Question

The International financial reporting standards (IFRS) encourage ASX listed companies to use fair value accounting (FVA) replacing the historical cost accounting (HCA) for valuing noncurrent assets. Use peer reviewed academic research to decide if FVA (claiming to have more value relevance) should totally replace HCA.?more than 650 words?

Answer 1

Yes replacing the FVA over HCA is having its Advantages and disadavantages, hence ASX should go through the following before proceeding ahead with the decsion:

The objective of financial reporting is as follows:

1. To provide information useful for making economic decision
2. To serve primarily those users who have limited authority, ability or resources to obtain information and who rely on financial statement as either principal source of information about an enterprise economic activity.
3. To provide information useful to investors and creditors for predicting, comparing and evaluating potential cash flow to them in terms of amount, timing and related uncertainty.
4. To provide users with information for predicting comparing and evaluating enterprise earning power.
5. To supply information useful in judging management’s ability to utilize enterprise resources effectively in achieving the primary enterprise goal.
6. To provide factual and interpretive information about transactions and other events which is useful for predicting comparing and evaluating enterprise earning power.
7. To provide information useful for the predictive process. Financial forecasts should be provided when they will enhance the reliability of user’s predictions

Historical Cost Accounting (HCA) This method is used in current accounting practice. It is the traditional method of recording assets at the original cost. The historical cost accounting is on the assumption that money is a stable unit of measurement. According to Meigs (1984), using this method, profit is determined by comparing sales revenue with the historical cost of the asset sold. Thus in income determination, accountants assumed that a business is well off when it has recovered its original money investment and that it is better off whenever it recovers more than the original sum of money invested in any given asset. The fact that historical cost accounting is based on historical cost, Jennings (1986), states that it is inadequate for accounting during price level changes. Supporting his assertions, he states that financial statements prepared with the historical cost concept have always been apparently defective to the extent that: a. It fails to reflect the effect of changing price level b. Assets are disclosed in the balance sheet at unrealistic values c. The profit and loss account does not bear proper charges particularly for depreciation and cost of material consumed. Furthermore, he stated that the situation has been aggravated through the 1970s by the accelerated rate of inflation. The products and services have been under-costed, producing, fictitiously high (illusionary) paper profit. This illusion created Leads Company’s management into wrong decision of paying high dividends, wages and corporate tax out of capital. Mergs et al., (1984), sharing the view with Jennings stated that when the general price level is rising rapidly, the HCA may significantly understate the current economic value of the resources being consumed. Simon (1987) in supporting the position of Jennings is of the firm belief that the misleading result of HCA profit which leads to over payment of taxes, dividends and wages during up-ward change in price (i.e. inflation) have made United Kingdom companies not to use the historical accounting in reporting assets. To further prove the inadequacies of the HCA during the period of changing prices, Farmer (1985) also reiterated the position of the accounting standard committee that: a) HCA information is not enough b) Reports are distorted if current revenues are matched with historical cost c) Balance sheet value may be unrealistic Barry (1980) also stated that the reliance on the HCA during inflation has been subjected to a number of criticisms. Among these are: a. The substantial under valuation of current value of the net book value of fixed assets The balance sheet figure for stock reflects price ruling at the date of purchase or manufacture rather than those at the year end. c. Changes made in arriving at the profit do not reflect the current value of assets consumed the effect being to exaggerate the profit in real terms. d. No account is taken off the effect of increasing price on monetary items e. The understatement of asset prevents a meaningful calculation of returns on capital employed. He stated further that in view of the various weaknesses of HCA, several solutions were proposed especially in the United Kingdom and United States all culminating in SSAP 16, issued in March 1980 on current cost accounting as preceded by many study groups and their reports. Although HCA has been criticized, it is not absolutely bad. Its failure in the present times has been as a result of continued rate of inflation in our economy. According to Hendriksen (1982) and Millichamp (1989), HCA possesses attributes such as simplicity, comparability, objectivity, verifiability and measurability. Anao (1989) noted that the important foundation of financial accounting is historical cost convention. The purpose of this convention is that all accounting entries should be made, and the resultant accounting factors measured on the basis of values which were established at the time of the initial transaction. The principle, he said is believed to have the advantage that it keeps accounting measurement objective and verifiable. He went further to state that despite this, however, a certain undesirable characteristic is associated with historical cost convention namely the fact that in period of fluctuating price level, value derived on the historical cost principle may have no relevance to the actual value (of assets or revenues) as at the material time of reporting. The fact that the monetary unit which is the basis of historical cost measurement has no stable value overtime, owing to the incidence of inflation (or in the opposite case, deflation) , is a major reason why conventionally prepared account may not give a realistic picture. The extremely high rate of inflation (running sometimes into double or triple digits) experienced by most world economies during the last two decades, as well as the accelerated pace of technological development witnessed in certain industries, have the combined effect of altering economic values so rapidly that the conventionally prepared accounts no longer present a satisfactory picture of the operating result or the financial condition of the firm. Accountants are therefore, constantly under pressure from users of accounting information to present financial statement which takes adequate account of changes in price level.

Current Cost Accounting (CCA) This is an approach to financial reporting whereby profits are measured by comparing revenue with the current replacement cost of the assets consumed in the earning process. The logic of this approach lies in the concept of the going concern. It recognizes in the income statement, the cost which a going concern actually has to pay to replace its expiring assets (Meigs et al., 1984). They went on to say that the profit figure resulting from CCA closely parallels the maximum amount which a business can distribute to its owners and still be able to maintain the present size and scale of its operations. Glautier and Underdown (1986), in sharing the same view with Meigs (1984) stated that CCA is concerned with the value of net asset to the business and combines replacement cost, realizable value and present value that should be attached to such assets. They went further to state that CCA is a modification of historical cost profit to arrive at the surplus after allowing for the impact of price changes on the funds needed to continue the existing business and to maintain its operating capacity, whether financed by share capital or borrowing. But Meigs (1984), stated that CCA represents a departure from the historical cost concept. Furthermore, they stated that, the term “current cost” usually refers to the current replacement cost of assets and in current cost, income statement; expenses are stated at the estimated cost to replace the specific asset sold or used up. Thus, current cost accounting involves estimates of current market value rather than adjustment to historical cost for changes in the general price level. Supporting the position of Meigs and Hendriken (1982) which states that CCA is a method of accounting that reflects prices that would need to be paid, for an asset or its uses, at the balance sheet date or the date of the use or sale, if the assets were already owned. He stated further that, for inventories, current cost is the current acquisition price of the merchandize, or the current cost to produce it. And for plant, equipment, and other property, the best measure of current cost is the use of asset prices of similar conditions and of the same age as the assets owned. Current cost accounting is therefore a valuation concept which combines the concepts of replacement cost and net realizable value in determining whether selling (existing) price should be used for the purpose of establishing the value of an asset to the business. In further discussions on valuation based on CCA in a competitive market with many buyers and sellers, the price of an asset in this market may reasonably be taken to reflect the current value of asset, if it is in expectation of other firms. Where there is no market for used assets the CCA concept recommends the approximation of the current cost of an identical new item purchased in current established market, less accumulated depreciation for the period, equal to the age of the asset in use (Hendriksen, 1982). Thus, CCA tends to reflect cost and value to a more realistic figure, relevant for decisions during the period of price level changes. In general, the advantages of CCA system are that, it overcomes the defect of historical cost system in that, being a current value system accounting, its aim is to represent as far as possible, the commercial reality of the situation to which it refers. Jennings (1986), in specific terms stated the advantages of CCA as: i. Current costs are matched with current revenue for depreciation and calculated on the value to the business of the assets concerned. In majority of cases, such value is the net current replacement cost, and cost of sales is calculated on actual or assumed date-of-sale cost prices. ii. The balance sheet shows assets at their value to the business. iii. As a result of i and ii, users of accounts have available more realistic information on cost, profit and loss, asset value and the return on capital and on assets iv. The system identifies profits and losses arising from business operations separately from those arising from price level changes. v. Current basic figures lead to better quality long term and short term decisions.  CCA represents the amount the firm would pay currently to obtain the asset or its services, therefore representing the best measure of the value of the input being matched against current revenue for predictive purposes. 2. CCA permits the identification of holding gains and losses, thereby reflecting the result of assets value and management decisions. 3. CCA represent the value of assets to the firm, if the firm is continuing to acquire such assets, and if value has not been added by the enterprise to the assets. 4. The summation of assets expressed in current terms is more meaningful than the addition of historical cost incurred at different times. 5. It permits the reporting of current operating profit useful in predicting future cash flow. The current cost accounting, although very promising, is not without a hitch. Certain aspects of CCA principle give grounds for doubts as to whether the lofty advantages expected of it are in reality, achievable.. The decrease in value of monetary assets b. The decrease in value of obligation represented by monetary liabilities. c. The whole effect of inflation on the value of the proprietor’s interest in the company or other organization concerned, irrespective of whether that interest is represented by non-monetary or monetary assets. d. The description of the incremental difference between an asset’s original cost and its value to the business as a “holding gain” is potentially misleading as the whole or part of the gain will be the result not of a real gain in wealth, but of a decrease in the value of money. e. The problem of making valid comparisons over a period of time when the unit of measurement is unstable. Anao (1989) stated that current cost or value approach seeks to value all assets and inputs consumed in the process of generating income on the basis of their “current” value at the time of consumption or realization. The expected net result is the figure of net income which is stripped of any windfall element (holding gain) and thus reflect the pure earnings capacity of the firm and also, of a net asset figure which reflects as closely as possible, the current valuation of the firm’s component assets, he argued that CCA is not simply an inflation accounting technique but rather a technique for obtaining accounting data that reflect current values. Although CCA seeks to make accounting information more up to date and relevant for business decisions, certain practical difficulties still tend to hinder the achievement of ideal results. He added that, the most critical problem, which is created by CCA, is the increased difficulty in achieving the determining net realization cost (NRC), net realization value (NRV), and the expected value (EV) in respect of each asset. CCA is based on values, which are as a result of estimates, and there is the difficulty in determining the accurate contribution made by each asset to an income, which results from joint use.On the whole, the concept of capital maintenance is more relevant to the operations of a business than the general purchase power concepts. Therefore, if a choice has to be made between CCA and the current purchasing power accounting, CCA should be adopted (Glautier & Underdown 1986).