ACCA F7 (INT) Financial Reporting - Study text - 2010

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Chapter 2: Recognition and measurement

 If an entity used historical cost accounting to measure profit, and then

distributed all this profit as dividends to shareholders, it would be unable to

replace all the assets it has consumed in the cost of sales.

 There is no recognition of the effect of inflation on monetary items, such as

loans, trade payables and trade receivables. For example, if an entity borrows $1

million for five years, inflation will reduce the ‘real’ cost of the loan over time.

This results in a benefit for the borrower and the ‘loss’ for the lender. However,

historical cost accounting ignores this.

 Comparative figures for previous periods are at out-of-date values, so that (for

example) what appear to be improvements in revenues and profits are really

caused by the effects of inflation.

Because historical cost accounting has so many weaknesses, other methods of

accounting have been proposed as an alternative to HCA. Two of these are current

value accounting and constant purchasing power accounting.

4.2 Current value accounting

The current value approach to financial reporting is based on the principle that

assets should be measured at their current value to the business, and the cost of

sales should be valued at its current cost as at the time of sale.

The current value of an asset might be any of the following:

 its current replacement cost

 its current net realisable value

 its economic value. This is the value of the future cash flows arising from the

asset, discounted to their present value.

In current value accounting, an asset should be valued at its deprival value, (or

value to the business) which is the loss the business would suffer if it were

deprived of the asset.

 Deprival value is the lower of replacement cost and ‘recoverable amount’.

 Recoverable amount is the amount the business should recover from an asset it

will not want to replace.

 Recoverable amount is the higher of net realisable value and economic value.

Deprival value is therefore defined as the lower of:

 replacement cost, and

 the higher of net realisable value and economic value.

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Valuetothebusiness

=lowerof

Replacementcost  Recoverableamount

= higherof

EconomicvalueNetRealisable

 inuse value

Example

An item of inventory has a current replacement cost of $12,000. It could be disposed

of by selling it in its current form for $8,000. Alternatively, it will be used in the

production of finished goods that will contribute economic value of $20,000 to the

business.

The asset has economic value in excess of its replacement cost, and so would be

replaced if the business were deprived of it. The current value of the asset is

therefore $12,000.

In current value accounting, all non-monetary items, such as tangible non-current

assets and inventories are measured at deprival value.

Monetary items, such as loans and other debts, trade receivables and monetary

liabilities (trade payables, taxation payable and so on) are not adjusted, because they

are already measured at their value to the business.

The most common form of current value accounting is current cost accounting

(CCA).

Advantages of current value accounting

Current value accounting provides users with relevant information. Assets are

stated at their current value to the business and holding gains are excluded from

profit. Therefore users can assess whether the business has maintained its operating

capability.

Disadvantages of current value accounting

Current value is subjective and therefore less reliable than historical cost. Most of

the methods of current value accounting (such as current cost accounting) are

complicated to apply.

There may be practical problems in arriving at current value. It may be difficult to

obtain a reliable market value for some items, particularly if they are rare or

specialised.

Chapter 2: Recognition and measurement

Current value accounting assumes that the business intends to replace all its

existing assets. This may not be the case. The nature of the business may change, or

advances in technology may mean that equivalent assets no longer exist.

It only recognises the effect of price changes relating to the specific assets held by

the business. It does not recognise the effect of general inflation.

4.3 Constant purchasing power accounting

Another alternative to HCA is constant purchasing power accounting (CPP), also

called general purchasing power accounting (GPP).

With CPP, the financial statements are adjusted so that all the figures are presented

in terms of money with the same purchasing power. Items are therefore adjusted to

the same ‘purchasing power’ using a general price index, such as a consumer prices

index.

When CPP is used, items are usually adjusted to their price level as at the balance

sheet date. The most common form of CPP is therefore ‘current’ purchasing power

accounting.

In CPP, a distinction is made between monetary items and non-monetary items:

 Monetary items. These are items whose amount is fixed by contract in terms of

units of currency and will not be altered by inflation. Examples of monetary

items are trade receivables, trade payables, bank loans and bonds. With

inflation, a business loses by having monetary assets but gains by having

monetary liabilities, because these lose ‘real’ value over time.

 Non-monetary items. These are items whose value, in terms of ‘constant

purchasing power’, is not affected by inflation. Examples of non-monetary items

are inventory and non-current assets. A business entity neither gains nor loses

purchasing power with non-monetary items as a consequence of inflation.

Example

On 1 January Year 8, an entity was established with capital of $10,000. It purchased

an item of inventory for $10,000 which it then sold for $14,000 (cash). Inflation

during Year 8 was 7%. There were no other transactions in the year.

Using historical cost accounting (HCA), the profit for Year 8 is $4,000 (= $14,000 –

$10,000).

Using constant purchasing power accounting, the profit for Year 8 is $3,300 (=

$14,000 – $10,000 – (7% × $10,000)).

With CPP accounting profit is adjusted to reflect the general change in prices during

the year. The historical cost accounting profit of $4,000 is reduced by $700 because

of inflation. Since inflation has been 7%, the expected cost of a similar item of

inventory now would be an additional $700.

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The profit reported by CPP is lower than the profit with HCA. The difference is

because CPP allows for the need to maintain the financial capital of the business in

real terms. Historical cost accounting also maintains the financial capital of the

business, but not in real terms. In this example, if the business paid out all its HCA

profit of $4,000 as a dividend (which is permitted by law) it would no longer be able

to go out and buy another similar item of inventory, because the inventory would

be expected to cost 7% more.

Advantages of CPP accounting

CPP accounting is a true system of inflation accounting, because it adjusts for

changes in general purchasing power.

It is easy for users to assess the performance of an entity over time. CPP also enables

meaningful comparisons to be made between the financial statements of different

entities.

CPP accounting is objective (a standard index is used) and is simple to apply.

Disadvantages of CPP accounting

CPP accounting measures changes in the value of money, rather than changes in the

value of assets. It does not show the current value to the business of assets and

liabilities.

It assumes that an entity is only affected by general inflation, rather than by specific

price changes (which may be quite different). This means that it may not always

provide relevant information.

4.4 The IASB Framework and concepts of capital maintenance

The IASB Framework states that there are two concepts of capital:

 a financial concept of capital

 a physical concept of capital.

Financial capital maintenance

A financial concept of capital is that the capital of an entity is measured as its net

assets, which is also its equity. Where a financial concept of capital is used, the main

concern of users of the financial statements is with the maintenance of the nominal

financial capital of the entity.

With a financial concept of capital maintenance, a profit is not earned during a

period unless (excluding new equity capital raised during the period and adding

back any distribution of dividends to shareholders) the financial value of equity at

the end of the period exceeds the financial value of equity at the beginning of the

period.

Chapter 2: Recognition and measurement

This reflects the basic accounting equation:

ASSETS less LIABILITIES = EQUITY

OPENING NET ASSETS + PROFIT – DISTRIBUTIONS = CLOSING NET

ASSETS

Historical cost accounting reflects the concept of money financial capital

maintenance. An entity has made a profit if closing equity exceeds opening equity

when net assets are measured using historical cost.

Constant purchasing power accounting reflects the concept of real financial capital

maintenance. An entity has made a profit if closing equity exceeds opening equity

when net assets are measured at current prices. (This means that opening equity is

uplifted by the general inflation rate.)

Physical capital maintenance

A physical concept of capital is that the capital of an entity is represented by its

productive capacity or operating capability. Where a physical concept of capital is

used, the main concern of users of the financial statements is with the maintenance

of the operating capability of the entity.

With a physical concept of capital maintenance, a profit is not earned during a

period unless (excluding new equity capital raised during the period and adding

back any distribution of dividends to shareholders) the operating capability of the

business is greater at the end of the period than at the beginning of the period.

Current value accounting reflects the concept of physical capital maintenance.

In a period of inflation, profits reported using a financial concept of capital will

normally be higher than profits reported using a physical concept of capital, such as

current value accounting.

Example

On 1 January Year 8, an entity was established with capital of $10,000. It purchased

an item of inventory for $10,000 which it then sold for $14,000 (cash). There were no

other transactions in the year. At the end of Year 8, the purchase cost of the same

item of inventory has risen to $11,000.

Applying the physical maintenance concept, the profit for Year 8 is $3,000 (= $14,000

– $11,000).

Under historical cost accounting, the profit is $4,000. However, if the business paid

out 100% of its profit of $4,000 as a dividend, it would not be able to go out and buy

another item of inventory, because the price of the item is now $11,000. To maintain

the physical operating capability of the entity, profit should be measured as sales

less the replacement cost of the item sold.

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Comparing the two concepts

Neither the IASB Framework nor accounting standards require the use of a specific

capital maintenance concept. In practice, almost all entities use money financial

capital maintenance, but both concepts can provide useful information.

Financial capital maintenance is likely to be the most relevant to investors as they

are interested in maximising the return on their investment and therefore its

purchasing power.

Physical capital maintenance is likely to be most relevant to management and

employees as they are interested in assessing an entity’s ability to maintain its

operating capacity. This is particularly true for manufacturing businesses, where

management may need information about the ability of the business to continue to

produce the same or a greater volume of goods.

4.5 International accounting standards and measurement

There used to be an international accounting standard IAS15 Information reflecting

the effects of changing prices. This was withdrawn with effect from 1 January 2005.

Inflation accounting requires the use of a system such as current cost accounting

(CCA) or current purchasing power accounting (CPP). Attempts to introduce full

inflation accounting have been unpopular. Each system has some advantages but

neither is ideal and neither has been widely accepted. It is extremely unlikely that

the IASB or any other major standard setter will require either of CCA or CPP in the

foreseeable future.

However, most people accept that information based on historical cost is not

particularly relevant to users. Many entities attempt to overcome this problem by

using modified historical cost accounting. Some or all non-current assets are

measured at a valuation, instead of at historical cost. For example, properties are

often included in the statement of financial position at their current market value.

The issue here is how assets and liabilities should be measured. This is the subject of

an important debate within the accounting profession. Some, including the UK

Accounting Standards Board, favour current value (that is value to the business or

deprival value). This has the advantage that it reflects economic reality and the

intentions of management. For example, a business will not sell an asset if it can

obtain a greater inflow of cash by continuing to use it (and vice versa). However,

current value can be complex to apply in practice and may not be easily understood

by users.

Others, including the US Financial Accounting Standards Board favour fair value.

The IASB is also moving towards greater use of fair value.

4.6 Fair value

Fair value is a possible basis for the valuation of assets in the financial statements.

Although it is not described in the IASB Framework, many IASs and IFRSs require it

Chapter 2: Recognition and measurement

to be used instead of historical cost or as an alternative to historical cost. For

example, IAS 39 requires many types of investment to be measured at fair value.

Fair value is defined as ‘the amount for which an asset could be exchanged between

knowledgeable, willing parties in an arm’s length transaction’ (IAS16).

Fair value is normally open market value. If an item does not have a reliable market

value (for example, because it is unusual or specialised), it may be possible to

estimate its fair value in other ways.

Fair value may be used in financial statements in the following circumstances.

 After its initial recognition at acquisition, a non-current asset may be re-valued

to its fair value.

 Inventory is measured in the statement of financial position at the lower of cost

or net realisable value. Net realisable value (NRV) is the selling price of the

inventory item in the ordinary course of business, less the estimated further

costs to completion and the expected selling costs. NRV may or may not be the

same as fair value.

 Revenue should be measured in the income statement at the fair value of the

consideration received or receivable (IAS18).

Fair value is often approximately the same as current value, but sometimes fair

value and current value can be very different.

Example 1

An entity has a portfolio of investments that are traded in an active market. The fair

value of these investments is their market value. The value to the business (current

value) of the investments is their replacement cost or their net realisable value. In

this case both are the same amount: open market value. (Economic value is not

relevant because the investments are held to be sold at a profit, not to be used in the

business).

Here, fair value and current value are the same.

Example 2

An entity has a machine. The machine has been specially adapted for use in this

entity’s particular business. The fair value of the machine is its open market value:

$20,000. This is quite low, because few other businesses could make use of the

machine without having to spend a considerable amount of money adapting it and

renovating it. The economic value of the machine is $30,000 and its depreciated

replacement cost is $25,000 (the amount that the entity would have to pay to acquire

an equivalent machine which has been used for the same length of time). Therefore

the current value of the machine is $25,000 (lower of replacement cost and

recoverable amount).

Here, fair value and current value are different.

Paper F7: Financial reporting (International)

Problems with the use of fair value

Fair value is easy to understand and less complicated to apply than value to the

business/current value. Arguably, it is also more reliable than value to the business,

because market value is more easily verified than (for example) economic value.

However, it has some serious disadvantages:

 There may not be an active market for some kinds of asset. Where there is no

active market, estimates have to be used and these may not be reliable.

 It anticipates sales and profits which may never happen (the entity may have no

plans to sell the asset).

 Market values can move up and down quite rapidly. This may distort trends in

the financial statements and make it difficult for users to assess an entity’s

performance over time.

Despite these problems, it looks increasingly likely that the IASB will require greater

use of fair value in future.

Paper F7 (INT)

Financial reporting

CHAPTER

Accounting for the substance

of transactions

Contents

1 The importance of accounting for substance

2 Recognising and derecognising assets and

liabilities

3 Examples of specific transactions

Paper F7: Financial reporting (International)

The importance of accounting for substance

 The IASB Framework

 Examples of previous abuses in this area

1 The importance of accounting for substance

1.1 The IASB Framework

There is no accounting standard on accounting for the substance of transactions.

However, the IASB’s Framework for the preparation and presentation of financial

statements refers to ‘substance over form’ as a factor affecting the reliability of

financial statements.

If accounting information is to provide a faithful representation of transactions, then

those transactions must be accounted for in accordance with their economic

substance and economic realities, and not merely in accordance with their legal

form.

For example, Entity A may dispose of an asset to Entity B in such a way that legal

title appears to have passed to Entity B. However, the agreement may be written in

such a way that Entity A continues to enjoy the future economic benefits embodied

in the asset. In such circumstances the reporting of a sale would not be a faithful

representation of what had really taken place.

The economic substance and the legal form would be different. In such cases,

financial statements should report the economic reality (‘substance’) rather than the

legal form of the transaction.

1.2 Examples of previous ‘abuses’ in this area

The need to account for ‘substance over form’ has been made apparent in the past

by some ‘dubious’ accounting practices by some companies. In some cases, the legal

form of transactions may be misleading. Here are some examples.

Controlled non-subsidiaries

Prior to IAS27 Consolidated and separate financial statements, some parent

companies deliberately set up entities that did not meet the definition of a

subsidiary entity, even though the entity was controlled by them. This meant that

the parent entity could avoid consolidation of the ‘subsidiary’ within its group

accounts. This meant that the assets and liabilities of the subsidiary would be

excluded from the consolidated group accounts. This could be useful for parent

companies wishing to ‘hide’ certain assets or liabilities.

ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing

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