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Recognition and Measurement Issues

Three Main Income and Capital
Measurement Systems
• The historic cost accounting system emerged after
the 1929 Wall Street collapse
• In the 1960s, several alternatives were developed
– current cost accounting
• financial capital maintenance (the purchasing power of
the financial capital)
• physical capital maintenance (the physical ability to
produce goods and services)
– exit price accounting

Historic cost accounting
• Separation of ownership and control
– information asymmetry
• Most critical objective of accounting is accountability - stewardship
• Critiques of HC argue that reporting only income (that matches inputs
on an HC basis) with no recognition of the changing value of assets and
liabilities is misleading and results in incorrect dividend policies.
• This is because there may be HOLDING GAINS/LOSSES simply from
holding assets or liabilities and they should be recognized when
evaluating performance on a regular basis.
• The income statement is paramount
– transaction based
– revenue recognition
– matching
– profit measurement 3
Arguments for Historic Cost Accounting
(support for HC)
• Relevant in making economic decisions (decisions for future
commitments , managers need data on past transactions)
• Based on actual, not merely possible, transactions (supporting record is
• Data have been found to be useful ( based on some studies e.g. Ball and
Brown, 1968)
• The best understood concept of profit ( a measure of successful
• Must guard data against internal modifications ( records of past
transactions are necessary for accountability)
• Profit based on alternatives may not be useful (there is no intention to
selling the assets or securities regardless of their fluctuations in market
prices . How useful is it to users to show variations in the market price as
• Market prices can be disclosed as supplementary data (EMH)
• Insufficient evidence to reject historical cost accounting. 4
Objectives of accounting
• Stewardship is only a secondary objective ( decision useful
approach calls for a “Forward Looking” position rather than a
preoccupation past)
• Providing the decision making needs of users is the primary
objective and historic cost data is a failure in this regard
• Historic cost information is
– not objective
– can be easily manipulated
– does not maintain the entity’s capital*
• * Capital is the operating capability of the firm, profit is the change in
firm’s operating capability during the reporting period.

Information for decision making
• Is irrelevant and insufficient when evaluating
past or business decisions
• After acquisition, historic cost data is fictional
(unreal or mythical)
• Produces only flawed measures of profit

Criticisms: Basis of historic cost
• The going concern assumption does not
justify the use of historic cost accounting
– many businesses may fail
– no businesses continue indefinitely doing only or
at all what they are presently doing
– all businesses, except those presently existing,
cease operations
• All businesses have alternatives and choices
going forward
Criticisms: Matching
• In most cases, the matching of costs and revenues is a
practical impossibility
• Is totally arbitrary
• The balance sheet is important but through deferred
charges, it results into non-assets being classified as assets
and through deferred credits, non-liabilities being classified as
• Leads to volatility and smoothing.

Notions of investor needs
• Distorts and conceals important company
• Its goals are ill-conceived
• Creative accounting is common place
• Incentives to produce misleading data
• Today, investors pay little attention to historic
cost accounting data about a firm

Summary of Criticisms of HCA
• Objective of accounting and information for decision
• Basis of historical cost—the ‘going concern’
• Matching—fraught with estimates and assumptions
such that its application can be described only as
• Notions of investor needs—the distortion or
concealment of company disclosures.

Objective of
Current Cost Accounting
• CCA or replacement cost values assets at their current
market buying price and profit is determined using matching
expense allocations based on the current cost to buy
• Profit is more precisely defined as the change in capital over
the accounting period
• Managers are better able to evaluate their past decisions and
better use the firm’s resources to maximise future profits
• Shareholders, investors and others are able to make better
allocations of their resources

Objective of
Current Cost Accounting
With regard to profit, managers often face two decisions:
1. Holding decisions about whether to hold assets and liabilities or
to dispose of them (e.g. through sale of assets or repayment of debt)
2. Operating decisions about how to use and finance the
According to Edwards and Bell, business profit is comprising of :
a) the current operating profit: the excess of the current value of the
output sold over the current cost of the related inputs
b) realisable cost savings: increases in the current cost of assets held
-holding gains/losses whether realised/unrealised
• The business profit is therefore, calculated on real basis.

Business Profit Holding Gains & Operating Capital
*Critics point out that CCA violates the traditional revenue
recognition principle by recognizing increases in the value of assets
before they are sold.
• There is too much subjectivity used in accounting process by allowing
revaluations of assets and liabilities, especially when markets are thin and prices
• On the other hand, supporters of CCA believe that the main objective of
accounting is to provide useful information for economic decision making.
• It means the relevant current events of the period should be accounted for and
reported whether they give rise to realized transactions or not, because they
represent opportunity cost.
• Current events not only includes the acquisition and disposition of assets and
liabilities, but also the change in their cost value throughout the current period.
• Operating theorists maintain that the traditional going concern works better by
using current rather than Historical costs
Financial capital versus Physical capital

• From practical point of view, the main difference between the

financial capital and the operating capital is whether or not
holding gains (loses) are included in profit?
• Profit is the change in capital
• Holding gains are included in profit under financial capital
• Holding gains are excluded from profit under physical capital
and it is considered as a capital adjustment and not gain.

Financial and Physical Capital
• Illustration:
• A company begins operations with $1,000
cash on Jan 1 and immediately purchases 100
units for $10 each. On 31 Jan, it sells all the
units for $18 each. On this date, the current
cost has risen to $12 a unit. Assume that
profit is paid out as dividends at the end. The
computation of profit in both the concepts
will be as follows:
Financial Capital versus
Physical Capital
Financial Physical
capital view capital view
Sales revenue (100 x $18) $1,800 $1,800
Cost of Sales (100 x $12) 1,200 1,200
Current operating profit 600 600
Holding gain (100 x $2) 200 0
Profit $800 $600
Paid as dividends $800 $600

In Support of Physical capital
• In the previous case, the firm had 100 units at the beginning; if the capital is to be
maintained, then it must be in a position to purchase 100 units at the end of the
period. Because the price has risen by$2 per unit, the firm needs $200 more at
the end of the period to maintain its beginning operating capacity. Therefore, the
$200 is not a holding gain, rather a capital maintenance adjustment. The
following analysis illustrates the point:
• Profit after maintaining operating capacity of 100 units:
• Beginning capital …………………………………………………. $1,000
• Purchase of 100 units @$10 ( cash outflow) …… -1,000
• Sale of 100 units @$18 (inflow of cash) ………. +1,800
• Needed at the end to maintain capital (100 units x$12).. 1,200
• Profit for January $600
• If $800 were paid as dividends, the company would have $1,000 at the end which
could purchase only 83 units in Feb ($1,000/$12). Capital or the ability to maintain
the same level of operations, would not have been maintained.

• Allows separation of holding gains/losses and operating
• An inefficient company can hide inefficiency under
conventional accounting
• Current operating profit under current cost is equal to
expected profit (under management’s control)
• Expected profit = Mkt rate of return X beginning value of net
• Holding gains are directly related to unexpected profit.
Unexpected profit= Sporadic increases or decreases in PV of
net assets due to change in expectations regarding the level
of future cash flows.

Arguments for and against
Current Cost
• Recognition principle
– In CCA (under financial concept), the unrealized holding gains represent
actual free movement phenomena occurring in the current period, therefore
should be recognized if there is sufficient objective evidence to support the
price changes.
– Are holding gains profits or revaluation adjustments?
(Note: HC and physical capital theorists argue that holding gains should not be
recognized. Edward and Bell (current cost theorists) argue that they
constitute income and should be recognized.)
• Objectivity of current cost
– lacks objectivity
• Technological change
– appears to ignore technological advances

More Specific Criticisms
• Advocates of historic cost accounting
– violates the realisation principle; subjectivity of increase
• Comparisons of the results with historic cost
– industry variations
• Comparison of earnings under HC and CCA (FASB survey of 846 companies
• HC HC Current cost
• (Nominal $) (Constant $) (Nominal $)
• Profit from continuing $172 $120 $107
operations (before tax)
• Taxes 73 73 73
• Profit from continuing $99 $47 $34

Current Exit Price
• The amount of cash for which an asset might be sold or a
liability might be refinanced*.
• The price is generally agreed to correspond :
 To the selling price under conditions of orderly rather than
forced liquidation; and

 To the selling price at the time of measurement.

(*SFAS 157 defines fair value as the price that would be received to sell
an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date)

Current Exit Price
• All assets and liabilities are revalued at their
net realizable values
• Net realizable values are generally obtained
from market quotations adjusted for
estimated selling costs and therefore
correspond to the quoted sales prices on the
demand market.

Current Exit Price
Whenever net realizable values cannot be estimated directly
from the demand market, two alternatives may be considered:
• The use of specific sales price indices, computed either by
external sources or internally by the firm; and

• The use of appraisals by external appraisers or by management

(The use of external appraisers, as is common for property
interests (including investment property – Revaluation option
under IAS 16)
The use of external appraisers does not reduce management’s
ultimate responsibility for the fair value measurements (and
related disclosures) in the entity’s financial statements.
Current Exit Price
• Exit price = selling price = fair market value
• Has two major departures from historic cost
– the values of non-monetary assets are selling
prices and any changes are included in profit as
unrealised gains
– changes in the general purchasing power of
money affect both financial capital and profits

Current Exit Price

• Represents clean surplus accounting**

• The income statement explains all of the differences
existing between the opening and closing balance
** While calculating returns in clean surplus accounting,
transactions with shareholders are not included. The theory's
primary use is to estimate the value of a company’s shares .
It is designed to provide predictability for the investor.

Advantages of Current Exit Price
 Measures of the economic concept of opportunity costs. (Opportunity
cost includes both explicit and implicit costs)
(Economic profit is total revenue minus opportunity cost)
(Accounting profit is total revenue minus explicit cost)
 Provides a better guide for the evaluation of managers in their stewardship
 Eliminates the need for arbitrary cost allocation on the basis of the
estimated useful life of the asset. Hence financial statements are allocation
 Provides relevant and necessary information on which to evaluate the
financial adaptability and liquidity of the firm.

Advantages of Current Exit Price
Provides relevant and reliable information
– there is one way to determine profit that is superior to all
• profit is the difference between capital at two points in time
exclusive of additional investments by and distributions to owners
– to be relevant, information must be useful in the decision
models of accounting data users
– the present selling price is the only item of information
that is relevant to all decisions

Current Exit Price
• market prices are relatively more objective than
most believe
A measure of risk
• can indicate the financial risk of purchasing an

Current Exit Price
• Additively (that is, they refer to one characteristic
– if we use different measurement systems then no
practical or commercial meaning can be deduced
from the aggregate
– even if we use historic cost accounting as the sole
measurement system, the jumble of historic costs
on different dates means we cannot put any
meaning on the calculation of net assets or profit
– CEP does not have this problem

Disadvantages of Current Exit Price
 Relevant only for assets that are expected to be sold for a determined
market price.
 Not relevant for assets that the firm expects to use.
 The valuation of certain assets and liabilities at the current exit price has
not yet been adequately resolved.
 Abandonment of the realization principle at the point of sale.
 Does not take into account changes in the general price level.
 Profit concept :
- does not provide a meaningful concept of profit
– the critical event does not relate to the performance of the firm
– does not produce realistic financial reports

Arguments Against Exit Price
The valuation of liabilities
• valuing liabilities at face value and not market value is
internally inconsistent
Current cost or exit price
– at what stage of the operating cycle should exit price
dominate asset valuation?

A Global Perspective and International
Financial Reporting Standards
• Current cost in the United States
– an experiment but abandoned (1976 -1984)
• Current cost in the United Kingdom
– implemented but abandoned (1975 – 1985)
• Current cost in Australia
– recommended but abandoned (1976 – 1980’s)

International Accounting
Standards and Current Costs
• IASB/FASB have agreed that fair value is the
best measurement basis (2004)
– the amount for which an asset could be
exchanged, or a liability settled, between
knowledgeable, willing parties in an arm’s length

International Accounting
Standards and Current Costs
• Historic cost accounting still generally applied
• Distinct movement toward current value systems
• IASB moving toward exit prices (2004)
• But still a mixed valuation approach
• Fair value means – current market entry price,
current market selling price, historic cost and
discounted future cash flows
There is no mention in the standards of capital
maintenance concepts
How is historic cost applied
• Subjectivity is involved in the determination of
the acquisition cost of an item
• Thereafter the measurements are even more

Historic cost under attack

• The era of historic cost accounting has ‘ended’

-it produces irrelevant, unreliable, non-comparable
and non-understandable data

A Mixed Measurement System and
International Standards
• Market values - exit prices - are implied in
the ‘fair value’ approach in international
financial reporting standards
• A lack of a theoretical concept of valuation,
capital maintenance and profit measure, has
resulted in a still mixed measurement system
and a lack of consistency

Issues for Auditors
• The mixed measurement model creates
misstatement so that auditors struggle to
meet one of their primary objectives
– determining whether the financial statements
present a true and fair view

• Overview of three main measurement systems
• The historic cost system and arguments for and
• Current cost accounting
• Financial capital versus physical capital
• Exit price accounting
• Global initiatives and fair value accounting
• Issues for auditors