liabilities or whether to dispose of them.  It is also faced with decisions on how to use and finance the organisation’s operations.  Edwards and Bell maintain that in order to evaluate both the holding and operating decisions of management, “business profit” should be applied.  This comprises “current operating profits” which is the surplus of the current value of output sold over the current cost of the related inputs, and “realisable cost savings” which is the increase in the current cost of assets held in the current period.

• Proponents of current cost accounting argue that:

1. Historical costs do not account for inflation regarding all profits as operating profits.
2. Current cost accounting separates operating profit and holding gains that can be used for asset maintenance.
3. Current cost accounting provides investors with more relevant information for decision-making.
4. Moreover, it also provides users with information about management capabilities.
5. Current cost accounting is consistent with the going concern assumption.

• Criticism against current cost accounting include:

1. Current replacement cost may not be readily available for many assets.
2. Particular assets are often not replaced with same assets.
3. The holding gain and losses are unrealised and only realised profits should be included.
4. Exit price proponents argue that the market value of the assets better reflects the opportunity costs, than the replacement cost.

6. Exit Price Accounting

Exit price accounting is based on the market value of assets, (i.e. net realizable value or current cash equivalents).  In this method there is no provision for depreciation, with variations in asset values being included in the profit calculation.  Continuously Contemporary Accounting is the most popular system in the area of exit price accounting.

The criticism of historical cost is not that it is a cost based measure, but rather that it is historical, and therefore of limited relevance at the balance sheet date.  Obviously, the same does not apply to current prices reflecting current replacement values.  Moreover, using entry values merely perpetuates the practice of reporting gains from selling assets or settling liabilities only when the transaction occurs, and not before.

• Proponents of exit price accounting argue

1. The information provided by exit price accounting is objective, relevant and useful.
2. Market value represents the company’s ability to fund purchases and to pay debts at a given date.
3. Net profit reflects the change in real purchasing power of the net assets, excluding additional investments by and distributions to owners.
4. Figures reflected under exit price accounting are real and present market prices.

• Criticism against exit price accounting

1. Exit price ignores the concept of ‘value-in-use’.
2. Exit price accounting is inconsistent with the objective of accounting measuring past events.
3. The exit price accounting lacks a stewardship objective.
4. It is unrealistic to assume the possibility of annual liquidation of the firm.
5. The effect of price changes may be outside the influence of the firm.
6. Replacement cost data allows evaluation of operating efficiency, compared to exit price data that records the effect of external price changes.

7. Mixed Measurement Systems

There has recently been a tendency for organisations to use “mixed measurement” accounting systems, incorporating components of the various valuation bases referred to above.

Mixed measurement system requires organisations to match the measurement basis to the particular category of assets of liabilities, within a particular situation.   Mixed measurement systems are flexible utilising either the historical cost or current value dependent on the prevailing organisational circumstances and the maturity of the accounting regime.

1. Problems with mixture measurement systems

Where assets have independent cash flows, the organisation’s assessment of the present value can be used to value the cash flows.  Where the assets do not generate independent cash flows, the market’s assessment of the present value will be applied to measure the cash flows.  However, it is seldom possible to determine the net cash flows generated from individual assets.

The stability of replacement cost is undermined during periods of rapid changes in markets and technology.  Accordingly, inadequate adjustments for technological change and associated productivity gains are measurement errors, which could overvalue the deprecation cost and the replacement value.  

Fair value information is the most important component of measurement. Fair value require several assumptions with minor changes potentially having a huge affect on the results, providing managers with more chances to manipulate the profit.  Moreover, since the assumptions are subjective it is difficult for auditors to verify.  The many methods of determining fair value it make it difficult to judge management performance and to predict future performance.

8. Fair (Market) Value

In the past, the convention was to use historical cost to value assets like land and financial instruments.  For example, where a company purchased an equity investment at $5per share, the investment would have been recognised and disclosed at $5 per share.  However, when the share price has dropped and those shares are only trading at only $2 per share, it is necessary that the investment value should be adjusted accordingly.  This information should be disclosed to shareholders, being useful for economic decision-making.  Fair value is accordingly a reality that cannot merely be ignored.

9. Impact of Changing Prices

There are two issues related to changes in prices.  The first is the decline in the purchasing price of money.  The second is the increase in prices and accordingly value of particular assets.  Additionally, given the depreciating value of money, long term liabilities are likely to be overstated, since the payment, when made, will be worth less.

Given that the convention has been for historical cost, the world’s major accounting bodies and industry associations are recommending (or prescribing for large company’s) the inclusion of a supplemental statement taking cognisance of inflationary pressures and specific price changes.

10. Market Value versus Book Value

When an asset was purchased for a particular amount, the transaction provides an objective measure of the asset’s value.  However, it may have been purchased some time ago, and may have little relevance today.  Moreover, the traditional convention is to account for the gradual deterioration of the asset over its useful life, by deducting depreciation from the asset value.  Whereas in some instances an asset purchased several years ago may be technologically obsolete and virtually worthless, in other instances it may be worth several times its original cost.  This is especially true in respect of land and shares and the impact of inflation.  A problem exists in that it is often not feasible to objectively determine the current values of many assets.  To an extent it is the desire to “be precisely wrong, rather than vaguely right”.  In the USA the Securities and Exchange Commission and the Financial Accounting Standards Board are prescribing that certain assets and liabilities appear on financial statements at market vales instead of historical cost.  The affected assets and liabilities are those that trade actively in markets, including common stocks and bonds.  Bankers were particularly vociferous since they were concerned about the potential volatility and the fact that some corporations were worth less than historical cost financial statements indicated.

Moreover, equity investors acquire shares for future income flows, not for the value of the assets.  The assets have no intrinsic value and their sole purpose is to generate future income.

However, adjusting the income statement for the effects of inflation is not enough to reflect the impact of changing price levels.  Certain categories of fixed assets, particularly land and buildings should be revalued to reflect a more reasonable value on the balance sheet.  

11. Telstra

In July 2003, the Australian Competition & Consumer Commission published a paper to ensure that Telstra will prepare and provide current cost accounts (CCA), as well as their existing historical cost accounts.  It is envisaged that this will allow the Commission to better understand the costs that Telstra faces as an ongoing sustainable business.  The purpose is to ensure that Telstra’s CCA reporting regime adequately fulfils both the Government’s and the Commission’s policy objectives, including providing the Commission, access seekers and the public with greater transparency about Telstra’s ongoing and sustainable wholesale and retail costs. 

12. British Telecommunications plc

The current cost statements for the businesses and activities were prepared under the financial capital maintenance convention in accordance with the principles set out in the handbook “Accounting for the effects of changing prices”, that was published in 1986 by the (UK) Accounting Standards Committee.  The existence of this “old” guideline provides further evidence that options other than historical cost have already been considered for some time.  Under this convention, current cost profit is normally determined by adjusting historical cost profits taking account of changes in asset values and of the erosion in the purchasing power of shareholders’ equity during the year, due to general inflation.  Asset values are adjusted to their value to the business, usually equivalent to their net current replacement cost.  Changes in asset values are referred to as unrealized holding gains or losses. These include other movements, which are taken directly to reserves in historic cost accounting.

The effect of the revaluation of assets on the profit and loss account was to increase the historical cost profit through any unrealized holding gains (UHG) arising in the year and decreasing it by unrealized losses.  In the Financial Statements, UHG’s for the various categories of fixed asset are treated in the same way as depreciation, so that losses increase costs and gains reduce them. CCA adjustments to the Profit & Loss and balance sheet values are allocated to Businesses using the same principles and processes as the historical cost values for the assets to which they relate.

The methods employed for the valuation of assets are based upon the valuation assumption is dependent upon:

• Indexation: The appropriate method when there has been little technological change in the asset category and all the direct costs associated with bringing the asset into service would be incurred if it were to be replaced today. A major advantage of indexation is that the valuation is directly linked to the historical cost values of fixed assets, so any assets recorded in the historical cost accounts are included in the CCA valuation.
• Absolute Valuation: Difficulties may arise when using indexation could arise in establishing appropriate indices.  It may accordingly be more accurate and reliable to use physical volumes and unit prices to derive an absolute valuation. This method may in turn present difficulties, for example in establishing meaningful current unit prices.  The choice of method for a particular asset therefore depends on individual circumstances.
• Modern Equivalent Asset: Where there is technological change, existing assets will not be replaced in an identical form.  In such cases the replacement cost is based on the cost of a modern equivalent asset, i.e. with similar service potential. In some cases the rate at which modern assets can be introduced is limited by practical constraints such as manufacturing capacity and lead times. The problems of assessing capacity and unit costs are the same as for any absolute valuation.
• Low Value/Short Life: Where assets have a relatively low value, the asset is accounted for at its historical cost and is not revalued. Similarly, where the life of an asset is relatively short, the asset is not revalued but retained at its historical cost

13. Existing Accounting Standards

While the valuation bases for balance sheet items are presently rather topical, “non historical” accounting has been used for several years.  In fact the following Australian Accounting Standards Board standards makes provision for accounting according to bases other than historical cost.  It is no longer sufficient that current values are merely disclosed; an accounting adjustment should also be made.

AASB 1019 is the oldest standard that advocates a move away from historical cost accounting, requiring inventory to be valued at the lower of cost or net realisable value.  

Additionally, figure 8.1 in Accounting Theory, provides a comprehensive list of accounting standards and exposure drafts, listing deviations from historical cost accounting.  Therefore despite appearing to be a rather contentious subject at present, the divergence from historical cost accounting has received uniform acceptance and been implemented by accounting bodies around the world for some time.  The since the principle has been accepted, it is really the form, adoption and subsequent implementation that still requires work.

14. Conclusion

The decision over which accounting valuation basis to use for asset and liability accounting is, and should continue to be based upon the nature of the relevant asset and liability.  Preliminary research indicates that this is more likely in high technology industries and organisations in which the public have a stake (i.e. state owned).  The means test to be applied is the extent to which it reflects the true value of the asset and/or liability and whether it provides users of financial statements with added value with respect to aiding effective decision-making.  

It can therefore be argued that over time, financial statements will be produced by organisations, based on a combination of valuation methods.  Caution should be exercised to ensure that a “one size fits all” approach where one doctrine is uniformly applied is avoided.  The decision of a valuation basis will be subjective, based upon the nature of the asset and the particular circumstances of the organisation.

However, it is important that the evolving accounting standards used should be consistent, allowing for meaningful comparisons and effective decision-making.  This is especially relevant given the globalisation of business.  It is important that there should be adequate disclosure in the financial statements of the relevant accounting basis used enabling informed decision-making.

Finally, given that the primary purpose of financial statements is to provide users with the tools required for effective decision-making, the more relevant and reliable the data provided, the more effective will be decisions.  Appropriate mixed valuations can provide users with meaningful information aiding effective economic decision-making.  The consistent application thereof should avoid the type of high profile financial surprises that have recently become prevalent, (e.g. Enron, Parmelat, etc.).

Bibliography

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10. J Godfrey, A Hodgson & S Holmes : Accounting Theory (5th Edition)
11. http://www.frc.org.uk/asb/publications/it8_p62.html
12. Robert C. Higgins – Analysis for Financial Management (6th Edition)
13. The Australian Competition & Consumer Commission – Accounting Separation (July 2003)
14. BT Group : “Current Cost Accounting – Detailed Valuation Methodology” – 6th December 2002
15. M C Miller & J A Loftus : “Measurement entering the 21st century: A clear or blocked road ahead?”  published in Australian Accounting Review, Vol. 11, No. 2, 2000,
16. L De Beer : “Why AC 133?” published in Accountancy SA, January 2004
17. D Paterson & A Wilson - Generally Accepted Accounting Practice (UK), 6th Ed. 1999
18. C Sayther : “Fair value accounting: fair for whom?” - Financial Executive;  Vol. 20 Issue 2, 2004
19. J Knapp & S Kemp : Accounting Handbook – 2004, Volume 1

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