Chapter 12
Current-value
accounting
Arguments in favour of
measuring income – I
• Income is a basis for the taxation and
redistribution of wealth among
individuals
• Income is perceived as a guide to a
firm’s dividend and retention policy
• Income is viewed as an investment and
decision-making guide in general
The AAA’s normative
shareholders’ valuation model
• The American Accounting Association’s
Committee on External Reporting defined a
normative shareholders’ valuation model
centring on:
– the future dividend-per-share flows to be
derived from an investment
– the risk associated with these flows
• The Committee on External Reporting also
suggested that a firm’s ability to pay dividends
is a function of the following variables:
– net cash flows from operations
– non-operating cash flows
The AAA’s normative shareholders’
valuation model (cont’d)
– cash flows from changes in the levels of
investment by stockholders and creditors
– cash flows from investment in assets
– cash flows from priority claims
– cash flows from random events
– management attitudes regarding stocks of
resources
– cash dividend policy
Arguments in favour of
measuring income – II
• Income is perceived as a predictive
device that aids in the prediction of
future incomes and future economic
events
• Income may be perceived as a measure
of efficiency
Accounting income
Accounting income is operationally
defined as the difference between the
realised revenues arising from the
transactions of the period and the
corresponding historical costs
Attributes of accounting income
There are at least five attributes of
accounting income:
1. accounting income is based on the
actual transaction entered into by the
firm (primarily revenues arising from
the sales of goods or services minus
the costs necessary to achieve these
sales)
2. accounting income is based on the
revenue principle and requires the
definition, measurement, and
recognition of revenues
Attributes of accounting income
(cont’d)
3. accounting income requires the
measurement of expenses in terms of
historical cost to the enterprise,
constituting a strict adherence to the cost
principle
4. accounting income requires that the
realised revenues of the period be related
to appropriate or corresponding relevant
costs
5. accounting income is also based on the
period postulate and refers to the financial
performance of the firm during a given
period
Advantages of accounting
income
• Accounting income has survived the test of
time
• Because it is based on actual, factual
transactions, accounting income is measured
and reported objectively and is therefore
basically verifiable
• By relying on the realisation principle for the
recognition of revenue, accounting income
meets the criterion of reliability
• Accounting income is considered useful for
control purposes, especially in reporting on
stewardship
Disadvantages of accounting
income
• The arguments against the use of
accounting income question its
relevance in decision making
• The most serious problem with
accounting income is that it is
predicated on the assumption of a
stable monetary unit, which means that
as a result it fails to recognise increases
in the values of assets and liabilities
held in a given period
Disadvantages of accounting income
(cont’d)
• A host of authors have observed that,
because the monetary unit is unstable
in modern economies, accounting
income can easily give a mistaken and
misleading impression of an entity’s
earnings, financial strength and
performance
• Accounting income effectively allows
entities to ‘manage’ results
Disadvantages of accounting income
(cont’d)
• The reliance of accounting income on
the historical-cost principle makes
comparability difficult, given the
different acceptable methods of
computing ‘cost’ and the different
acceptable methods of cost allocation
deemed arbitrary and incorrigible
The nature of the economic
concept of income
The concept of income has always been an
important point of interest to economists:
• Adam Smith was the first economist to
define income as an increase in wealth
• most classicists followed Smith’s concept of
income and linked its conceptualisation to
business practices
• towards the end of the nineteenth century,
the understanding that income is more than
cash was expressed in Von Bohm Bawerk’s
theories on capital and income
Fisher
Fisher defined economic income as a series of
events that correspond to different states – the
enjoyment of psychic income, real income and
money income:
• psychic income is the actual personal
consumption of goods and services that produce
a psychic enjoyment and satisfaction of wants …
it cannot be measured directly, but it can be
approximated by real income
• real income is an expression of the events that
give rise to psychic enjoyment and is best
measured by the cost of living
• money income represents all the money received
and intended for use in consumption to meet the
cost of living
Lindahl
• Lindahl introduced the concept of income
as interest, referring to the continuous
appreciation of capital goods over time
• The differences between the interest and
consumption anticipated for a given
period are perceived as saving
• This idea led to the generally accepted
concept of economic income as
consumption plus saving expected to take
place during a certain period, the saving
to being equal to the change in economic
capital
Hicks
Hicks used the concepts introduced by
Fisher and Lindahl to develop a general
theory of economic income, defining a
person’s personal income as:
‘the maximum amount he can
consume during a week and still
expect to be as well-off at the end of
the week as he was at the beginning’
Capital maintenance
• The concept of capital maintenance
implies that income is recognised after
capital has been maintained or costs
have been recovered
• Return on capital (income) is
distinguished from return of capital
(cost recovery)
• SAC 4 identified two concepts of capital
maintenance: financial and physical
Financial and physical capital
maintenance
• Financial and physical capital maintenance
can be in the form of units of money or
general purchasing power
• This gives rise to four concepts of capital
maintenance:
1. money maintenance, being financial
capital measured in units of money
2. general purchasing-power money
maintenance, being financial capital
measured in units of the same purchasing
power
Financial and physical capital
maintenance (cont’d)
3. productive-capacity maintenance,
being physical capital measured in
units of money
4. general purchasing-power,
productive-capacity maintenance,
being physical capital measured in
units of the same purchasing power
Capitalisation (present value)
• Under the capitalisation method for calculating
current value, the capitalised value of an asset,
group of assets or total assets is the net
amount of the discounted expected cash flows
of such assets during their useful lives
• To compute the capitalised value, four variables
must be known:
1. expected cash flows from asset use or
disposal
2. the timing of those expected cash flows
3. the number of years of the asset’s remaining
life
4. the appropriate discount rate
Capitalisation (present value)
(cont’d)
• The present-value income is the total pureprofit income expected to be accrued up to
the firm’s planning horizon
• It is an ex ante income, or economic income,
that reflects expectations about future cash
flows
Economic income versus
accounting income
• Economic income is an ex ante income
based on cash-flow expectations
• Accounting income is an ex post or
periodic income based on historical
values
Current entry price
• Current entry price can be defined as the amount
of cash or other consideration that would be
required to obtain the same asset or its
equivalent
• The following interpretations of current entry
price have been used:
– replacement cost – used is equal to the amount
of cash or other consideration that would be
needed to obtain an equivalent asset on the
second-hand market, having the same
remaining useful life
– reproduction cost is equal to the amount of
cash or other consideration that would be
needed to obtain an asset identical to the
existing asset
Current entry price (cont’d)
– replacement cost – new is equal to the
amount of cash or other consideration
needed to replace or reproduce the
productive capacity of an asset with a new
asset that reflects changes in technology
• The common characteristic of the three
notions of current entry prices is that they all
correspond to the costs of replacing or
reproducing an asset held
Measurement of current
entry prices
• The issue that remains to be solved is
the choice of method of measurement
of current entry prices
• The three most-advocated methods
use:
– quoted market prices
– specific price indexes
– appraisals
Holding gains and losses
• The valuation of assets and liabilities at current
entry prices gives rise to holding gains and
losses as entry prices change during a period
of time when they are held or owed by a firm
• Holding gains and losses may be divided into
two elements:
1. the realised holding gains and losses that
correspond to the items sold or to the
liabilities discharged
2. the holding gains and losses that
correspond to the items still held or to the
liabilities owed at the end of the reporting
period
Backlog depreciation
• Three methods have been suggested to
account for backlog depreciation:
1. charge or credit to retained earnings
2. charge or credit to current income
3. adjust holding gains and losses by the
amount of backlog depreciation
• The three methods result from two
fundamentally different interpretations of
depreciation:
– that depreciation should provide a reserve
for the future replacement of assets so that
backlog depreciation should be treated
according to either of the first two methods
Backlog depreciation (cont’d)
–
that depreciation is a current cost of
operations, so that backlog depreciation
should be treated according to the third
method
Advantages of current-entryprice-based accounting
The primary advantage of current-entry-pricebased accounting results from the breakdown
and segregation of current-value income into
current operating profit and holding gains and
losses:
• as noted by Edwards and Bell, the dichotomy
between current operating profit and holding
gains and losses is essential for evaluating the
past performance of managers
• the dichotomy between current operating
profit and holding gains and losses is useful in
making business decisions
Advantages of current-entry-pricebased accounting (cont’d)
• current operating profit corresponds to the
income that contributes to maintaining
physical productive capacity – that is, the
maximum amount that the firm can distribute
and maintain its physical productive capacity
• the dichotomy between current operating
profit and holding gains and losses provides
important information that can be used to
analyse and compare inter-period and intercompany performance gains
• the current-entry-price method allows a
distinction between realised holding gains and
losses and unrealised holding gains and losses
Disadvantages of the currententry-price system
• Each claim about the benefits to be derived
from dichotomising current-value income into
current operating profit and holding gains and
losses has been contested
• The current-entry-price system is based on
the assumptions that the firm is a going
concern and that reliable current-entry-price
data may be obtained easily
• There is also the difficulty of correctly
specifying what is meant by ‘current entry
price’
Disadvantages of the current-entryprice system (cont’d)
• There have been other conceptual criticisms
of replacement-cost accounting
• There have been suggestions that the
current-entry-price system recognises
current value as a basis of valuation but
does not account for changes in the general
price level, and gains and losses on holding
monetary assets and liabilities
Current exit price – I
• Advocates of exit value accounting
emphasise the notion of opportunity
costs
• Opportunity cost means the value of the
next best alternative
• In order to know the next best
alternative, it is relevant to know the
market value or the selling price of an
asset
Chambers’ model
• One of the most popular exit-value models was
developed by Chambers in 1966
• His model is better known as continuous
contemporary accounting, or CoCoA
• According to Chambers, a firm must continually
make adjustments to stay in tune with its
environment and the marketplace, in order to
survive and prosper
• Capacity for adaptation necessitates that entities
can quickly modify, replace or redeploy an existing
asset base as the need arises
• Decisions relating to changes in the composition of
resources require knowledge of selling prices, not
buying prices
Continuous Contemporary
Accounting (CoCoA)
According to Chambers (1975), CoCoA is based
on three key ideas:
1. a statement of financial position is only
understandable and significant in relation to
financial dealings if its components are
amounts of money and prices expressed in
money
2. no reasonable action can be taken on the
basis of a statement of financial position
unless the statement corresponds
reasonably well with the actual financial
position of a firm as at the date the
statement bears
Continuous Contemporary
Accounting (CoCoA) (cont’d)
3. specific price movements in a period
affect both the income of the period
and the financial position at the end
of the period
Current exit price – II
• Current exit price represents the
amount of cash for which an asset
might be sold or a liability might be
refinanced
• The current exit price is generally
agreed to correspond to:
– the selling price under conditions of
orderly rather rather than forced
liquidation
– the selling price at the time of
measurement
Advantages of current-exitprice-based accounting
• The current exit price and the capitalised
value of an asset provide different measures
of the economic concept of opportunity costs
• Current exit price provides relevant and
necessary information on which to evaluate
the capacity for adaptation and liquidity of a
firm
• Current exit price provides a better guide for
the evaluation of managers in their
stewardship function because it reflects
current sacrifices and other choices
Disadvantages of current-exitprice-based accounting
• The current-exit-price-based system is relevant
only for assets that are expected to be sold for
a determined market price
• The current-exit-price-based system is not
relevant for assets that the firm expects to use
• Some writers have questioned the relevance of
operating profit as determined under the exitvalue model
• The valuation of certain assets and liabilities at
the current exit price has not yet been
adequately resolved
Disadvantages of current-exit-pricebased accounting (cont’d)
• The abandonment of the realisation principle
at the point of sale and the consequent
assumption of liquidation of the firm’s
resources contradict the established
assumption that the firm is a going concern
Other interpretations of
current values
Other proposals for the implementation
of current-value accounting have been
made, such as:
• essential versus non-essential assets
• value to the firm
• SEC replacement-cost proposal
• combination of values
• the concept of business income
Essential versus nonessential assets
• The Australian Accounting Standards Committee
published a preliminary exposure draft ‘A
Method of Current-Value Accounting’ in June
1975
• The exposure draft introduced a form of currentvalue accounting that uses different treatments
for essential assets and non-essential assets
• Essential assets are determined on the basis of
‘the expected role of particular assets in the
entity’s operations in the immediately forseeable
future’
Essential versus non-essential assets
(cont’d)
• A non-essential asset is valued at its current
exit price
• An essential asset is valued at its current
entry price
Essential versus nonessential assets
• The holding gains and losses on essential
assets are credited or debited to a
revaluation account
• The holding gains and losses on nonessential assets are included in income
• The distinction between essential and nonessential assets represents a modification
of the current-entry-price-based system to
reflect economic realities
The Sandilands Report
• In the UK, the ‘Report of the Inflation
Accounting Committee’, which was chaired by
F. E. P. Sandilands, was issued in 1975:
– the Report’s most important recommendation
is the use of the value to the firm as a
valuation base
– accounting based on the value to the firm is
also described as current-cost accounting
(CCA)
– according to this approach, assets are valued
at an amount that represents the opportunity
cost to the firm
The Sandilands Report (cont’d)
• The Sandilands Report also recommends
that:
– all holding gains and losses be excluded
from current-cost profit
– a ‘summary statement of total gains and
losses for the year’ appear immediately
after the income statement
SEC replacement-cost
proposal
• The Securities Exchange Commission (SEC)
cited replacement cost as the mandatory
method of disclosure for large corporations
• Replacement cost is defined as the lowest
amount that would have to be paid in the
normal course of business to obtain a new
piece of equipment operating at productive
capacity
• The regulation requires that designated firms:
– estimate the current replacement cost of
inventories and productive capacity
SEC replacement-cost proposal
(cont’d)
– restate the cost of goods sold and
services, depreciation, depletion and
amortisation for the two most recent full
fiscal years on the basis of the
replacement cost of equivalent productive
capacity
• The SEC proposal was a timid attempt to
show the impact of inflation on fixed assets
and inventory, rather than on all monetary
and non-monetary assets
The combination of values
• The combination-of-values approach avoids
some of the disadvantages of the current-exitprice, current entry price and capitalisation
methods
• The Canadian Accounting Research
Committee’s preliminary position favours a
combined use of current entry and current exit
prices
• Although the combination-of-values approach
may appear to be based on arbitrary rules,
advocates of this approach have suggested
specific decisions rules for the choice of a
valuation method based on the marketopportunity costs of assets
The concept of business income
• Edwards and Bell have introduced the
concept of business income
• We have defined accounting income as the
difference between the realised revenues
arising from the transactions of the period
and the corresponding historical costs
• Business income differs from accounting
income in two ways:
1. business income is based on
replacement-cost valuation
2. business income recognises only the
gains accrued during the period