22 Accounting for inflation

Question 1

Advantages of historical cost accounting As we are still using historical cost accounting, it may be supposed to have a number of advantages. The most important ones are:

Answer 1

 Amounts used are objective and free from bias.  Amounts are reliable, they can always be verified, they exist on invoices and documents.  Amounts in the statement of financial position can be matched perfectly with amounts in the statement of cash flows.  Opportunities for creative accounting are less than under systems which allow management to apply their judgement to the valuation of assets.  It has been used for centuries and is easily understood.

Question 2

Disadvantages of historical cost accounting Historical cost accounting has a number of disadvantages. They arise as particular problems in periods of inflation. The main ones are:

Answer 2

 It can lead to understatement of assets in the statement of financial position. A building purchased 50 years ago will appear at the price that was paid for it 50 years ago.  Because assets are understated, depreciation will also be understated. While the purpose of depreciation is not to set aside funds for replacement of assets, if an asset has to be replaced at twice the price that was paid for its predecessor, the company may decide that it may have been prudent to make some provision for this in earlier years.  When inventory prices are rising, and when the company is operating a FIFO system, the cheapest inventories are being charged to cost of sales and the most expensive are being designated as closing inventory in the statement of financial position. This leads to understatement of cost of sales.  An organisation selling in an inflationary market will see its revenue and profits rise, but this is ‘paper profit’, distorted by the understated depreciation and cost of sales.

Question 3

From these disadvantages various issues arise:

Answer 3

 Understatement of assets will depress a company’s share price and make it vulnerable to takeover. In practice, listed companies avoid this by revaluing land and buildings in line with market values.  Understated depreciation and understated cost of sales lead to overstatement of profits, compounded by price inflation.  Overstated profits can lead to too much being distributed to shareholders, leaving insufficient amounts for investment.  Overstated profits will lead shareholders to expect higher dividends and employees to demand higher wages.  Overstated profits lead to overstated tax bills.

Question 4

Current value accounting The move towards current value accounting has already taken a number of steps. Entities are now permitted to revalue non-current assets such as land and buildings in line with market value and financial assets and liabilities such as securities and investments can be carried at fair value, defined in IFRS 13 as: ‘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’. T/F

Answer 4

Current value accounting The move towards current value accounting has already taken a number of steps. Entities are now permitted to revalue non-current assets such as land and buildings in line with market value and financial assets and liabilities such as securities and investments can be carried at fair value, defined in IFRS 13 as: ‘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’.

Question 5

We will now go on to look at two alternative systems which have sought in the past to address the shortcomings of historical cost accounting – current purchasing power (CPP) and current cost accounting (CCA). We begin by looking at the fundamental difference between these two systems – a different concept of capital maintenance and therefore of profit. T/F

Answer 5

We will now go on to look at two alternative systems which have sought in the past to address the shortcomings of historical cost accounting – current purchasing power (CPP) and current cost accounting (CCA). We begin by looking at the fundamental difference between these two systems – a different concept of capital maintenance and therefore of profit.`

Question 6

Define Capital & physical concept of capital

Answer 6

Capital. Under a financial concept of capital, such as invested money or invested purchasing power, capital is the net assets or equity of the entity. The financial concept of capital is adopted by most entities. Under a physical concept of capital, such as operating capability, capital is the productive capacity of the entity based on, for example, units of output per day.

Question 7

Define profit

Answer 7

Profit. The residual amount that remains after expenses (including capital maintenance adjustments, where appropriate) have been deducted from income. Any amount over and above that required to maintain the capital at the beginning of the period is profit.

Question 8

The main difference between the two concepts of capital maintenance is the treatment of the effects of changes in the prices of assets and liabilities of the entity. In general terms, an entity has maintained its capital if it has as much capital at the end of the period as it had at the beginning of the period. Any amount over and above that required to maintain the capital at the beginning of the period is profit:

Answer 8

(a) Financial capital maintenance: profit is the increase in nominal money capital over the period. This is the concept used in CPP, and used under historical cost accounting. (b) Physical capital maintenance: profit is the increase in the physical productive capacity over the period. This is the concept used in CCA

Question 9

Capital maintenance in times of inflation Profit can be measured as the difference between how wealthy a company is at the beginning and at the end of an accounting period.

Answer 9

(a) This wealth can be expressed in terms of the capital of a company as shown in its opening and closing statements of financial position. (b) A business which maintains its capital unchanged during an accounting period can be said to have broken even. (c) Once capital has been maintained, anything achieved in excess represents profit.

Question 10

Define Current purchasing power (CPP)

Answer 10

CPP accounting is a method of accounting for general (not specific) inflation. It does so by expressing asset values in a stable monetary unit, the $ of current purchasing power.

Question 11

To counter the problems of specific price inflation some system of current value accounting may be used (such as current cost accounting). The capital maintenance concepts underlying current value systems do not attempt to allow for the maintenance of real value in money terms. Current purchasing power (CPP) accounting is based on a different concept of capital maintenanc

Answer 11

CPP measures profits as the increase in the current purchasing power of equity. Profits are therefore stated after allowing for the declining purchasing power of money due to price inflation.

Question 12

The advantages and disadvantages of CPP accounting

Answer 12

a) The restatement of asset values in terms of a stable money value provides a more meaningful basis of comparison with other companies. Similarly, provided that previous years’ profits are re-valued into CPP terms, it is also possible to compare the current year’s results with past performance. (b) Profit is measured in ‘real’ terms and excludes ‘inflationary value increments’. This enables better forecasts of future prospects to be made. (c) CPP avoids the subjective valuations of current value accounting, because a single price index is applied to all non-monetary assets. (d) CPP provides a stable monetary unit with which to value profit and capital; ie $c. (e) Since it is based on historical cost accounting, raw data is easily verified, and measurements of value can be readily audited.

Question 13

The disadvantages and disadvantages of CPP accounting

Answer 13

a) It is not clear what $c means. ‘Generalised purchasing power’ as measured by a retail price index, or indeed any other general price index, has no obvious practical significance. ‘Generalised purchasing power has no relevance to any person or entity because no such thing exists in reality, except as a statistician’s computation.’ (T A Lee) (b) The use of indices inevitably involves approximations in the measurements of value. (c) The value of assets in a CPP statement of financial position has less meaning than a current value statement of financial position. It cannot be supposed that the CPP value of net assets reflects: (i) The general goods and services that could be bought if the assets were released (ii) The consumption of general goods and services that would have to be forgone to replace those assets In this respect, a CPP statement of financial position has similar drawbacks to an historical cost statement of financial position.

Question 14

Current cost accounting (CCA) reflects an approach to capital maintenance based on maintaining the operating capability of a business. The conceptual basis of CCA is that the value of assets consumed or sold, and the value of assets in the statement of financial position, should be stated at their value to the business (also known as ‘deprival value’). T/F

Answer 14

Current cost accounting (CCA) reflects an approach to capital maintenance based on maintaining the operating capability of a business. The conceptual basis of CCA is that the value of assets consumed or sold, and the value of assets in the statement of financial position, should be stated at their value to the business (also known as ‘deprival value’).

Question 15

Define deprival value

Answer 15

The deprival value of an asset is the loss which a business entity would suffer if it were deprived of the use of the asset.

Question 16

Value to the business, or deprival value, can be any of the following values:
Replacement cost
Net realisable value
Economic value

Answer 16

(a) Replacement cost: in the case of non-current assets, it is assumed that the replacement cost of an asset would be its net replacement cost (NRC), its gross replacement cost minus an appropriate provision for depreciation to reflect the amount of its life already ‘used up’. (b) Net realisable value (NRV): what the asset could be sold for, net of any disposal costs. (c) Economic value (EV), or value in use: what the existing asset will be worth to the company over the rest of its useful life.

Question 17

If the asset is worth replacing, its deprival value will always be net replacement cost. If the asset is not worth replacing, it might have been disposed of straight away, or else it might have been kept in operation until the end of its useful life. You may therefore come across a statement that deprival value is the lower of:

Answer 17

Net replacement cost (NRC)  The higher of net realisable value and economic value

Question 18

We have already seen that if an asset is not worth replacing, the deprival value will be NRV or EV. However, there are many assets which will not be replaced either:

Answer 18

(a) Because the asset is technologically obsolete, and has been (or will be) superseded by more modern equipment; or (b) Because the business is changing the nature of its operations and will not want to continue in the same line of business once the asset has been used up.

Question 19

CCA profits and deprival value The deprival value of assets is reflected in the CCA statement of profit or loss by the following means.

Answer 19

(a) Depreciation is charged on non-current assets on the basis of gross replacement cost of the asset (where NRC is the deprival value). (b) Where NRV or EV is the deprival value, the charge against CCA profits will be the loss in value of the asset during the accounting period; ie from its previous carrying value to its current NRV or EV. (c) Goods sold are charged at their replacement cost. Thus if an item of inventory cost $15 to produce, and sells for $20, by which time its replacement cost has risen to $17, the CCA profit would be $3.

Question 20

CCA preserves the operating capability of the company but does not necessarily preserve it against the declining value in the purchasing power of money (against inflation). As mentioned previously, CCA is a system which takes account of specific price inflation (changes in the prices of specific assets or groups of assets) but not of general price inflation. T/F

Answer 20

CCA preserves the operating capability of the company but does not necessarily preserve it against the declining value in the purchasing power of money (against inflation). As mentioned previously, CCA is a system which takes account of specific price inflation (changes in the prices of specific assets or groups of assets) but not of general price inflation.

Question 21

A strict view of current cost accounting might suggest that a set of CCA accounts should be prepared from the outset on the basis of deprival values. In practice, current cost accounts are usually prepared by starting from historical cost accounts and making appropriate adjustments. T/F

Answer 21

A strict view of current cost accounting might suggest that a set of CCA accounts should be prepared from the outset on the basis of deprival values. In practice, current cost accounts are usually prepared by starting from historical cost accounts and making appropriate adjustments.

Question 22

CCA accounts CAC accounts will include the following adjustments:

Answer 22

(1) Depreciation adjustment – to amend depreciation in line with the gross replacement cost of the asset. (2) Cost of sales adjustment – to take account of increases in inventory prices and remove any element of profit based on this. (3) Working capital adjustment – to remove any element of profit or loss based on holding payables or receivables in a period of inflation. You do not need to know how to do these adjustment, but you can see that they attempt to deal with the areas where inflation can lead to ‘holding gains’.

Question 23

The advantages of current cost accounting:

Answer 23

(a) By excluding holding gains from profit, CCA can be used to indicate whether the dividends paid to shareholders will reduce the operating capability of the business. (b) Assets are valued after management has considered the opportunity cost of holding them, and the expected benefits from their future use. CCA is therefore a useful guide for management in deciding whether to hold or sell assets.
c) It is relevant to the needs of information users in: (i) Assessing the stability of the business entity (ii) Assessing the vulnerability of the business (eg to a takeover), or the liquidity of the business (iii) Evaluating the performance of management in maintaining and increasing the business substance (iv) Judging future prospects (d) It can be implemented fairly easily in practice, by making simple adjustments to the historical cost accounting profits. A current cost statement of financial position can also be prepared with reasonable simplicity.

Question 24

The disadvantages of current cost accounting:

Answer 24

(a) It is impossible to make valuations of EV or NRV without subjective judgements. The measurements used are therefore not objective. (b) There are several problems to be overcome in deciding how to provide an estimate of replacement costs for non-current assets. (c) The mixed value approach to valuation means that some assets will be valued at replacement cost, but others will be valued at net realisable value or economic value. It is arguable that the total assets will, therefore, have an aggregate value which is not particularly meaningful because of this mixture of different concepts. (d) It can be argued that ‘deprival value’ is an unrealistic concept, because the business entity has not been deprived of the use of the asset. This argument is one which would seem to reject the fundamental approach to ‘capital maintenance’ on which CCA is based.