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Unformatted text preview: ACCT3003 Issues in Accounting Theory 2009 Topic 3: Normative Theory Solutions to topic review questions Chapter 5 5.1 Historical cost accounting assumes that the purchasing power of the currency remains constant across time. Related to this it is assumed that the value of assets acquired in different time periods can simply be added together to give an indication of their value at a particular point in time. In a time of rising prices, historical cost accounting can cause the following outcomes: • If prices of different assets acquired in different periods are simply added together then the total figure can be quite meaningless, like adding together different currencies. The final figure will generally understate the current market value of the assets. • Tied to the above point, if assets are understated then this will in turn mean that the net book value of the entity (assets less liabilities) is understated. This could, perhaps, lead to the owners selling an entity for less than it is actually worth (although clearly the owners should consider other information about the value of the organisation before determining how much to sell it for). • Following on from the above points, historical costs information lacks relevance in times of rising prices (Chambers). • When historical cost accounting is used, depreciation and cost of goods sold are based on historical costs which means that profits are effectively overstated in times of rising prices (because expenses through depreciation are understated). Because dividends in turn can be paid out of profits, the actual operating capacity of the firm might be eroded because too much has been distributed to the owners and not enough has been retained to replace certain assets whose replacement costs have increased. • Historical cost accounting distorts the current year’s operating results because it includes in current year income holding gains that might have accrued over a number of periods. For example, if an asset such as land is acquired for $10 000 and increases in value by $1000 each year (and assuming no revaluations are undertaken), then if it is sold in year 5 for $15 000, a $5 000 gain will be shown wholly in year 5. No 1 5.2 Issues in Accounting Theory 2009 Solutions: Topic 3 gain will be shown in any other year. Given this aspect of historical cost accounting, management might elect to sell certain assets in certain years simply to offset losses that might otherwise be reported. 5.3 The answer to this question depends upon whether we assume that managers are motivated by efficiency considerations, or whether they are motivated by opportunistic considerations. From an efficiency perspective, managers might consider that historical cost provides a more objective measure of the value of an item and this is preferable in terms of demonstrating proper stewardship over the resources contributed to an organisation. They might also consider that other bases of measurement—such as market values—provide less relevant or reliable information. For example, perhaps they operate in an industry that has high volatility in asset values, and they may consider that if assets were valued on the basis of fluctuating market values then this might create confusion in the minds of the financial statement readers. From an opportunistic perspective managers might prefer to retain the use of historical cost accounting as it can allow them to manipulate profit by determining when to sell an asset that has appreciated in value—with such appreciation not being acknowledged until the asset is ultimately sold. The accumulated gain will be fully recognised in the period of the sale. Also, historical cost accounting can lead to higher profits (due to such factors as lower depreciation given that depreciation will be based on the original cost of an asset which could be significantly lower than its current marker value). This attribute of historical cost might be particularly attractive to managers who are paid a bonus tied to reported profits. The capital maintenance approach adopted within historical cost requires that dividends should only be distributed to the extent that financial capital is not eroded by the dividends. For example, assume that an entity started the year with $200 in assets and $50 in liabilities (that is, net assets or owners’ equity of $150 which we also will assume was contributed by the owners). Also assume that at the end of the year the net assets had increased by $100 to $250 and that no additional capital contributions had been made by the owners throughout the year. To maintain financial capital intact (the approach to capital maintenance adopted within historical cost accounting), $100 can be distributed as dividends. The financial capital maintenance approach adopted within historical cost accounting ignores the fact that the replacement costs of many assets could have changed during the year and that while the financial capital has remained intact, if the entity was required to replace 2 5.6 Issues in Accounting Theory 2009 Solutions: Topic 3 5.7 certain assets it may not be able to. That is, its real operating capacity may have decreased. Within historical cost accounting realised holding gains or losses are treated as part of income. This can be contrasted with other methods of accounting, such as current cost accounting, which treats holding gains as capital adjustments rather than treating them all as part of distributable income. Under a physical capital maintenance approach to determining income the reporting entity calculates how much income can be distributed yet allow it to retain sufficient funds to replace current assets as required. Under methods of accounting, such as current cost accounting, a measure of profit is determined that represents the maximum amount that can be distributed while maintaining the operating capital intact. Holding gains are not generally considered to be available for dividend distribution. (a) Current purchasing power accounting (CPPA) separately considers monetary items and non‐monetary items. Monetary items are those assets and liabilities that remain fixed in terms of their monetary value regardless of changes in the purchasing power of money (the majority of liabilities would be monetary items). Conversely, the monetary equivalent of non‐monetary items will be expected to change over time as a result of factors such as inflation. Under current purchasing power accounting, gains and losses are deemed to relate to the holding of monetary items (typically a loss if monetary assets exceeds monetary liabilities, otherwise a gain), but do not arise from holding non‐monetary items. Further, in undertaking current purchasing power accounting adjustments are made to the book value of non‐ monetary items, generally by way of a general price index. The carrying value of monetary items, however, is not adjusted. Hence, from this brief description we can see that CPPA treats monetary and non‐monetary items differently, and hence, they must be considered separately. (b) The view is that if an entity holds a monetary asset, such as cash, and if there is a general decrease in the purchasing power of money (for example, because of inflation), then that cash will buy less: it will suffer from a purchasing power loss. With non‐monetary assets it is assumed that the assets will retain their equivalent purchasing power. For example, if an entity holds land that cost $10 000 and inflation has been recorded at 5 per cent then the adjusted value of the land might be shown as $10 500 and if this land was sold then it is assumed that the cash received would have the same purchasing power. Although the monetary equivalent of the land has increased, no gain or loss 3 Issues in Accounting Theory 2009 Solutions: Topic 3 would be recognised. By comparison, $10 in cash held now is still worth $10 in cash 2 years later, but its purchasing power would have declined and this reduction in purchasing power would be recognised in determining the entity’s financial performance. 5.12 Some strengths of historical cost accounting would include the following: • Information generated by the historical cost accounting system seems to be demanded by the market whereas various studies have indicated that price level adjusted information is not in great demand. • It is a generally accepted accounting system, hence maintaining its use will not lead to drastic changes in accounting practice, which in turn could cause a variety of social and economic consequences. • People are used to preparing and reading historical cost accounting reports, hence there is no need to re‐educate them about the strengths and limitations of historical cost accounting. Some weaknesses of historical cost accounting would include the following: • The assumption that the purchasing power of the dollar remains constant is simplistic and flawed. • Information generated through historical costs accounting suffers from the ‘additivity problem’—it is argued that it makes little sense to add together the costs of assets acquired in different time periods. • Historical cost accounting relies upon arbitrary cost allocations (for example, in relation to depreciation) which may have little correspondence to the actual changes in an asset’s values. • Historical cost accounting can lead to an overstatement of profits in times of rising prices and this overstatement can cause a reduction in the operating capacity of the entity because an excess amount of dividends might be distributed (because historical cost accounting relies upon a financial capital maintenance perspective). • Historical cost accounting data is of limited relevance to current decisions. • Historical cost accounting assists an organisation to manipulate its profits given that the decision to dispose of a non‐current asset can directly lead to the recognition of gains on disposal, even though those gains actually related to prior periods. The decision to sell an asset might be made in an effort to offset other losses that will be recorded. Some strengths of current purchasing power accounting would include: • Current purchasing power accounting is relatively simple and inexpensive to apply and does not require collecting data about 5.13 Issues in Accounting Theory 2009 Solutions: Topic 3 4 • replacement costs or market values. Information about movements in general price indices would be easily available. Relative to historical cost accounting, it can reduce the possibility of paying excessive dividends, which in turn could reduce the operating capacity of an entity. Some weaknesses of current purchasing power accounting would include: • It is not generally favoured by the business or professional community and hence any attempts to put it in place could be thwarted. • Tied to the above point, various studies show there is not a great deal of demand for price‐adjusted information. • People are used to preparing and reading historical cost accounting reports, hence there would be a need to re‐educate them about the strengths and limitations of current purchasing power accounting— this might be costly. • It assumes one price index applies to all assets—this is a very simplistic assumption. • Because one price index is generally applied to all assets, the adjusted values of the assets may show little correspondence with their actual values (whether this be in terms of replacement or market values). • Tied to the above point, the reported values may cause some confusion—report users may think that the values represent current values. • It still relies upon arbitrary cost allocations, for example, in the form of depreciation. Some strengths of current cost accounting would include: • Relative to historical cost accounting, it can reduce the possibility of paying excessive dividends which could otherwise reduce the operating capacity of an entity. • If all assets are valued at replacement cost then logically they can be added together, which solves the ‘additivity’ problem. • Allows for a separation of holding gains and losses from other results and therefore provides a better insight into management performance. Some weaknesses of current cost accounting would include: • It is questionable whether replacement costs are reflective of the value of the assets to the particular organisation. Perhaps the organisation, if given the option, would acquire alternative types of assets. • Replacement costs do not provide an indication of the asset’s current value if the entity decides to sell. Issues in Accounting Theory 2009 Solutions: Topic 3 5 5.14 • • • • • It will not always be easy to determine replacement costs—for specialised assets the values can be very subjective. Implementing current cost accounting requires the entity to go to the expense of collecting information about replacement costs. There is not much evidence to support a view that people actually demand such information. People are used to preparing and reading historical cost accounting reports, hence there would be a need to re‐educate them about the strengths and limitations of current cost accounting—this might be costly. It still requires a reliance upon arbitrary cost allocations, for example, through depreciation. 5.15 Some strengths of Continuously Contemporary Accounting would include: • CoCoA provides information about an entity’s capacity to adapt. Chambers considers such information crucial for effective decision making • It solves the ‘additivity’ problem—there is a common basis of valuation (net‐market values) so it makes logical sense to add the various asset values together. • There is no need for arbitrary cost allocations through depreciation. Some weaknesses of Continuously Contemporary Accounting would include: • Not all assets will have a readily determined market price—hence a deal of subjectively will be involved. • Some assets can generate income within a particular entity, but have little or no value to anybody else (for example, the case of the blast furnace). The ‘value in use’ of such assets is ignored. • It values assets on the basis of the separate disposal of the respective assets. The implication of this is that assets which cannot be separately sold are deemed to have no value—for example, goodwill. This attribute of CoCoA has attracted a great deal of criticism. • CoCoA has never had widespread acceptance within the business community and hence there would be numerous obstacles to its implementation. • Because CoCoA would represent a radical departure from current methods of accounting, its adoption could cause major social and economic implications. • People are used to preparing and reading historical cost accounting reports, hence there would be a need to re‐educate them about the strengths and limitations of CoCoA—this might be costly. • If an entity does not expect to sell an asset, it is questionable whether the selling price is really that relevant. Issues in Accounting Theory 2009 Solutions: Topic 3 6 • • Tied to the above point, valuing all assets on the basis of selling prices has been criticised if it is considered that the entity is a going concern. Determining the market price of unique assets introduces a degree of subjectivity into the accounting process. 5.17 Edwards opposes the use of exit prices to value all assets on the basis that an entity, operating as a going concern, would not be expected to dispose of all of its assets at a point in time. Further, if an entity is expanding, the notion that they would dispose of all of their assets is even more questionable. Edwards, an advocate of using replacement costs, suggests that in some circumstances the use of exit values might be appropriate when they are less than the replacement costs of an asset ‘and the firm has taken a definite decision not to replace the asset or even the function it performs’. As we can see, Edwards’ approach to valuation admits the possibility that a consideration of management’s intention at a point in time might influence a decision as to how an asset will be valued. This in itself could introduce some problems as allowing such considerations to influence asset valuation could introduce issues associated with biases and manipulations. A change in intention would lead to a change in valuation—we can imagine that Chambers would oppose such a possibility. Also, if some assets are valued at replacement costs and others at exit prices then we again will encounter problems associated with ‘additivity’. Cover this question and 6.11 together In terms of why many recently released accounting standards have embraced fair values rather than historical costs, there could be numerous reasons—as this chapter has demonstrated. The chapter, as well as previous chapters, has discussed various reasons why the accounting standard‐setters might put in place particular requirements ranging from self‐interest arguments to public interest arguments. Adopting a public interest argument, it is very conceivable that the regulators believed that measurements based on fair values are much more relevant to the decisions of financial statement users than measurements or valuations based on historical costs. However, while accounting standards have gradually created a movement away from historical costs towards fair values, this has happened at a time when conceptual frameworks have not really addressed the measurement issue. In a sense, underlying concepts are being changed gradually through the vehicle of accounting standards (and some would argue, by ‘stealth’), rather than in ‘one hit’, via a major change to our conceptual framework. Arguably, an agreement on changes to conceptual frameworks in terms of the incorporation of measurement issues (and the related debate) should 5.20 Issues in Accounting Theory 2009 Solutions: Topic 3 7 6.11 have preceded the general shift in measurement bases used in accounting standards. The chapter has discussed a number of reasons why standard‐ setters might have decided not to address measurement issues with conceptual framework projects. Certainly the measurement issue has appeared to be a major stumbling block in the development of conceptual framework. Conceptual frameworks have failed to provide clear guidance in relation to contentious measurement issues. Reasons for this could include: • There is so much debate and disagreement on what the appropriate basis of measurement is (for example, historical cost, market values, replacement costs, present values, fair values) and whether one method should be applied to all items, that perhaps the standard‐ setters are currently unsure which approach is the best and are awaiting further debate/knowledge before endorsing one approach in preference to another. Perhaps the efforts of accounting standard‐setters have been diverted to other more ‘pressing’ issues. For example, in recent years many accounting standard‐setters have been spending considerable time considering issues associated with the international harmonisation and standardisation of accounting standards. Because standard‐ setters typically have limited resources, when pressing issues arise the conceptual framework might tend to be put on the ‘back‐burner’. Hines has argued that conceptual frameworks are put in place to bolster the image and support for the accounting profession and accounting standard‐setters. Because measurement issues generate a wide amount of debate, support of one method in preference to another may reduce the support of the accounting‐standard setters. Perhaps this might have influenced their lack of support for one approach to measurement in favour of another. Perhaps it is easier to ‘cop‐out’ (Solomons 1986). • • Issues in Accounting Theory 2009 Solutions: Topic 3 8 Chapter 6 6.5 Neutrality and representational faithfulness have been proposed as important qualitative attributes of financial information. However, there are a number of issues that can be raised to question whether financial information can really be considered as neutral and representionally faithful. These include: • Those responsible for accounting (accountants) are responsible for determining what issues need to be accounted for, and those that do not. This relies upon a great deal of judgement. If something is not separately identified and accounted for then it might be deemed unimportant. Attention will tend to be directed towards those attributes of performance that are identified and measured. Identifying what is important is a subjective process. • The recognition criteria of the elements of accounting relies upon a consideration of probabilities, for example, the probability that an item of expenditure will generate future economic benefits. The determination of probabilities can be quite subjective. • When accounting standards are developed, accounting standard‐setters consider the potential economic and social consequences that might result if the standard is issued. Once standard‐setters allow such considerations to influence their standard‐setting activities it is questionable whether the standards are developed in an objective manner. If the accounting standards are not developed in an objective manner, then it is also questionable whether the accounting reports which are developed in accordance with those standards can be objective. • Related to the above point, the process involved in the development of accounting standards can be considered to be a political process given that constituents are encouraged to provide a lobbying submission during the process of developing accounting standards. A political process is not generally considered to be an objective process. To some extent, the ongoing existence of standard‐setting bodies is reliant upon constituent support. • Some accounting researchers use various economic theories to explain what motivates managers to support one accounting method in preference to another. Proponents of Positive Accounting Theory assume that individual self‐interest motivates the selection of accounting methods within a firm. Self‐interest and objectivity are mutually exclusive. The answer to this question is very much a matter of opinion. Possible answers would include: 9 6.9 Issues in Accounting Theory 2009 Solutions: Topic 3 • Users of financial statements might be considered as possible beneficiaries of a conceptual framework as financial statements will be more consistent and comparable and this should assist various resource allocation decisions. It should also reduce costs associated with using accounting data, as there will be less need to adjust for differences in accounting approaches between alternative reporting entities. Following the above point, it could be argued that society as a whole will benefit because more informed resource allocation decisions will be made and this might reduce the likelihood of resources flowing to inefficient uses. Reporting entities could benefit because they will be given explicit guidance on many key reporting issues. Further, they will have general guidance when no accounting standards exist in relation to a specific accounting issue. Also, because conceptual frameworks developed around the world have many commonalities, acceptance of a conceptual framework could assist in the inflow of resources from foreign investors (the perspective being that differences in accounting practices between countries might impede foreign investment). There are a number of perspectives which suggest that standard‐ setters might benefit from the development of conceptual frameworks. One argument is that standard‐setters will be subject to less political pressure and interference because the basis for many of their decisions will be embodied within an accepted framework. Another perspective is that conceptual frameworks benefit standard‐ setters because they legitimise the existence of the standard setters, thereby enabling them to maintain self‐regulation and to counter threats to their own employment. Conceptual frameworks have also been argued to represent a means of boosting the public image of the accounting profession as a whole. Authors such as Hines argue that conceptual frameworks promote notions of objectivity, reliability and so forth and such qualities themselves are generally deemed to be the cornerstone of a sound profession. It has also been argued that conceptual frameworks provide benefits to people with a financial interest in the firm, as opposed to people with other interests. For example, conceptual frameworks define the elements of accounting in such a way as to ignore social and environmental issues, and to emphasise financial performance. Hence, the implication is that organisations with ‘sound’ financial performance will appear to be ‘better’ performers, even if they have many negative social and environmental implications (most of which • • • • Issues in Accounting Theory 2009 Solutions: Topic 3 10 might be ignored). ‘Better’ performers will in turn generate greater community support and this should increase the value of the entity. 6.16 If newly developed accounting proposals represent a major departure from existing practices then history indicates that the degree of opposition to the requirements could be quite significant. There are a number of reasons for this. Firstly, accountants will be familiar with existing generally accepted accounting principles and will potentially be sceptical about whether the benefits associated with new approaches will outweigh the costs associated with learning the new approaches. Also, it could be quite costly to implement changes to existing recording systems to collect the new information potentially required by the new accounting approaches. There might also be a view that financial statement readers are familiar with existing rules, and that changing them might lead to confusion for the users. Managers might also consider that the rules they currently use provide the best reflection of the entity’s economic performance and that to change them will lead to inefficiencies in the ability of external parties to assess the performance of the entity. It is also possible that new accounting rules could lead to significant economic consequences for some sectors of the community. For example, if a new rule comes in that requires certain assets to be recorded on a new basis then this might deflate the assets of some entities and this could be deemed in turn to affect community confidence in an organisation. Also, some companies might be put into technical default on certain borrowing agreements as a result of the newly proposed rules. Hence, potential economic consequences might impact support for newly developed requirements. Accounting standard‐ setters are quite open in stating that they consider the economic consequences of new rules before implementing them. This has obvious implications for the neutrality and objectivity of the new rules. The newly proposed rules might also eliminate some discretion that the firm previously had in relation to choosing the methods of accounting it would apply in given circumstances. This discretion might have been used to smooth accounting earnings in periods which would otherwise show great volatility in earnings. Lack of support for particular proposals has been shown in the past to lead to standard‐setters removing particular issues from their agenda. Standard‐ setting is a political process, and the continuity of the standard‐setter (and the employment of the people working therein) can be very much dependent upon constituency support. Issues in Accounting Theory 2009 Solutions: Topic 3 11 6.18 To answer this question it is useful to consider the objective of financial reporting identified within the IASB Framework. According to the IASB Framework, the objective of general purpose financial reporting is: to provide information about the financial position, performance, and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions. Hence, there is clearly a bias towards considering users that have an economic interest in the reporting entity. Other members of the community that do not have a direct economic interest are effectively excluded. Further, organisations have various social, economic, and environmental impacts. Whilst some members of the community would be interested in the economic performance of an entity (which perhaps is reflected by financial accounting data), general purpose financial reports are not terribly useful for assessing an entity’s social or environmental impacts. Therefore, we can question whether conceptual frameworks prescribe the disclosure of information that members of the community would find useful in assessing the overall contribution that an organisation makes to the community. To understand the 'current thinking' of the IASB and the FASB in relation to the objective of financial reporting it is useful to consider the exposure draft released by the IASB as part of the ongoing efforts to develop a revised conceptual framework. In relation to the objective of financial reporting it states (IASB, 2008, p. 14): The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers. Information that is decision‐useful to capital providers may also be useful to other users of financial reporting who are not capital providers. It would appear that the focus remains with those parties that have a financial interest or stake in the reporting entity rather than with parties who have an interest in the overall contribution of an organisation to the community. Issues in Accounting Theory 2009 Solutions: Topic 3 12 ...
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