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Chapter 5 Normative theories of accountingthe case of accounting for changing prices Slides written by Craig Deegan and Michaela Rankin
Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan
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Learning objectives
In this chapter you will be introduced to
some particular limitations of historical cost accounting in terms of its ability to cope with various issues associated with changing prices a number of alternative accounting methods developed to address problems associated with changing prices some of the strengths and weaknesses of the various alternative accounting methods evidence that the calculation of income pursuant to a particular method of accounting will depend on the perspective of capital maintenance that has been adopted
Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan
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Problem of additivity Can overstate profits in times of rising prices, with distribution of profits leading to an erosion of operating capacity Including holding gains which accrued in previous periods in current years income distorts the current years operating results
Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan
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Definition of Income
The maximum amount that can be consumed during the period while still expecting to be as well off at the end of the period as at the beginning of the period (Hicks 1946) Consideration of well-offness relies on a notion of capital maintenance Different notions of capital maintenance will provide different perspectives of income
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Calculating indices
A price index is used when applying general price level accounting A price index is a weighted average of the current prices of goods and services related to a weighted average of prices in a prior period (base period)
e.g. Australian Consumer Price Index (CPI)
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Holders of monetary liabilities gain, given the amount they have to repay at the end of the period is worth less than at the beginning
Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan
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Purchasing power gains or losses are included in income for the period
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If the entity requires replacement assets it may be more efficient and less costly to acquire different assets Replacement cost does not reflect what the asset would be worth if sold
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Chambers argued that key information for decision making relates to capacity to adapt
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Profit directly relates to changes in adaptive capital Adaptive capital reflected by the total exit values of assets
Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan
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Capacity to adapt
Chambers approach focuses on new opportunities
the ability of the entity to adapt to changing circumstances
The ability of the firm to go into the market with cash for the purposes of adapting oneself to contemporary conditions (Chambers 1966, p.91) Assumes the objective of accounting is to guide future actions
Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan
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Profit is tied to the increase (or decrease) in the current net selling prices of the entitys assets No distinction between realised and unrealised gainsall gains are treated as part of profit
Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan
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Advantages of CoCoA
By using one method of valuation for all assets (exit values) the resulting numbers can be logically added together (additivity) No need for arbitrary cost allocation for depreciation as gains or losses on assets are based on movements in exit price
Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan
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Criticisms of CoCoA
If implemented CoCoA would involve a fundamental shift in financial accounting
revenue recognition points and asset valuations could lead to unacceptable social and environmental consequences
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Questioned whether appropriate to value all assets at exit prices if the entity is a going concern Determining exit prices for unique assets introduces subjectivity into accounts
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Surveys of users indicate information not helpful, not used and information does not tell users anything new Findings interesting given the extent of voluntary disclosure by corporations
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In UK Sutton (1988) found politically sensitive firms more likely to lobby in support of exposure draft recommending disclosure of CCA
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