Financial Accounting Theory
Craig Deegan
Chapter 5
Normative theories of accounting—the case
of accounting for changing prices
Slides written by Craig Deegan
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Learning objectives
• In this chapter you will be introduced to:
– some particular limitations of historical cost accounting in
terms of its ability to cope with various issues associated
with changing prices
– a number of alternative accounting methods developed to
address problems associated with changing prices
– some of the strengths and weaknesses of the various
alternative accounting methods
– evidence that the calculation of income pursuant to a
particular method of accounting will depend on the
perspective of capital maintenance that has been
adopted
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Limitations of historical cost in times
of rising prices
• Historical cost assumes money holds a constant
purchasing power
• Three aspects of the economy which make the
assumption less valid than when historical cost
was developed
– specific price level changes (shifts in consumer
preference; technological advances)
– general price level changes (inflation)
– fluctuation in exchange rates
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Limitations of historical cost in times
of rising prices (cont.)
• Problem of relevance in times of rising prices
– asset’s current value may be different from historical cost
• Problem of additivity (adding together assets
bought at different times)
• Can overstate profits in times of rising prices, with
distribution of profits leading to an erosion of
operating capacity
• Including holding gains which accrued in previous
periods in current year’s income distorts the
current year’s operating results
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Support for historical cost
accounting
• Predominant method used for many years so
tended to maintain support of profession
• If not found useful business entities would have
abandoned it
• Nevertheless, recent accounting standards being
released have embraced ‘fair values’ as the basis
of measurement. However, various assets are still
measured on an historical cost basis
– e.g. inventory, which is measured at the lower of cost and
net realisable value; property, plant and equipment where
the ‘cost model’ and not the ‘fair-value model’ has been
adopted; many intangible assets
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Definition of Income
• The maximum amount that can be consumed
during the period, while still expecting to be as well
off at the end of the period as at the beginning of
the period (Hicks 1946)
• Consideration of ‘well-offness’ relies on a notion of
capital maintenance
• Different notions of capital maintenance will
provide different perspectives of income
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Capital maintenance perspectives
• Financial capital maintenance
– perspective taken in historical cost accounting
• Purchasing power maintenance
– historical cost accounts adjusted for changes in the
purchasing power of the dollar
• Physical operating capital maintenance
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Development of accounting for
changing prices
• Research initially related to using price indices to
restate historical costs to account for changing
prices
• Literature then moved towards current cost
accounting
– the basis of measurement changed to current values not
historical values
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Current purchasing power accounting
(CPPA)
• Also called general purchasing power accounting;
general price level accounting; constant dollar
accounting
• Based on the view that in times of rising prices, if
an entity were to distribute unadjusted profits
based on historical costs, in real terms the entity
could be distributing part of its capital
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Calculating indices
• A price index is used when applying general price
level accounting
• A price index is a weighted average of the current
prices of goods and services related to a weighted
average of prices in a prior period (base period)
– e.g. Australian Consumer Price Index (CPI)
• Can use a general or specific price index
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Performing current purchase power
adjustments
• All adjustments are performed at the end of the
period
• Adjustments are applied to historical cost accounts
• Monetary and non-monetary assets considered
separately
– values of monetary assets do not change as a result of
inflation
– liabilities generally considered monetary items
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Performing current purchase power
adjustments (cont.)
• In times of inflation, holders of monetary assets will
lose in real terms
– the assets have less purchasing power at the end of the
period relative to the beginning of the period
• Holders of monetary liabilities gain, given the
amount they have to repay at the end of the period
is worth less than at the beginning
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Performing current purchase power
adjustments (cont.)
• No change in purchasing power arises from
holding non-monetary assets
– non-monetary assets are restated to current purchasing
power so no gain or loss is recognised
• Purchasing power gains or losses are included in
income for the period
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Movements in net monetary assets
• Must identify changes in net monetary assets as a
result of revenues or expenses
• In times of rising prices there will be a loss in
purchasing power of cash received during the year
• More expenses are able to be paid earlier in the
year as more cash required for expenses incurred
later in the year
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Advantages of current purchasing
power adjustments
• Relies on data already available under historical
cost accounting
• No need to incur cost or effort to collect data about
current asset values
• CPI data also readily available
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Disadvantages of current purchasing
power adjustments
• Movements in the prices of goods and services
included in a general price index (CPI) may not
reflect specific price movements in different
industries
• Information generated under CPPA may be
confusing to users
• Studies of share price reactions failed to find much
support for decision usefulness of CPPA data
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Current cost accounting (CCA)
• Based on actual valuations not adjusted historical
cost
• Differentiates between profits from trading and
holding gains
• Holding gains can be realised or unrealised
• Income perspective adopted will determine
whether holding gains or losses treated as income
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Treatment of holding gains or losses
• Financial capital maintenance perspective
– holding gains or losses can be treated as income
• Physical capital maintenance perspective
– holding gains or losses can be treated as capital
adjustments
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CCA under physical capital
maintenance approach
• Advocated by Edwards and Bell
• Valuations based on replacement costs
• Operating income represents realised revenues
less the replacement cost of assets in question
• Generates a measure of income that represents
the maximum amount that can be distributed, while
maintaining operating capacity intact
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Adjustments using Edwards and Bell
approach
• Adjustments usually made at year end
• Historical cost accounts used as basis of
adjustments
• Operating profit calculated by using replacement
costs
• Holding gains excluded in calculating current cost
operating profit
– not available for dividends
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Adjustments using Edwards and Bell
approach (cont.)
• BUT holding gains are included in calculating
business profit
• Business profit shows how the entity has gained in
financial terms from the increase in cost of its
resources
• Depreciation of non-current assets based on the
replacement cost
• As with CPPA no restatement of monetary assets
required
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Advantages of current cost
accounting
• Differentiating operating profit from holding gains
and losses can enhance the usefulness of
information provided
– holding gains different to trading income as due to
market-wide movements that are often beyond
management’s control
• Better comparability of various entities’
performance
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Criticisms of current cost accounting
• Replacement cost of assets may not be the same
for all firms
– some firms may not choose to replace the asset
• If the entity requires replacement assets it may be
more efficient and less costly to acquire different
assets
• Replacement cost does not reflect what the asset
would be worth if sold
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Criticisms of current cost accounting
(cont.)
• Often difficult to determine replacement costs
• Allocating replacement cost via depreciation is still
arbitrary as with historical cost accounting
• Chambers (1995) claimed products of CCA were
irrelevant and misleading
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Continuously Contemporary
Accounting (CoCoA)
• Proposed by Chambers as well as others
• Based on valuing assets at net selling prices (exit
prices) at reporting dates on the basis or orderly
sales
– referred to as current cash equivalent
• Chambers argued that key information for decision
making relates to capacity to adapt
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Continuously Contemporary
Accounting (CoCoA) (cont.)
• The balance sheet (statement of financial position)
considered to be the prime financial statement
– shows the net selling prices of the entity’s assets
• Profit directly relates to changes in adaptive capital
• Adaptive capital reflected by the total exit values of
assets
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Capacity to adapt
• Chambers approach focuses on new opportunities
– the ability of the entity to adapt to changing
circumstances
• The ability of the firm to ‘go into the market with
cash for the purposes of adapting oneself to
contemporary conditions’ (Chambers 1966, p.91)
• Assumes the objective of accounting is to guide
future actions
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Definition of wealth under CoCoA
• Present (selling) price is seen as the correct
valuation of wealth at a point in time
– past prices are a matter of history so not relevant to
current actions
• Profit is tied to the increase (or decrease) in the
current net selling prices of the entity’s assets
• No distinction between realised and unrealised
gains—all gains are treated as part of profit
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Definition of wealth under CoCoA
(cont.)
• Profit is the amount that can be distributed, while
maintaining the entity’s adaptive ability (adaptive
capital)
• Abandons notion of realisation in terms of
recognising revenue
– revenues are recognised at point of purchase or
production rather than sales
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Capital maintenance adjustment
• Unlike CCA there is an adjustment to take account
of changes in general purchasing power (inflation
adjustment)
• Capital maintenance adjustments form part of the
period’s income with a corresponding credit to a
capital maintenance reserve (part of owners’
equity)
• Calculated by multiplying net assets by the
proportional change in a general price index over
the period
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Advantages of CoCoA
• By using one method of valuation for all assets
(exit values) the resulting numbers can be logically
added together (additivity)
• No need for arbitrary cost allocation for
depreciation as gains or losses on assets are
based on movements in exit price
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Criticisms of CoCoA
• If implemented CoCoA would involve a
fundamental shift in financial accounting
– revenue recognition points and asset valuations
– could lead to unacceptable social and environmental
consequences
• Relevance of exit prices questioned if we do not
expect to sell the assets
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Criticisms of CoCoA (cont.)
• Assets of a specific nature considered to have no
value under CoCoA because cannot be separately
disposed of
– CoCoA ignores the ‘value in use’ of an asset
• Questioned whether appropriate to value all assets
at exit prices if the entity is a going concern
• Determining exit prices for unique assets
introduces subjectivity into accounts
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Criticisms of CoCoA (cont.)
• CoCoA requires assets to be valued separately
rather than as a bundle
– therefore would not recognise goodwill as an asset
– value of assets sold together can be very different from
separate sale
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Demand for price adjusted
accounting information
• Limited evidence that stock markets react to
current cost and CPPA information
– little or no share price reaction to price adjusted
accounting information found
– results may have been due to limitations with research
methods used
 reaction to other information released at the same time
could not be distinguished
 users may have obtained information from other sources
prior to release of annual reports
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Demand for price adjusted
accounting information (cont.)
• Surveys of managers find limited corporate
support for current cost accounting
– cost, limited benefits from disclosure and lack of
agreement as to approach are all considerations
• Surveys of users indicate information not helpful,
not used and information does not tell users
anything new
• Findings interesting given the extent of voluntary
disclosure by corporations
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Reasons for lobbying
• Watts and Zimmerman examined lobbying reaction
to release of FASB Discussion Memorandum on
general price level accounting
• Found that political visibility a major factor in
explaining lobbying positions
– large firms favour general price level accounting as leads
to lower reported profits
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Reasons for lobbying (cont.)
• Supported in New Zealand by Wong (1988)
– corporations adopting CCA during period of rising prices
had higher effective tax rates and larger market
concentrations than those that did not
• In UK Sutton (1988) found politically sensitive firms
more likely to lobby in support of exposure draft
recommending disclosure of CCA
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Professional support for various
approaches
• Current purchasing power accounting generally
supported by standard-setters from 1960s to mid1970s
• From about 1975 preference shifted to current cost
accounting
• Late 1970s and early 1980s standard-setters
issued recommendations which favoured a mixture
of CPPA and CCA
• From mid-1980s support waned (time of falling
inflation)
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Potential reasons for lack of
continued support
• May question the relevance of current cost
information in times of falling inflation
• Drastic change to accounting conventions could
cause disruption and confusion in capital markets
• New method of accounting could have taxation
consequences
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Potential reasons for lack of
continued support (cont.)
• Self-interest motives of corporations
• Limited relevance to decision makers
• Nevertheless, in recent years there have been
movements towards the use of ‘fair values’ as new
accounting standards are being released
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