Historical cost accounting has traditionally been used to prepare financial statements. Income and Expenses are recorded at their historical amount
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1 TOPIC 3: ALTERNATIVES TO HISTORICAL COST ACCOUNTING HCA Historical cost accounting has traditionally been used to prepare financial statements Assets and Liabilities at historical cost (less accumulated depreciation in the case of non current assets). Income and Expenses are recorded at their historical amount Advantages of HCA 1. Provides objective measurements of many values. The cost of an asset is not a subjective measurement. 2. HCA is easy to apply i.e. assets are valued at their original cost price Disadvantages of HCA When there is a high rate of inflation and a significant rise over time in selling prices and costs, the weaknesses of HCA are: 1. The Net Book Value of non current assets is often significantly lower than their current fair value Depreciation Understated Profit Overstated 2. The value of inventory in the SOFP is its value at the date of purchase/manufacture, not its value at the end of the reporting period. For slow moving items of inventory, in a period of high inflation the historical cost of the inventory might be substantially different from its current value 3. The cost of sales measured at historical cost does not represent the current value of the assets consumed. The replacement cost of the assets consumed could be much higher than their historical cost, due to a high rate of inflation. Therefore profit in statement of profit or loss is overstated. 4. There is no recognition of the effect of inflation on monetary items such as loans, trade payables and trade receivables. For example, if a seller sells goods on credit for 100 to a customer, and the customer takes 12 months to pay, inflation in the intervening 12 months will reduce the value of 100 debt to the seller. HCA Does not recognise this loss to the seller 1
2 5. Comparative figures for previous persons are out of date values so that for example, what appear to be improvements in revenues and profits are really caused by the effects of inflation 2 alternatives to HCA Constant Purchase Power Accounting Current Value/Cost Accounting Constant Purchasing Power Accounting The financial statements are adjusted so that all the figures are presented in terms of money with the same purchasing power (based on for example, the Consumer Price Index) When CPP is used, items are usually adjusted to their price level as at the reporting date * So values in the FS are adjusted for inflation based on an index like the Consumer Price Index.* 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 Monetary Items cash, trade receivable, trade payables and loans Holders of monetary assets 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 opposite applies to those having monetary liabilities. Monetary items cannot be restated as their amount is fixed Non Monetary Items Inventory and Non Current Assets A business entity neither gains nor losses purchasing power with non monetary items as a consequence of inflation. Non monetary items are restated in line with a general price index and the balancing figure is equity. With CPP, accounting profit is adjusted to reflect the general change in prices during the year. 2
3 Example of CPP: On 1-1-YR8, an entity purchased an item of inventory for $10,000 which it then sold for $14,000 (cash). Inflation during the year was 7% Under HCA Sales 14,000 Cost of Sales (10,000) Profit 4,000 Under CPP Sales 14,000 Cost of Sales (10,700) (10,000 x 1.07) Profit 3,300 Advantages of CPP Accounting - True system of inflation accounting because it adjusts for changes in general purchase power. - CPP accounting is objective because a standard index is used. - It allows users to make meaningful comparisons about the performance of an entity over time. Disadvantages of CPP Accounting - CPP Accounting measures changes in the value of money (i.e. Purchasing Power) rather than changes in the value of assets and liabilities. 3
4 Current Value Accounting Based on the principle that assets should be measured at their current value and the cost of sales should be valued at its current cost as at the time of sale In current value accounting, an asset should be valued at its deprival value Deprival Value i.e. if the business was deprived of the asset Lower Replacement Cost Recoverable Amount Higher Net Realisable Value Economic Value Advantages of Current Value Accounting: Provides users with relevant information Disadvantages of Current Value Accounting: Current Value is subjective (i.e. NRV) and therefore less reliable than HCA. Also it may be difficult to obtain a reliable market value for some items, particularly if they are rare of specialised. 4
5 To Summarise CVA Measures changes in the value of assets and liabilities and cost of sales but not the value of money i.e. not a system of accounting for inflation CPP Measures changes in the value of money not assets and liabilities i.e. a system of accounting for inflation 5
6 Fair Value As discussed, Historical Cost Accounting has its weaknesses. Also, it is unlikely that the IASB will require either Current Value Accounting or CPP Accounting to be used in the foreseeable future. Many entities attempt to overcome the problems of HCA by using modified historical cost accounting where some or all non current assets are measure at a valuation instead of at historical cost. The UK Accounting Standards Board favour Deprival Value when revaluing non current assets. The IASB are in favour of fair value What is fair value? Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date Fair value is normally open market value. Fair value may be used in financial statements in the following circumstances: 1. After its initial recognition on acquisition, a non current asset may be revalued to its fair value. 2. Inventory is measured in the SOFP at the lower of cost and NRV. NRV may or may not be the same as fair value. 3. Revenue should be measured in statement of profit or loss at the fair value of the consideration received or receivable (IAS 18). Problems with the Use of Fair Value 1. There may not be an active market for some kinds of asset. 2. It anticipates sales and profits which may never happen (the entity may have no plans to sell the asset). 3. Market values can move up and down quite rapidly. This may distort trends in the financial statements and make trend analysis difficult. 6
7 4. Market values may be distorted by monopoly, oligopoly cartels. In other words, not all market prices come from perfectly competitive markets. Despite the above, the IASB is likely to require greater use of fair values going forward. For further information on fair value, refer to IFRS 13. 7
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