Chapter 4 - Normative Accounting Theories

 

Chapter 4 - Normative Accounting Theories The case of accounting for changing price There are various prescriptive theories of accounting that were advanced by various people on the basis that historical cost accounting has too many shortcomings, particularly in times of rising prices. Page 83 Chapter 4

1.

Histor His torica icall cost cost accou accounti nting ng in tim times es of of rising rising pric prices es

Historical cost accounting assumes that money holds a constant purchasing power. Page 84!

As Elliot states: "#n implicit and troublesome assumption in the historical cost model is that the monetary unit is fi$ed and constant over time. #rgument for the limitation%& However, there are three components of the modern economy that ma'es this assumption less valid than it was at the time the model was developed.( 

)ne component is specific price&level changes, occasioned by such things a technological advances and shifts in consumer preferences*

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+econd component is general price&level changesinflation!* and

Third component is the fluctuation in e$change rates for currencies. Thus, the boo' value of a company company,, as reported in financial statements, only

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coincidental reflects the current value of assets. Page Page 84 of inancial #ccounting Theory - eegan! #s we would appreciate, the method of accounting predominantly used today is based on historical cost accounting. The very fact that historical cost accounting has continued to be applied by business entities has been used by a number of academics to support its continued use.

 

Chapter 4 - Normative Accounting Theories 1.

Histor His torica icall cost cost accoun accountin ting g in times times of risin rising g prices prices (cont (cont))

oint to note: /.

0t ha hass be been en a argue rgued d tha thatt his historica toricall co cost st ac accounti counting ng iinfor nformatio mation n suf suffers fers from problems problems of relevance in times of rising prices. #t issue is whether it is really logical to add together assets ac1uired in different periods when those assets were ac1uired with dollars of different

 purchasing power power.. (page 85) 2.

There is a also lso a an n ar argumen gumentt tha thatt me methods thods of a accoun ccounting ting that do n not ot ta ta'e 'e account of changing prices, such as historical cost accounting, can tend to overstate profits in times of rising price, and that distribution of H.C.

 “Operating capacity” – profits can actually lead to an erosion of  “Operating  purchasing power remain remain intact.(page 86) 3.

Operating result – Historical cost accounting distorts the current years operating results by including in the current year yearss income holding gains that actually accrued in previous periods. page 8!

4.

Capital maintenance - Two versions namely capital maintenance is based on maintaining financial capital intact and maintaining purchasing power intact. page 85!

6.

7se o off act actual ual c cur urren rentt val value ue is m made ade u unde nderr ano anothe therr app approa roach ch to accounting which see's to provide a measure of profits which, if distributed, maintains physical operating capital intact. They based on  present values, entry entry or exit prices. prices. (page  (page 88)

 

Chapter 4 - Normative Accounting Theories !.

Curr Cu rren entt pu purrcha hasi sing ng po po" "er ac acc coun unti ting ng page 88 to //!

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urchasing po"er an# capital maintenance CPP# was developed on the basis of a view that in times of rising prices, if an entity were to distribute unad9usted profits based on historical costs, the result could be a reduction in the real value of an entity that is in real terms the entity could otherwise distribute part of its capital. Current purchase power accounting with its reliance on the use of indices is generally accepted as being easier and less costly to apply than methods that rely upon current valuations of particular assets.

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erforming erf orming current purchase po"er a#$ustments :hen applying CPP#, CPP#, all ad9ustments are done at the end of the period, with the ad9ustments being applied to accounts prepared under the historical cost convention. a.

;on ;on&mo &monet netary ary a asse ssets ts ca can n be de defin fined ed as tthos hose e ass assets ets w whos hose e monetary e1uivalents will change over times as a result of inflation, and would include such things as plant and e1uipment and inventory inventory. ;et moneta monetary ry assets would be defined a ass monetary assets less monetary liabilities.

b.

0t is stre stressed ssed tthat hat un under der C CPP PP#, #, no chang change e in tthe he pu purcha rchase se pow power er of entity is assumed to arise as a result of holding non&monetary assets. 7nder general price level accounting, non&monetary assets are restated to current purchasing power and no gain or loss is recogni