1. International Developments in Accounting ACFI3217
Accounting for changes in price levels
Dr. Samuel Owusu-Agyei HU 3.40

2. Historical cost accounting (HCA)
The transaction-based HCA records transactions at cost. No further changes are made.
HCA unchallenged until inflation became high, reaching an annual rate of increase of 20% in the mid 1970s.
Then there were growing criticisms on HCA

3. Criticisms of HCA
Profit overstated when inflationary changes in the value of assets ignored (e.g. inventory)
Understatement of SoFP values
Expenses (depreciation) understated as they are based on lower asset values

4. Criticisms of HCA
Gains and losses on monetary assets are undisclosed. e.g. cash loses value in times of rising prices
Comparability of business performance and growth becomes distorted. E.g. rise in profits versus inflation rates.

5. Review of the problems of HCA
Financial reports confusing because revenue is mismatched with differing historical cost levels
The decision-making process, the formulation of plans and the setting of targets may be suboptimal if underlying financial data is out of date.

6. Accounting for changing prices
The limitations of HCA in inflationary times raise a need for current value accounting.
Adjustments for changes after original entries.

7. Accounting for changing prices-IASB approach
When inflation rates were high IAS 15 was issued in 1983
“Information reflecting the effects of changing prices”
IAS 15 was withdrawn in 2003 when inflation rates were low
IAS 29 still extant
“Financial reporting in hyperinflationary economies”

8. Hyperinflationary indicators
Qualitative indicators
When people prefer non-monetary assets
When people prefer prices to be stated in an alternative stable currency
Quantitative indicators
When the cumulative inflation rate over three years approaches 100%

9. Current value accounting disadvantages:
It destroys the factual nature of HCA, which is transaction based: Transaction based historic values are replaced by judgmental values.
It is not as objective as HCA because it is less verifiable.
It entails recognition of unrealised profit.
No improvement in comparability because of the degree of subjectivity in measuring current value.
The lack of a single accepted method of computing current values.

10. Methods of accounting for changing price levels
Current Purchasing Power (CPP)
Current entry or replacement cost (RCA)
Current exit or Net Realisable Value (NRVA)

11. Data to illustrate HCA method
Transactions during January 20X3
1 January 20X3 Initial capital in cash 3,000
1 January 20X3 Purchased 6 computers for 500 each
15 January 20X3 Sold 3 computers for 900 each
31 January 20X3 Cash was 2,700
31 January 20X3 HCA Inventory was 1,500

12. HCA Income Statement and SOFP
Sales x ,700
Cost of sales x ,500
Profit ,200
Capital ,000
Profit ,200
4,200
Inventory x ,500
Cash ,700

13. Current Purchasing Power (CPP)
CPP applies a general price index to HCA figures
Such indices are often prepared by a government department e.g. Retail Price Index in the UK
Holding monetary assets during periods of inflation leads to losses in the purchasing power of money

14. Current Purchasing Power (CPP)
Transactions are restated
from the date the transaction occurred to the closing SOFP date
CPP accounts are expressed in units of Purchasing Power as CPP (not in £s)

15. CPP - Virtues An objective measure – transaction based
A measure of shareholders’ capital with capital being maintained in terms of purchasing power units
Introduces the concept of gains and losses on monetary items

16. CPP - defects
General price indices may not reflect the effect of inflation on a particular business
Creates an alien unit of measurement
Its concept of profit is dangerous for decision making

17. Replacement cost accounting (RCA)
Assesses income and value of assets by reference to current replacement costs of materials and other assets.
Where asset values are increasing, a holding gain is recognised.

18. RCA – COSA RCA recognises a holding gain in the value of assets.
The holding gain is the difference between the Replacement cost and Historic cost as at the date the transaction occurred.
Thus, a holding gain is recognised because the cost to replace the asset has risen.

19. Illustration
Assume that 3 units of inventory was purchased at £500 but can only be replenished at £700 per unit at the end of the period
Cash balance is at £2700
How will this be presented in the SoFP using RCA? How does it compare to HCA?

20. RCA SoFP Asset section Inventory 3x 500 1,500 3 x 700 2,100
HCA RCA
Inventory x , x ,100
Cash , ,700
4, ,800
The significant information is
Replacement cost at the SOFP date.
Inventory is restated at its replacement cost.
The Holding Gain is 600 which is recorded as a
Gain in the SOFP.

21. RCA - virtues Its unit of measurement is the monetary unit
It identifies and isolates holding gains and so maintains physical operating capability
It introduces realistic current values

22. RCA - defects
A subjective measure based on estimates of values often using index numbers
It assumes replacement with similar assets which may not be the case

23. Net realisable value accounting (NRVA)
Accounting based on the selling price of assets less necessary costs to sell.
Based on the economist’s concept of opportunity cost
Sometimes called current exit cost
For many assets the value used would be the value that could be realised on a sale – this is the exit value

24. Illustration- NRVA
Opening position 1.1.X3 Capital 3, X3 Purchased 6 items at 500 each 3,000 Transaction 15.1.X3 Sold 3 items for 900 each 2,700 Closing position 31.1.X3 Cash was 2, X3 Inventory was 3 at 500 each 1,500

25. NRVA – What is the significant date?
The significant date is the selling price at the closing SOFP date.
The difference between the Selling Price at the SOFP date and Historic Cost will be shown as a Holding Gain in the Income Statement.

26. NRVA Income Statement
HCA NRVA Sales 3x 900 2,700 2,700 Cost of sales 3x 500 (1,500) (1,500) Holding gain 3 x ( ) 1,200 Profit 1,200 2,400 This Holding Gain will be added to Inventory in the NRVA SOFP.

27. NRVA SOFP Capital 3,000 3,000 Profit 1,200 2,400 4,200 5,400
HCA NRVA
Capital , ,000
Profit , , , ,400
Inventory 3x , x ,700
Cash , ,700
4, ,400

28. NRVA - virtues
Readily understood by users who think in terms of selling prices
No need to estimate depreciation – rather it is the difference between NRV at the beginning and end of the period
Based on opportunity cost and therefore more meaningful

29. NRVA - defects
It is subjective and lacks prudence in calculating profit because unrealised profits are included
NRVA is not relevant to assets that will be used rather than sold
Hard to determine the NRV where there is no obvious market for the asset
Violates the going concern concept
Less reliable and verifiable than HC

30. Summary Traditional accounting using HC has many weaknesses
Rising prices have led to three models
CPP
Replacement cost
Realisable value