Chapter 14

1. Chapter 14 Alternative asset-valuation and income-determination models

2. Attributes that may be measured There are four attributes of assets and liabilities that may be measured: • historical cost • current entry price • current exit price • capitalised or present value of expected cash flows

3. Units of measure Two units of measure may be used to measure assets and liabilities: • money • purchasing power

4. Asset valuation and income determination models • Historical-cost accounting • Replacement-cost accounting • Net-realisable-value accounting • Present-value accounting • General price-level accounting • General price-level replacement cost accounting • General price-level net realisable-value accounting • General price-level present-value accounting

5. Present-value models Although theoretically considered the best accounting models, present-value models have recognised practical deficiencies: • they require the estimation of future net cash receipts and the timing of those receipts, as well as the selection of the appropriate discount rates • when applied to the valuation of individual assets, they require the arbitrary allocation of estimated future net cash receipts and the timing of those receipts as well as the selection of the appropriate discount rates

6. Present-value models (cont’d) • when applied to the valuation of individual assets, they require the arbitrary allocation of estimated future net cash receipts among the individual assets

7. Definition of four attributes • Historical cost refers to the amount of cash or cash-equivalent that would be paid to acquire an asset, or the amount of cash-equivalent liability • Replacement cost refers to the amount of cash or cash-equivalent that would be paid to acquire an equivalent or the same asset currently, or that would be received to incur the same liability concurrently

8. Definition of four attributes (cont’d) • Net realisable value refers to the amount of cash or cash-equivalent that would be obtained by selling the asset currently, or that would be paid to redeem the liability currently • Present or capitalised value refers to the present value of net cash flows expected to be received from the use of the asset, or the net outflows expected to be disbursed to redeem the liability

9. Classification of attributes • They may be classified with respect to whether they focus on the past, present or future • They may be classified with respect to the kind of transactions from which they are derived • They may be classified with respect to the nature of the event that originates the measure

10. Different price levels • A change in the general price level refers to changes in the prices of all goods and services throughout the economy • A change in the specific price level refers to a change in the price of a particular product or service • A change in the relative price level of a commodity refers to the part of the specific price change that remains after the effects of the general price-level change have been eliminated

11. Criteria for comparison and evaluation: timing errors The criteria for determining what attributes of the elements of financial statements should be measured should favour the attribute that avoids timing errors, because: • timing errors result when changes in value occur in a given period but are accounted for and reported in another period • a preferable attribute would be the recognition of changes in value in the same period that they occur

12. Measuring-unit errors The criteria for determining what unit of measure should be applied to attributes of the elements of financial statements should favour the unit of measure that avoids measuring-unit errors, because: • these occur when financial statements are not expressed in units of general purchasing power • a preferred measuring unit would recognise the general price-level changes in the financial statements

13. First criterion: interpretability • The resulting statement should be understandable in terms of meaning and use • Given that we have two possible units of measure, the interpretation of the accounting models will be one of the following: • if it measures using units of money, its results are expressed in the number of dollars (NOD) • if it measures historical cost in units of general purchasing power, its results are still expressed in NOD • if it measures current values in units of general purchasing power, its results are expressed in the command of goods (COG)

14. Second criterion: relevance • The resulting financial statements should be useful • Focus on what ought to be measured – COG or NOD?: • from a normative point of view, the answer is COG, because it expresses changes in both the specific and general price levels • COG can be defined, in terms of the input market, as price-level adjusted replacement cost; and, in terms of the output market, as a price-level-adjusted net realisable value

15. Historical-cost accounting • Historical-cost accounting is characterised primarily by four aspects: • the use of historical cost as the attribute of the elements of financial statements • the assumption of a stable monetary unit • the matching principle • the realisation principle • Accordingly, historical-cost income, or accounting income, is the difference between realised revenues and their corresponding historical cost

16. Historical-cost financial statements Historical-cost financial statements: • contain timing errors • contain measuring-unit errors • are interpretable because they are based on the concept of money maintenance, and the attribute being expressed is the number of dollars (NOD) • are not relevant because the command of goods (COG) is not measured

17. Replacement-cost accounting • Replacement-cost accounting is characterised primarily by five aspects: • the use of replacement cost as the attribute of the elements of financial statements • the assumption of a stable monetary unit • the realisation principle • the dichotomisation of operating income and holding gains and losses • the dichotomisation of realised and unrealised holding gains and losses

18. Replacement-cost financial statements Replacement-cost financial statements: • contain timing errors in operating profit • contain measuring-unit errors • are interpretable as NOD for profit-and-loss statement figures and COG for asset figures • provide relevant measures of COG only for asset figures

19. Net-realisable-value accounting • Net-realisable-value accounting is characterised primarily by four aspects: • the use of net-realisable value as the attribute of the elements of financial statements • the assumption of a stable monetary unit • the abandonment of the realisation principle • the dichotomisation of operating income and holding gains and losses

20. Net realisable-value financial statements Net realisable-value financial statements: • contain no timing errors • contain measuring-unit errors • are interpretable as NOD for net income and as COG for asset figures • provide relevant measures of COG only for asset figures

21. Alternative accounting models Three models of accounting reflect changes in the general price level: • general price-level-adjusted historical-cost accounting • general price-level-adjusted replacement-cost accounting • general price-level-adjusted net-realisable value accounting

22. General price-level-adjusted historical-cost accounting • This type of accounting is characterised primarily by four aspects: • the use of historical cost as the attribute of the elements of financial statements • the use of general purchasing power as the unit of measure • the matching principle • the realisation principle • Accordingly, it is the difference between realised revenues and their corresponding historical costs, both expressed in units of general purchasing power

23. General price-level-adjusted historical-cost financial statements • General price-level-adjusted historical-cost financial statements: • contain timing errors • contain no measuring-unit errors • are interpretable • provide relevant measures of COG only for cash figures (and monetary assets and liabilities)

24. General price-level-adjusted replacement-cost accounting • General price-level-adjusted replacement-cost accounting is characterised primarily by five aspects: • the use of replacement cost as the attribute of the elements of financial statements • the use of general purchasing power as the unit of measure • the realisation principle • the dichotomisation of operating income and real realised holding gains and losses • the dichotomisation of real realised and real unrealised holding gains and losses

25. General price-level-adjusted replacement-cost financial statements • General price-level-adjusted, replacement-cost financial statements: • contain timing errors • contain no measuring-unit errors • are interpretable • provide relevant measures of COG in the input market

26. General price-level-adjusted net-realisable-value accounting • This type of accounting is characterised primarily by five aspects: • the use of net-realisable value as the attribute of the elements of financial statements • the use of general purchasing power as the unit of measure • the abandonment of the realisation principle • the dichotomisation of operating income and real holding gains and losses • the dichotomisation of real realised and real unrealised gains and losses

27. General price-level-adjusted net-realisable-value financial statements General price-level-adjusted net-realisable-value financial statements: • contain no timing errors • contain no measuring-unit errors • are interpretable • provide relevant measures of COG in the output market

28. The current-value accounting tradition in Australia • The 1970s was a particularly active period in Australian accounting, fuelled by: • high inflation rates • a growing body of Australian and international literature recommending abandonment of the historical-cost model • movement towards a system of current-value accounting by international standard-setting bodies

29. Exposure drafts on current-value accounting • Three exposure drafts (EDs) were released by the AARF between 1974 and 1978: • ED 7 ‘Accounting for Changes in the Purchasing Power of Money’ • ED 9 ‘A Method of Current Value Accounting’ • ED 10 ‘The Recognition of Gains and Losses on Holding Monetary Resources in the Context of Current Value Accounting’

30. SAP 1 ‘Current Cost Accounting’ • A Statement of Provisional Accounting Standards, DPS 1.1 ‘Current Cost Accounting’, was issued by the professional bodies in 1977 and accompanied by DPS 1.2 ‘Explanatory Statement: The Basis of Current Cost Accounting’ • In 1980, the ED 15 ‘Current Cost Accounting’ omnibus exposure draft was issued, and suggested an expansion to the Provisional Accounting Standard

31. SAP 1 ‘Current Cost Accounting’ (cont’d) • This provisional standard was issued as SAP 1 in November 1983 • A nationwide survey by Jones and Love indicates that the number of companies adopting SAP 1 in Australia has significantly increased since the mid-1980s

32. Conclusion • Of the models compared, general price-level-adjusted, net-realisable-value accounting is the only model to meet each of the four criteria set forth • SAP 1 does not adopt this model • Australia has opted for a predominantly replacement-cost-based model • Preferences for exit-value and present-value-based models have, however, manifested in recent accounting regulations