Exit price accounting &

Capital Maintenance

Lecture 6
Learning Objectives

At the conclusion of this lecture, you should

have an appreciation of:
• the background to the reporting of exit price
accounting
• the concept and advantages of adaptive
behaviour
Learning Objectives

At the conclusion of this lecture, you should

have an appreciation of:
• the criticisms of exit price accounting
• the difference between value in use and
value in exchange
• the movements away from strict historical
cost accounting in international accounting
standards
Learning Objectives

At the conclusion of this lecture, you should

have an appreciation of:
• what is capital maintenance
• two types of capital maintenance
• Importance of capital maintenance.
In support of Exit Price
Accounting
Providing useful information
• MacNeal’s argument
• Current accounting principles an outgrowth of
‘primitive conditions’ that have largely ceased
to exist
 In support of Exit Price
Accounting
Providing useful information:
MacNeal divided accounting history
into three phases:
• 1st era, 12th to 17th century
• accountant to provide information to
the owner-manager about the total
costs incurred in ventures and
projects
In support of Exit Price
Accounting
MacNeal (continued)
• 2nd era, 18th to 19th century
• Business firms more established, less transaction
risk

• Third era, 20th century onwards

• Separation of ownership from control
• External financial reports required
In support of Exit Price
Accounting
MacNeal:
• Marketable assets at market price (exit price)
• Non-marketable, non-reproducible assets at
historical cost
• Occasional non-marketable,
non-reproducible assets at historical cost
In support of Exit Price Accounting

Adaptive decision making

• Chambers’s comprehensive proposal
• ‘continuously contemporary accounting (CoCoA)’
• adaptive entity engaged in buying and selling goods
and services
• need knowledge of the cash and current cash
equivalents of net assets
• financial position determined with market values
In support of Exit Price Accounting

Adaptive decision making

Chambers:
…the single financial property which is uniformly
relevant at a point of time for all possible future
actions in markets is the market selling price of
realisable price of any or all goods held
In support of Exit Price Accounting

Relevant and reliable information

Sterling’s argument
• the problem of income measurement is
one of valuation
• information content of valuation method
• decision usefulness
In support of Exit Price Accounting
Sterling
• Model to predict the consequences of currently
available alternative courses
of action
• For the wheat trader, three decision problems
are posed:
• The continuing decision to enter and stay in the
market
• The continuing decision to holder either cash
or wheat
• The evaluation of past decisions
In support of Exit Price Accounting

Sterling: items relevant to decisions

• The expected future price of wheat
• expected future price of other alternatives
• The present selling price of wheat
• present buying price of other alternatives
In support of Exit Price Accounting

Sterling: items relevant to decisions (continued)

• The price at the last evaluation
• The quantity of wheat and money at the last
evaluation
• The present quantities
In support of Exit Price Accounting

Sterling's conclusions:
Present market method of valuation is:
• Relevant to all users
• Reliable
• Empirically meaningful
• Additive, in the sense that the sum of the parts is
equal to the independent measurement of the whole
In support of Exit Price Accounting

Other advantages
• Additivity (Chambers)
• Allocation (Thomas)
• Reality (Real world examples)
• Objectivity (Parker)
• A measure of risk
Criticisms of Exit Price Accounting
• Profit concept
• Exit price does not provide relevant data fro
matching
• Bell…current cost advocate
• Additivity
• Chamber’s assumption of a gradual and orderly
liquidation
• Other weaknesses
• Chambers… implies that liabilities must be legally
enforceable
Value in Use versus Value in
Exchange
Adam Smith
• Distinction between value in use and value in
exchange)
• Value in use assesses long-term solvency
• Value in exchange assesses short-term liquidity
• Exit value accused of ignoring value in use
• Valuation difference arises when there are
market liquidity/efficiency problems
A Mixed Measurement System &
International Standards

• Miller and Loftus

• Market price or current value information makes
financial statements more relevant
• IAS uses a mixture of valuation methods
• Miller & Loftus: piecemeal approach and lack
of consistency
• Theoretical basis for valuation measurements
unclear
Summary
• MacNeal, Chambers & Sterling arrived at the
same conclusion:
• that current exit prices should be used to better
meet user information needs
• Exit price financial statements are allocation
free and better relate to the real world
• Miller and Loftus have pointed out
• the accounting standards have taken a piecemeal
approach to valuation
CAPITAL MAINTENANCE CONCEPT

The issue – how does an entity define the

concept of CAPITAL that it seeks to maintain?
Companies should only pay dividends out of
profits in order to maintain a company’s capital
and therefore protect providers of capital
(shareholders and providers of finance)
So how do we define profit and do we take
into account the effect of changing price?
 CAPITAL MAINTENANCE CONCEPT
The issue – how does an entity define the concept of
CAPITAL that it seeks to maintain?
Two concepts
Financial capital maintenance
Net Asset (A – L) is greater than or equal to the
balance at the beginning of year.
Physical capital maintenance
Productive capacity or operational output
e.g. Can you manufacture or sell or give as much
production at end of the year as compared to the
beginning of the year.
CAPITAL MAINTENANCE CONCEPT

The issue – how does an entity define the

concept of CAPITAL that it seeks to maintain?
Companies should only pay dividends out of
profits in order to maintain a company’s capital
and therefore protect providers of capital
(shareholders and providers of finance)
So how do we define profit and do we take
into account the effect of changing price?
 CAPITAL MAINTENANCE CONCEPT

Example
 Coy X commences business on 1 January 2010 with $100 001 share
capital
 Coy X purchases 20 000 units of inventory $5 each on 1 January
2010, total cost of $100 000
 Coy X sold all inventory during 2010 for a total of $120 000 in cash
 Therefore a profit of $20 000 for 2010 is earned.
 If $20 000 dividend is paid, then capital (equity) would be
unchanged for the year.
 CAPITAL MAINTENANCE CONCEPT
Equity balance
(1) Bank 100 001
Share capital 100 001 100 001
----------------------------------------------------------
(2) Inventory (SFP) 100 000
Bank 100 000 -
-----------------------------------------------------------
(3) Bank 120 000
Revenue(P/L) 120 000 120 000
----------------------------------------------------------
COS (P/L) 100 000
Inventory (SFP) 100 000 (100 000)
---------------------------------------------------------- ------------------
120, 001
 Equity balance
(1) Bank 100 001
Share capital 100 001 $100 001
---------------------------------------------------------------
(2) Inventory (SFP) 100 000
Bank 100 000 -
---------------------------------------------------------------
(3) Bank 120 000
Revenue(P/L) 120 000 $120 000
---------------------------------------------------------------
COS (P/L) 100 000
Inventory (SFP) 100 000 ($100 000)
--------------------------------------------------------------- --------------
$120, 001
(4) Dividend declared (EQ) 20 000
Bank 20 000 $ 20 000)
$100 001
 CAPITAL MAINTENANCE CONCEPT
Now will see the physical capital concept using the same example.
• Now let us assume that the company wishes to purchase another
20 000 units on 1 January 2011 (the second year)
• What happens, prices go up (inflation) and now inventory will cost
$5.40
• Therefore with the same capital $100 000, the company can only
purchase 18 518 units of inventory.

2010 20 000 units ($100 000)

2011 18 518 units
 CAPITAL MAINTENANCE CONCEPT
 Therefore by distributing the full $20 000 in dividend, the
company’s ability to purchase goods/services has been eroded.
 Should the profit of $20 000 not recorded as
- $120 000 - $108 000 (20 000 units x $5.40) = $12 000?

 IAS 2 still sticks to measure inventory at lower of cost or net

realisable value, but many other assets are now measured at fair
/current cost/replacement value for this reason.
 CAPITAL MAINTENANCE CONCEPT
 The framework refers to two different concepts of capital
 Financial capital maintenance

 Physical capital maintenance

 CAPITAL MAINTENANCE CONCEPT
 Financial capital maintenance
- profit is only earned if the financial (monetary) amount of
net assets at the end of the period exceeds the financial net
assets at the beginning of the period
 Physical capital maintenance
- profit is only earned if the physical productive capacity of
the entity at the end of the period exceeds the physical
productive capacity at the beginning of the year.
 CAPITAL MAINTENANCE CONCEPT
 It is not only an important topic for academic purposes but it does
help us understand some of the concepts behind why we do what
we do in accounting.
 The important concept to understand here is we need to maintain
capital in-order to protect investors and suppliers of capital. If you
don’t do that the whole corporate system doesn’t work and that is
the reason why much of this type of theory is incorporated to
many of the company’s act around the world.
eNd