1 The University of Birmingham College of Social Sciences Birmingham Business School Department of Accounting and Finance Accounting Theory

(07 !7"# Academic $ear 00%&'0

Study (uide to Chapters ) to 7 of Ale*ander+ Britton and ,orissen ( 00%- !'.' %#

, Introduction

The textbook deals with the subject of accounting for changing prices not only in a different order from that in the lectures on the accounting theory module but also in a different manner. With respect to the latter difference, students struggling with aspects of the material presented in the lectures may find the alternative approach in the textbook helpful. This study guide reconciles the two approaches where they are materially different as well as providing suggested solutions to some of the end of chapter exercises in the textbook.

!hapter " #conomic $aluation !oncepts %&1 '()

The first few pages of this chapter provide an overview of the issues which underlie the subject of accounting for changing prices generally in a similar manner to the first lecture on the module and hence the explanation and analysis of economic income per se does not begin until page '*. +ote the last paragraph of the introduction %p. &,). The first sentence echoes the distinction between deductive and inductive approaches to accounting theory made by Whittington %1(-&) which was introduced in the second lecture in the first week of the module.

With respect to the section on income and capital %p. &.) students should bear in mind the /aish criti0ue explained in the lectures on economic income in week , of the module. Individuals have a personal preference for capital over income or vice versa however, they are also willing to give up one type of wealth as long as they are compensated by a sufficient amount of the other type. This trade off is mapped in

. individuals1 indifference curves. 2owever, it is not clear that such indifference curves may be mapped for business entities as opposed to individuals.

3ctivity "., %pp. &" &4) merely serves to introduce valuation alternatives to historical %not historic) cost. The alternatives are replacement cost %5! 6 introduced in week " of the module), net realisable value %+5$ 6 week &) and net present or economic value %#$ 6 week ,). The final paragraph in the activity feedback %p. &4) 0uestions the assumption of stability in the monetary measurement unit and this topic is dealt with in week . of the module under current purchasing power accounting %!//3) and again in week 4 under real terms accounting %5T3). The subject of the changing value of the monetary unit is raised again in 3ctivity "." %p. &&).

The array of value concepts introduced on pages && &- is based on #dwards and 7ell %1(&1) and the recommendation to accounting students in the first sentence in this section cannot be supported enough. 2owever this source is now almost half a century old and it may be useful for today1s accounting students to know that the I387 %together with the 9387) is currently involved in a measurement project and has produced its own array of possible valuation concepts. These are listed in Table 1 below.

" Table 1: I387 ;easurement 7asis !andidates ;easurement 7asis <efinition Time 9rame: /38T 1. /ast entry price The price that an entity would have had to pay in the past in exchange for purchasing its asset. #xample: the amount that an entity would have had to pay in the past to purchase an office computer, ignoring any sales tax or $3T. ,. /ast exit price The price that an entity would have received in the past in exchange for selling its asset. #xample: The amount that an entity would have received in the past for selling a stock %share) investment. .. ;odified past amount The sum of all entry prices paid in the past to assemble, construct, or augment an asset over an extended period of time, including the prices paid for ac0uisition related goods or services. #xample: the accumulation of all amounts that were paid over a three year period to construct an office building. The amount assigned to an asset after allocating a past entry price to multiple items. #xample: The amount that was assigned to land in the past purchase of land and buildings for a single price. The remainder of an asset1s original past entry price or subse0uent past exit price after assigning some of that price to subse0uent accounting periods, according to an accounting rule for depreciation or amortisation. #xample: the depreciated cost of a motor vehicle, using straight line depreciation. <epreciated cost 3mortised cost 3llocated cost 2istorical cost /ast selling price 2istorical cost Terms used as synonyms

4 Time 9rame: /5#8#+T ". !urrent entry price The price that an entity would have to pay currently in exchange for purchasing its asset. #xample: The amount that an entity would have to pay currently to purchase its head0uarters building. The current entry price of replacing an existing asset with an identical one by purchase. 4. !urrent exit price The price that an entity would receive currently in exchange for selling its asset. #xample: the price that an entity would receive currently from selling a parcel of land. The price that an entity would receive currently in exchange for selling its asset less any prices it would have to pay for disposition related goods or services. #xample: the amount that an entity would receive from selling a parcel of land, net of an appraisal fee and a real estate transfer tax. &. !urrent e0uilibrium price The single e0uilibrium price for which an asset could be exchanged currently between knowledgeable, willing parties in an arm1s length transaction conducted in an efficient, complete, and perfect market. #xample: the price at which a security could be purchased or sold currently, if the securities market were efficient, complete, and perfect. '. $alue in use The value that an entity places on its own asset. In its most sophisticated form, the amount of the discounted net cash flow that the entity expects to receive from using its asset, including cash flow from the asset1s eventual disposition. <iscounted value of future cash flows /resent value %#conomic value) 9air value +et realisable value 5eplacement cost 9air value ;arket price=value !urrent cost ;arket price=value

& #xample: the forecast future cash flows from using a printing press% including cash inflows from printing revenues and the sale of the press at the end of its use, as well as cash outflows for supplies, repairs, and maintenance), discounted at a rate e0ual to the entity1s cost of capital and netted. Time 9rame: 9>T>5# -. 9uture entry price The price that an entity would have to pay in the future in exchange for purchasing its asset. #xample: the amount that an entity forecasts it would have to pay to purchase a replacement jet airplane eight years in the future. (. 9uture exit price The price that an entity would receive in the future in exchange for selling its asset. 9uture selling price 9uture cost

8ource: www.iasb.org.uk

$aluation is hence a very current issue and always subject to change %for example, the measurement bases in the textbook taken from #dwards and 7ell %1(&1) do not mention fair value as it was not a term in use at the time the book was written but nevertheless the book remains a timeless classic).

The short paragraph on capital maintenance %p. &() is misleading. There are in fact only three capital maintenance concepts. These are: money capital maintenance %as illustrated in activity ".' and which is the concept used in pure historical cost accounting 6 2!3)? financial capital maintenance %which preserves the spending power of shareholders in real terms and is seen most clearly in current purchasing power accounting 6 !//3)? and physical capital maintenance %which maintains the

' current replacement cost of an entity1s operating base such as non current assets, inventories and monetary working capital and is most clearly seen in current cost accounting 6 !!3, introduced in week ' of the module).

The discussion of economic income on pages '* '4 clearly shows that, for accounting purposes, 2icks1s approach provides the more useful definitions. It is far from clear how a business entity can have @psychic1 income.

3ctivity ".11 is a good illustration of the traditional way in which calculations of economic income are dealt with in financial accounting textbooks. In comparison with the lectures on economic income given in week , of the module, the textbook example has assumed static economic conditions in which neither the cash flow %A1,***) nor the interest rate %1*B) change. 2ence, the ex ante measures of economic income e0ual the ex post measures and it would appear that only one measure of economic income can be calculated.

In Table ".. on page '&, this calculation of economic income is presented in the usual very complex manner. The figure in column ( for total economic income may be derived much more simply by applying the constant interest rate to the present value of the discounted future cash flows %i.e. A,,"-& x *.1* C A,"-.& rounded up to A,"(). +ote the implicit capital maintenance assumption 6 the example maintains the capital %present) value of prospective receipts in money terms which, because the interest rate does not change, is e0uivalent to maintaining a constant annual income stream of A,"( %A,"( D *.1* C A,,"(* which, allowing for rounding error, is e0uivalent to the capital value of prospective receipts A,,"-&).

3ctivities ".1, and ".1. introduce ex post measures of economic income but as only the cash flows change while the interest rate remains constant, only versions 3 and 7 of Income +o. 1 can be calculated. The present value of the changed cash flows is: Eear 1 , . !ash flow 1,*** 1,*** 1,1** <iscount factor *.(*( *.-,& *.'41 /resent value (*( -,& -,& ,,4&1

#conomic income: ,,4&1 x *.1* C ,4& Income +o. 1 $ersion 3: ,,4&1 F ,4& 6 ,,"-& C ..1 Income +o. 1 $ersion 7: ,,4&1 F ,4& 6 ,4&1 C ,4&

The present value of the extra A1** received at the end of year . is A'4 which, if spent immediately, increases year 1 economic income to A..1. If, on the other hand, the additional cash is re invested, annual economic income increases %allowing for rounding error) from A,"( to A,4&, i.e. A' per year %A'4 x *.1*). Income +o. , is A,4&.

#xercise ".1

It is relatively easy to obtain the published accounts of companies listed on the G8#. 2owever, most of these published accounts are likely to be the consolidated financial statements of groups of companies and hence will have been prepared using I958 %see !hapter ., pages "* "4). 2ence one way in which to deal with this 0uestion is to consider the different valuation bases used in I958 and these are given in summary form in Table , below.

Table ,: 8ummary of I958 measurement re0uirements Has at Ictober ,**&J 3sset=Giability /roperty, plant and e0uipment Intangible assets #xploration and evaluation assets for mineral resources 3ssets held on finance leases ;easurement 7asis 2! or 9$ 2! or 9$ 2! or 9$ Gower of 9$ at ac0uisition date and <$ of minimum lease payments at that date, less subse0uent depreciation 9$ 9$ +et 9$ when harvested 8ome at 9$, others at 2! Gower of 2! and +5$ 2! plus a proportion of the expected profit +ot covered by I958 hence may be measured on various bases /rojected unit credit method using discounting ;ust not be discounted 7est estimate of settlement obligation, discounted where material Gower of related asset1s fair value at ac0uisition date and the <$ of the minimum lease payments at that date, less amounts written back so as to produce a constant periodic

/ension scheme assets 7iological assets %living plants and animals) 3gricultural assets 9inancial instruments Inventories !onstruction contracts ;ineral resources %mines, oil and gas wells) /ension scheme liabilities <eferred tax liabilities /rovisions

9inance lease liability

1* rate of interest on the remaining balance Initial cost of assets and liabilities ac0uired in a business combination 9$ at ac0uisition date Internally generated intangibles Kenerally not recognised. Where recognised measured at 2! unless ac0uired in a business combination when they may be recognised at 9$ at the date of the combination 9$ of goods and services or 9$ of e0uity instruments granted 9$ of e0uity instruments granted 5estatement in terms of current purchasing power

Koods and services received in a share based payment transaction Transactions with employees 9inancial statements of companies that report in the currency of a hyperinflationary economy

<efinitions of I958 measurement bases 7asis 2! <efinition Kross cost less depreciation, calculated taking into account its expected useful remaining life and its likely residual value. 2owever, if the asset1s recoverable amount is less than its depreciated historical cost it must be written down to its recoverable amount, which is the higher of its net 9$ and its value in use. $alue in use is the discounted value of its future attributable cash flows. 9$ less selling costs The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm1s length transaction ;arket value? estimated value? present value? selling price less the costs of disposal plus a reasonable profit allowance? selling price less the sum of coats to complete and costs of disposal, plus a reasonable profit allowance? current replacement cost? depreciated replacement cost? reference to an active market? the amount that a third party would charge

$alue in use +et 9$ 9$

9$ in a business combination

H8ource: I!3#W %,**&) ;easurement in 9inancial 5eporting, 1* 11.J

11 Is there consistency and additivity in the table aboveL !learly not 6 the application of I958 results in a mixed value system %which may be called modified recoverable historical cost accounting 6 ;52!3). 3s a result, the individual items in a balance sheet prepared using I958 are not genuinely additive. 2owever, although economists are keen to point out that apples and oranges cannot be added together, the accountant adopts a more pragmatic approach adding them together anyway and calling the total a basket of fruit. @Kenuine1 additivity might only be found in the field of pure mathematics.

#xercises "., and "..

8uggested solutions to these exercises are to be found on the student side of the textbook1s companion website 6 www.cengage.co.uk=abj"e.

#xercise "."

There is more than enough detail to answer this 0uestion on pages '* '" of the textbook.

#xercise ".4

8ee the lecture notes on economic income and the /aish criti0ue %week,).

1, #xercise ".&

If ideals are by definition unattainable, then the 0uestion cannot be construed as a criticism of economic income. 9urthermore, 2icks presents his definitions as no more than @approximations1 to the central concept of income and not as ideals. 2owever, although unattainable, it is always possible to aspire to an ideal. In this sense, economic income may act as a yardstick against which alternative valuation bases may be measured, the 0uestion being: to what extent is this particular valuation basis a good surrogate for economic incomeL

#xercise ".' !alculation of economic income Eear * 1 , . . !ash flow %1,***) "** 4** &** "** <iscount factor 1 1=1.1* 1=1.1*, 1=1.1*. 1=1.1*. /resent value %1,***) .&..&" "1..,, "4*.'( .**.4. 4,-.1-

#conomic income: 4,-.1- x *.1 C 4,.-,

Eear

!ash 9low A 1

!losing capital A , 4,-.1-1.** %"1*.(*) *

Ipening capital A . %"'1.-,) %"'1.-,) -1.* %"1*.(*)

Ipera ing Income A "

3mount rein $ested A 4

!umulative amount rein vested A &

Income on reinvested amount A '

#cono mic income A %"F') 4,.-, 4,.-, 4,.-,

* 1 , .

%1,***) "** 4** 1***

%"'.1-) -.1* %"1.*()

""'.1"(1.(* %"1*.(*)

""'.1(.(.*4,-.1-

%1**.**) "".', (..(1

1. The above table re0uires some explanation because the 0uestion in the exercise contains an opening year 1 cash outflow and the textbook does not include an example of how to deal with this situation.

The negative figures in the table above arise due to the specific pattern of cash flows given in the 0uestion. The initial investment is A1,*** to purchase the machine but the cash inflows for the first two years only total %4** F "**) A(** and so the project1s substantial positive net present value is all earned in year ..

In year *, there is a cash outlay of A1,*** and in exchange 8pock secures ownership of a project with a positive net present value of A4,-.1-. Kiven the assumptions behind 0uestions such as this 6 specifically the complete and perfect market assumptions 6 no bank will lend 8pock more than this lower amount. Therefore, 8pock needs to find the remaining cash to fund the purchase of the machine out of his own pocket and this is the reason for the negative amount of e0uity reported in column ..

3t the end of year 1, the first cash inflow of A"** is received. 2owever, the project is re0uired to provide 8pock with an economic income of A4,.-, as well as re investing A""'.1- %a total of A4**). The only way in which this re0uirement can be met is to borrow another A1** from the bank %column ') secured on the strength of the newly re invested amount. +ote that for the first year operating income is negative because of the need to pay 8pock interest at 1*B on the additional cash he lent the entity.

1" 3t the end of year ,, the second cash inflow of A4** is received together with an amount of A"".', %column ') being interest on the amount re invested at the beginning of year , %a total of A4"".',). 8pock receives his economic income of A4,.-, leaving A"(1.(* to be re invested at the end of year ,. 3t this point e0uity once again becomes negative because of the need to repay to 8pock the additional cash he lent the entity in year * in order to purchase the machine in the first place.

3t the end of year ., the final cash inflow is %&** F "**) A1,***. In order for the project to be left with a net present value of A4,-.1-, the entity pays back to 8pock the A"1*.(* together with interest on the amount.

3ny student who gets anywhere near this solution 6 there may be one or two 6 has a brain commensurate in ability with that of the eponymous alien. 3 greater number of students may have chosen to ignore the opening cash outflow, in which case they should obtain figures similar those detailed below:

!alculation of economic income ignoring opening cash outflow

Eear 1 , . . <escription !ash receipt !ash receipt !ash receipt <isposal proceeds !ash 9low A "** 4** &** "** <iscount 9actor M 1*B *.(*( *.-,& *.'41 *.'41 /resent $alue A .&..&" "1..,, "4*.'( .**.4. 1,4,-.1-

Total present value of business %opening capital)

#conomic income C %1,4,-.1- x *.1*) C 14,.-,

14

/roof of capital maintenance throughout if only A14,.-, is spent annually

Eear

!ash 9low A 1

!losing capital A , 1,-1.** (*(.1*N *

Ipening capital A . 14,-.11,-1.** (*(.*(

Ipera ing Income A " 14,.-, 1,-.1* (*.(1

3mount rein $ested A 4 ,"'.1.'1.(1 (*(.*(

!umulative amount rein vested A & ,"'.1&1(.*( 14,-.1-

Income on reinvested amount A ' * ,".', &1.(1

#cono mic income A %"F') 14,.-, 14,.-, 14,.-,

1 "** , 4** . 1*** N 5ounding error

3dding together columns , and & in each year proves that opening capital of A1,4,-.1- has been maintained throughout if economic income of A14,.-, %column the total of columns " and ') is spent in each period. +ote that the figure for economic income is exactly A1** greater than that in the previous solution. WhyL

!hapter 4 !urrent #ntry $alue %-1 (")

What in the textbook is called @current entry value1 is in the module lectures referred to as replacement cost and the subject is dealt with in week ".

The sentence opening the second paragraph of the introduction %p. -1) is confusing but presumably the @remaining five1 value concepts referred to are those found in Table "., of the previous chapter.

3ctivity 4.1 is an example of profit calculation using pure historical coat accounting %2!3). 3ctivity 4., illustrates the shortcomings of pure 2!3 when the replacement

1& cost of inventory is rising. 3ctivity 4.. is best ignored. /ages -. -- introduce the concept of holding gains with 3ctivity 4." explaining the realised and unrealised distinction. 3ctivity 4.4 is a comparison between 2!3 income and #dwards and 7ell1s %1(&1) notion of business income.

3ctivity 4.&, which re0uires the preparation of an 5! balance sheet %the term @current entry value1 having been conveniently discarded) is one which students need to understand fully. The suggested solution below is produced in a more recognisable balance sheet format.

7alance sheet as at .1 <ecember Eear 1 +on current assets Gand and buildings /lant and e0uipment !urrent assets Inventories Trade receivables #0uity 8hare capital 5etained earnings Gong term borrowings Goan !urrent liabilities Trade payables

A 1.4,*** .(,&** 1'",&**

.&,*** x 11*=1**) (*,*** x 1.*=114 1*1,'.( (*,***

1(1,'.( .&&,..( ,**,*** &&,..( ,&&,..( 4*,*** 4*,*** .&&,..(

7alancing figure

HIn the balance sheet on page -(, the figure for closing inventory is incorrectly rounded upwards to A1*1,'"* but the remainder of these notes, for convenience, accept this figure.J

1' The activity feedback on pages -- -( is confusing not least because it begins with an income statement which was not a re0uirement of the activity. In the textbook balance sheet, all holding gains are treated as non distributable consistent with the adoption of the physical capital maintenance concept. The activity did not specify which capital maintenance concept was to be applied. In the balance sheet above, the money capital maintenance concept has been applied with holding gains being reported as part of retained earnings. This is, in fact, all that can be done without the preparation of at least some of the calculations re0uired to produce an income statement, which was not asked for in the 0uestion.

The table below summarises the approach taken in the textbook to holding gains in a more familiar manner.

3nalysis of realised %52K) and unrealised %>2K) holding gains 52Ks Gand and buildings /lant and machinery Inventory "** (,*** (,"** >2Ks ,4,*** .,&** 11,'"* "*,."* Total ,4,*** ",*** ,*,'"* "(,'"*

The textbook is inconsistent in its calculation of the 52K on plant and e0uipment compared to that on inventory. The former is calculated using end of year replacement cost while the latter is calculated using average replacement cost for the year. 3 more consistent calculation is given below.

13nalysis of realised %52K) and unrealised %>2K) holding gains 52Ks Gand and buildings /lant and machinery 7acklog depreciation Inventory ,** ,** (,*** (,"** >2Ks ,4,*** .,-** %,**) 11,'"* "*,."* Total ,4,*** ",*** ,*,'"* "(,'"*

HWith respect to the income statement on pages -- -( of the textbook, the figure at the bottom should read A&&,."* and not A&&,.**. 8ome students may rightly 0uery the complete lack of any mention of loan interest in this 0uestion.J

/resumably, the inconsistency has been tolerated in the textbook to obviate the need to complicate the example with the problem of dealing with backlog depreciation at this early stage. 2owever, as the next 3ctivity 4.' addresses this issue directly in any case, it is difficult to see what has been gained by the delay.

#xercise 4.1

It is reasonably safe to assume, pace recent extraordinary events in the economy such as plummeting house prices and a falling 5/I, that prices in general are rising. In these more normal circumstances, the use of 5!3 results in operating profits which are lower than those reported under 2!3, assuming use of the physical capital maintenance concept. 9or example, in !haplin Gtd, the 5! operating profit is A1&,&** while in the 2! balance sheet the profit is A,&,***. In the 5! income statement, costs such as depreciation and the cost of sales are charged against current revenues at their higher 5!s and not at lower 2! amounts.

1(

2owever, what is bad news for the income statement is good news for the balance sheet whose book value is boosted by the inclusion of assets at their increased 5!s. 9or example, the value of e0uity in the !haplin Gtd 2! balance sheet is A,,&,*** but in the 5! balance sheet this figure has risen to A,&&,."* increasing book value per share from 11.p to 1..p.

+ote however that both of these effects, falling profits and increasing balance sheet asset values, combine to inflict a double whammy on the evaluation of the entity1s financial performance using a measure such as, for instance, return on e0uity %5I#). In 2! terms, 5I# is %,&,***=,,&,***) *.114 but in 5! terms it is only %1&,&**=,&&."*) *.*&,.. The 2! results overstate 5I# by %*.114 6 *.*&,.=*.*&,.) *.-"4(, almost -4B. In the 2! accounts, profit is overstated by %,&,*** 1&,&**=1&,&**) *.4&&. and assets undervalued by %,&&,."* ,,&,***=,,&,***) *.1'-4. The effects of these errors are multiplicative, as the table below illustrates.

5! 5I# *.*&,.

Iverstated profit times 1.4&&.

>nderstated assets times 1.1'-4

2! 5I# e0uals *.114

The use of the physical capital maintenance concept restricts the income statement to reporting only operating profits because all holding gains are held in a sort of @revaluation reserve1 in the balance sheet. 2owever, if holding gains are considered distributable, then they are included in the income statement thereby boosting reported profit. In this case, the accounts will have been prepared using the money capital maintenance concept. 9or example, in !haplin Gtd, reported profit in the

,* income statement would increase to %1&,&** F "(,'"*) A&&,."*. 5I# increases to %&&,."*=,&&,."*) *.,"(1, almost ,4B. This is a clear illustration of how the amount of reported profit depends upon the capital maintenance concept %rather than the valuation basis) adopted in the financial statements. This was the lesson learned, albeit rather painfully, in the lectures on economic income in week , of the module.

In 3ctivity 4.-, the first advantage claimed for 5!3 is that it splits profits between those earned from operating activities and those earned from holding assets in a time of rising prices hence facilitating appraisal of earlier actions and providing more useful data for decision making. That these data are more useful may be demonstrated by considering !haplin Gtd1s reported 2! profit of A,&,*** which, in the 5! income statement, is split between 5! operating profit of A1&,&** and realised holding gains of A(,"**. !onsidering the 2! reported profit alone, users are informed that any dividend up to and including this amount may be distributed and still leave in tact the original money capital of A,**,***. 2owever, the disaggregation of this amount between 5! operating profit and realised holding gains provides additional information to the effect that only a smaller dividend of up to and including A1&,&** may be distributed should the entity wish to maintain in tact its physical capital.

That this disaggregation permits better appraisal of earlier actions may be illustrated by comparing two companies, 3 and 7, which earn identical 2! profits in the following different ways:

,1 3 Am 5! operating profits 5! holding gains Total ( 1 1* 7 Am 1 ( 1*

It would appear that 3 is very good at selling but 7 is better at investing.

#xercise 4.,

3 suggested solution to this exercise is to be found on the student side of the textbook1s companion website 6 www.cengage.co.uk=abj"e.

#xercise 4..

%a) 52Ks are those which relate to assets valued at 5! and which have been used up in the earning of revenues and hence are matched to the latter in the income statement. In 5!3, these are the realised holding gains relating to depreciable non current assets and inventories. The gains are calculated with reference to the e0uivalent 2! charges for depreciation and cost of sales. %b) The answer to this 0uestion depends upon the capital maintenance concept adopted in the financial statements. If physical capital maintenance is preferred, then none of the holding gains, realised or unrealised, will appear in the income statement. If the money capital maintenance concept is adopted instead, then all holding gains are reported in the income statement to give a measure of @business income1. If the financial capital maintenance concept is adopted, the answer becomes more complex. 9or example, the !haplin Gtd

,, 0uestion gives data on movements in general inflation which index has risen from 1** to 1,* over the year. In order to maintain the start of year spending power of the shareholders, e0uity at the end of the year must be %,**,*** x 1,*=1**) A,"*,***. Kiven this new capital base, retained earnings must be %,&&,."* 6 ,"*,***) A,&,."*. 2ence, financial capital maintenance reports 5! holding gains as part of profit in the income statement. %c) 3 0uick glance at the balance sheets of !haplin Gtd provides an easy answer to this 0uestion. 2owever the holding gains are reported, whether in the balance sheet or the income statement, none are immediately distributable because the company has no cash and cash e0uivalents. This is a far from trivial point. The payment of a dividend is as much a financing decision as it is a decision about how much capital should be maintained. /rofit and cash are very different concepts. 2owever, if the financing constraint were lifted from !haplin Gtd by assuming that the company has unrestricted access to bank overdraft or loan facilities, then the distributability issue is reduced to the 0uestion simply of how much profit has been made and reported in the income statement and this has been discussed in part %b) above. 7ut if the 0uestion is interpreted within the narrower confines of #nglish company law, which is based upon the 2!3 model, then distributable profit is limited to the 2! amount of A,&,*** %i.e. including 52Ks) but >2Ks are confined to a @revaluation reserve1 in the balance sheet which, legally, is not available for dividend purposes.

,. #xercise 4."

This exercise is in effect an empirical 0uestion and it is a moot point as to whether any data exist which may provide empirical evidence on which to base an answer to this 0uestion. It would appear that three sets of data are re0uired: 1. a long run series of reported 2! profit figures? ,. a long run series of reported 5! profit figures? .. an objective indicator of long run economic performance. The data for 1 are available. The data for . might be constructed %e.g. market capitalisation figures for listed companies). The data for , are not available.

#xercise 4.4

3gain, this exercise may be interpreted as an empirical 0uestion but the fact that it has been phrased in 3unt 8ally terms invites some sort of response. In support of the statement, it is possible to list the first three disadvantages cited in activity 4.- on page (1. In terms of advantages, only +o. . on page (* refers explicitly to the balance sheet.

It may be argued that the main advantage of a 5! balance sheet over a 2! balance sheet is that the former captures an important element of the changing economic environment which the latter ignores 6 the inescapable fact of changing asset prices. In other respects, e.g. the use of arbitrary depreciation allocation methods and the failure to recognise certain assets such as internally generated goodwill, the 5! balance sheet shares the failings of the 2! balance sheet. Kiven this modest

," assessment of its superiority, it is perhaps less surprising that actual financial statements eschew use of 5!s and continue to be produced using ;52!3 principles.

#xercise 4.&

%a) 2istorical cost accounts for the years ,*O1 and ,*O,
Income 8tatements year ending .1 <ecember 5evenues !ost of sales Kross profit 5ent /rofit before tax Tax /rofit for year 5etained earnings brought forward 5etained earnings carried forward +ote 1 , ,*O1 A .,*** ,,*** 1,*** &** "** ,** ,** ,** ,*O, A .,&** ,,*** 1,&** '** (** "4* "4* ,** &4*

7alance sheets as at .1 <ecember !urrent assets Inventory !ash and cash e0uivalents #0uity 8hare capital 5etained earnings Total e0uity

+ote .

,*O1 A &,"** .,-** 1*,,** 1*,*** ,** 1*,,**

,*O, A ',,** .,"4* 1*,&4* 1*,*** &4* 1*,&4*

+otes 1 , . ,*O1 6 %, x 1,4**) ,*O, 6 %, x 1,-**) ,*O1 6 %, x 1,***) ,*O, 6 %, x 1,***) H9I9IJ ,*O1 6H %" x 1,***) F %, x 1,,**)J ,*O, 6 H% , x 1,***) F %, x 1,,**) F %, x 1,"**)J H9I9IJ

,4 %b) I. ;. !onfused 5eplacement cost accounts for the years ,*O1 and ,*O,
Income statement year ending .1 <ecember 5evenues !ost of sales Kross profit 5ent /rofit before tax Tax /rofit for period 5ealised holding gain on inventory >nrealised holding gain on inventory Total earnings %as per 2! accounts) %, x 1,1**) %average replacement cost) %as per 2! accounts) %as per 2! accounts) %,,,** 6 ,,***) %5! 6 2! cost of sales) H%& x 1,,**) 6 &,"**J %5! 6 2! closing inventory) ,*O1 A .,*** ,,,** -** &** ,** ,** ,** -** 1,***

7alance sheet as at .1 <ecember !urrent assets Inventory !ash and cash e0uivalents #0uity 8hare capital 5etained earnings Total e0uity %& x 1,,**) %!losing 5!) %as per 2! accounts)

,*O1 A ',,** .,-** 11,*** 1*,*** 1,*** 11,***

Income statement year ending .1 <ecember 5evenues !ost of sales Kross profit 5ent /rofit before tax Tax Goss for period 5ealised holding gain on inventory >nrealised holding gain on inventory Total earnings Total earnings brought forward Total earnings carried forward %as per 2! accounts) %, x 1,.**) %average replacement cost) %as per 2! accounts) %as per 2! accounts) H%, x 1,.**) 6 %, x 1,,**)J %5! ,*O, average 6 5! ,*O1 closing) P%& x 1,"**) 6 H%" x 1,,**) F %, x 1,"**)JQ %5! ,*O, closing 6 5! ,*O1 closing for " units and ,*O, closing 5! for , units)

,*O, A .,&** ,,&** 1,*** '** .** "4* %14*) ,** -** -4* 1,*** 1,-4*

,&
7alance sheet as at .1 <ecember !urrent assets Inventory !ash and cash e0uivalents #0uity 8hare capital 5etained earnings Total e0uity %& x 1,"**) %5! closing) %as per 2! accounts) ,*O, A -,"** .,"4* 11,-4* 1*,*** 1,-4* 11,-4*

%c) I. ;. !onfused 7rief comments on the significance of the results

!omparison of results 2istorical cost operating income 5eplacement cost operating income 5eplacement cost total earnings %including holding gains) 5ealised holding gains on inventory >nrealised holding gains on inventory 2istorical cost net assets 5eplacement cost net assets

,*O1 A ,** 1,*** ,** -** 1*,,** 11,***

,*O, A "4* %14*) -4* ,** -** 1*,&4* 11,-4*

The comparison between operating incomes highlights the fact that 2! overstates income during periods of price increase in comparison with 5!, which reports much lower profits because revenues at current selling prices are matched against current %higher) costs rather than against historical %lower) costs. The inclusion of tax in the 0uestion also highlights the fact that in taxing 2! profits what in fact maybe being taxed are holding gains and not operating profits. 2owever, the balance sheet comparison reveals that although 5! is bad news for the income statement it is good news for the balance sheet because asset values have increased materially because in the 5! balance sheet they are stated at their increased current values.

+ote that the realised and unrealised holding gains are the same for each year which is intuitively correct given that the inventory level in each period was & units with ,

,' units sold in each period and the absolute price increase in ,*O1 was A,** per unit %from A1,*** to A1,,** with an average of A1,1**) and that this increase was the same in absolute terms as that in ,*O, %from A1,,** to A1,"** with an average of A1,.**). +otice that holding gains in ,*O, are calculated in relation to the previous year1s replacement cost accounts and not in relation to the ,*O, historical cost accounts on the grounds that only replacement cost accounts are prepared for reporting purposes.

5econciliation between 5! operating income and 2! income 5! operating income 5ealised holding gains on inventory >nrealised holding gains on inventory accrued in ,*O1 but realised in ,*O, 2! income

,*O1 A

,*O, A %14*)

,**

,** "**

,**

"4*

The reconciliation between 5! and 2! income highlights the fact that reported 2! income is a mixture of different types of gains which have occurred in different accounting periods. The ,*O, 2! profit of A"4* is in fact made up of a ,*O, operating loss of A14*, a ,*O, realised holding gain of A,** and an unrealised 5! holding gain of A"** realised in the ,*O, 2! accounts but which actually arose in ,*O1R In the 5! accounts, gains are reported in the period in which they arise.

,#xercise 4.'

%a) 2istorical cost accounts for the year ,*O1

Income statement year ending .1 <ecember 5evenues !ost of sales /urchases !losing inventory Kross profit Keneral expenses <epreciation Goan interest /rofit before tax %',,** F 1*,-** F 14,&** F 1",.**) %-,*** F -,,4* F -,4** F 1*,-**) H%".* 6 .(*) x A(* per unitJ %(,*** x 1*B) %-,*** x 1,B)

,*O1 A

,*O1 A "',(**

.4,44* .,&** 1.,,** (** (&*

.1,(4* 14,(4* 14,*&* -(*

7alance sheet as at .1 <ecember +on current assets !urrent assets Inventory !ash and cash e0uivalents %(,*** 6 (**)

,*O1 A .,&**

,*O1 A -,1**

%1*,*** F -,*** 6 (,*** F "',(** 6 .4,44* 6 1.,,**)

!urrent liabilities loan interest +et current assets Total assets less current liabilities +on current liabilities loan #0uity Irdinary share capital 5etained earnings Total e0uity

-,14* 11,'4 * (&* 1*,'(* 1-,-(* -,*** 1*,-(* 1*,*** -(* 1*,-(*

%b) ;allard !o 5eplacement cost accounts for the year ,*O1

Income statement year ending .1 <ecember 5evenues %as per 2! accounts) !ost of sales /urchases %".* x A1**) %closing 5!) !losing inventory %"* x A1**) %closing 5!) Kross profit Keneral expenses %as per 2! accounts) <epreciation H%1,,&** x 1*=() x 1*BJ Goan interest %as per 2! accounts) 5eplacement cost operating profit %loss)

,*O1 A

,*O1 A "',(**

".,*** ",*** 1.,,** 1,"** (&*

.(,*** -,(** 14,4&* %&,&&*)

,(

7alance sheet as at .1 <ecember +on current assets !urrent assets Inventory !ash and cash e0uivalents !urrent liabilities 6 loan interest +et current assets Total assets less current liabilities +on current liabilities loan #0uity Irdinary share capital 5etained earnings %losses) 2olding gains 5ealised holding gain on inventory 5ealised holding gain on non current assets >nrealised holding gain on inventory >nrealised holding gain on non current assets Total e0uity %1",*** 6 1,"**)

,*O1 A

,*O1 A 1,,&**

",*** -,14* 1,,14* (&* 11,1(* ,.,'(* -,*** 14,'(* 1*,*** %&,&&*) %.(,*** 6 .1,(4*) %5! 6 2! cost of sales) %1,"** 6 (**) %5! 6 2! depreciation charge) %",*** 6 .,&**) %5! 6 2! closing inventory) %1,,&** 6 -,1**) %5! 6 2! net book value) ',*4* 4** "** ",4** 1,,"4* 14,'(*

%c) ;allard !o +ature of holding gains and their ability to be distributed >nderlying the notion of holding gains is the perception that managers may increase the wealth of the entity in one of two ways: by buying low and selling high or by buying low and then sitting on the asset until the price rises.

2olding gains represent gains from the latter strategy and arise when the prices of factors of production increase %and holding losses arise when they decrease) in comparison with their original %historical) ac0uisition costs. They are distinguished from replacement cost operating gains and losses which arise when factors of production are utilised and traded in transactions with third parties and are matched against current revenues at their current replacement costs.

.* 2olding gains are classified as realised to the extent that they relate to factors of production that have been used to generate revenues such as goods sold or depreciation of non current assets and hence are gains on factors of production which have passed through the income statement. >nrealised holding gains are price increases in the stocks of unused inventory and non current assets which remain in the balance sheet because they have not yet been used to generate revenues.

The extent to which holding gains may be regarded as distributable depends upon the capital maintenance concept adopted by the entity. In the example above, none of the holding gains are regarded as distributable because none are accounted for in the income statement because the entity has adopted a physical capital maintenance concept. In this basis, nothing can be distributed to the owners as dividends until the physical capital of the entity has been maintained which re0uires, in this case, the introduction of another A&,&&* of financial capital. In other words, the entity is selling its goods at prices which do not recover the current replacement costs of the assets used to generate the revenues in the first place. In the longer term, this is not a sustainable policy.

If the company decided to distribute A-(* as a dividend, i.e. its historical cost accounting profit, then de facto in this case the entity would be regarding its realised holding gains as distributable because the 2! income is made up of the 5! operating loss and the realised holding gains %A',44* A&,&&* C A-(*). If the company decided that all of its holding gains realised and unrealised were distributable, then it would be maintaining financial capital in money %or nominal) terms %i.e. the original A1*,***

.1 raised on the share issue). What is distributable income, therefore, depends upon the capital maintenance concept adopted.

%d) ;allard !o !omparison between 5! and 2! profits using different stock flow assumptions H+ote: this re0uirement has been added in order to provide some justification %missing in the textbook) for all of the transaction details relating to the purchase and sale of widgets provided in the 0uestion. If use of 9I9I is assumed 6 and why should it not beL 6 such details are conspicuously redundant. 2owever, it is sometimes claimed that use of the GI9I inventory flow assumption better matches costs against revenue when prices are rising. This claim, inter alia, is examined here in the calculations below. 9or some indication, albeit in very general terms, of the difference between periodic and perpetual inventory systems, see p. .&" of the textbook.J

/eriodic inventory system 6 calculations of closing inventory and cost of sales

2istorical cost bases 9I9I GI9I W3! %"* x (*) %"* x -*) H%.4,44*=".*) x "*J !losing inventory A .,&** .,,** .,.*' !ost of sales A .1,(4* .,,.4* .,,,".

>nder the replacement cost basis, the alternative to using the closing replacement cost of A1** per unit is to calculate the cost of sales and the closing inventory on the basis of average replacement cost computed based on the duration in months of each of the separate prices as follows:

H%-* x .=1,) F %'4 x .=1,) F %-4 x ,=1,) F %(* x .=1,) F %1** x 1=1,)J C -..'4

.,

!losing inventory is therefore %"* x -..'4) A.,.4* and the cost of sales is %.(* x -..'4) A.,,&&.. Ine of the reasons that these values are fractionally greater than those under the 2! W3! method is because the 5! method illustrated above includes the latest price increase which happened on 1 <ecember even though no inventory has actually been bought at that price in this financial year because the re0uirement of the 0uestion is to maintain physical capital intact as far as possible. The 2! cost of sales figure which is closest to the average 5! figure is that calculated using the GI9I inventory flow assumption. 2owever, the 2! GI9I figure is still materially lower that the cost of sales calculated using closing replacement costs.

;allard !o of sales

/erpetual inventory system 6 calculation of closing inventory and cost

2istorical cost bases

!losing inventory A .,&** .,.**

!ost of sales A

9I9I GI9I

%"* x (*) H%.* x -*) F %1* x (*)J %The GI9I balance is recalculated after each sale transaction.)

.1,(4* .,,,4*

W3!

8ale 1 %&* x -*) 8ale , H%"* x -*) F %11* x '4)J C A11,"4* A11,"4*=14* C '&... per unit H 5olling averageJ !ost of sales on 8ale , %(* x '&...) 8ale . H &* x '&...) F %1** x -4)J C A1.,*-* A1.,*-*=1&* C -1.'4 per unit H5olling averageJ !ost of sales on 8ale . %1.* x -1.'4) 8ale " H%.* x -1.'4) F %1,* x (*)J C A1.,,4, A1.,,4,=14* C --..4 per unit H5olling averageJ !ost of sales on 8ale " %11* x --..4) Totals %closing inventory 6 H"* x --..4J) .,4."

",-**

&,-'*

1*,&,-

(,'1.,,*1&

..

3 perpetual inventory system makes the more accurate calculations for GI9I and W3! performed above possible. The 9I9I calculation is unaffected.

#xercise 4.-

%a) %i) 2! Income statements for the period ending .* 8eptember 5evenues %11* F 1,* F 1.*) !ost of sales /urchases %1** F 11* F 1,* F 1.*) !losing inventory /rofit 2! 7alance sheets as at .* 8eptember Inventory #0uity !apital 5etained earnings

GA .&* "&* 1.* ..* .*

2A

1** 1**

1.* 1** .* 1.*

1** 1** 1**

%a) %ii) 5! Income statements for the period ending .* 8eptember 5evenues !ost of sales %. x 1.*) Iperating loss 5ealised holding gain >nrealised holding gain 7usiness income 5! balance sheets as at .* 8eptember Inventory #0uity !apital 5etained earnings

GA .&* .(* %.*) &* .*

2A

.* .*

1.* 1** .* 1.*

1.* 1** .* 1.*

." %b) 2 is a shrewd investor. G is poor at selling. There are no data on 21s selling ability. !an 2 realise the A.* business income by selling his widget for A1.*L G, for example, has made losses on his buying and selling activities in replacement cost terms. It is this uncertainty that may justify the 2! accounts in not reporting any profit for 2 because after all, 2 has done nothing. In the other hand, G is effectively in the same position in that his widget cost A1.* and it needs to be sold for at least this amount to avoid making a loss %as G has done on previous sales in comparison with replacement costs). The 2! accounts report a profit for G which has been re invested in the increased replacement cost of a widget. 2owever, G1s pricing policy, according to the 5! accounts, is not keeping up with the increased replacement costs of widgets as indicated by the 5! operating loss. 5egardless of the ultimate judgement as between G and 2, the 5! accounts provide a lot more to talk about than the 2! accounts.

!hapter &: !urrent #xit $alue and ;ixed $alues %(4 1*()

@!urrent exit value1 is the textbook1s terminology for what in the week & module lectures is called cash flow reporting %!95). >nder the heading of @mixed values1 the textbook considers deprival value accounting %<$3) and fair values %9$) which are also considered in week & of the module.

/ages (& 1** deal with current exit value accounting although the textbook reverts to the use of the more familiar term of net realisable value %+5$) as soon as is decent. The textbook provides two examples of !95 %on pages (& (' and in 3ctivity &.,) but in each case the solution is presented in the traditional format of an income statement

.4 and an accompanying balance sheet. This approach fails to do sufficient justice to the important change in the valuation basis as well as obscuring the principle underlying this change, i.e. the emphasis on the realisability of the entity1s assets. The examples in the chapter have been re worked below in a more familiar !95 format on the basis that the inventory is a readily realisable asset and that the non current is not. This re working reveals fatal flaws in the textbook solutions to these examples.

Textbook example %pp. (' (-)

7alance sheets as at the end of 5ealised assets !ash and cash e0uivalents 5eadily realisable assets Inventory +ot readily realisable assets +on current asset #0uity 8hare capital 5etained earnings %balancing figure) 8tatements of cash flow for the years ending !ash flow from operations !ash flow on investing activities +on current asset !ash flow on financing activities Issue of share capital Increase in cash and cash e0uivalents Ipening cash and cash e0uivalents !losing cash and cash e0uivalents

Eear 1 A 1,,*** ,,4** &,*** ,*,4** 14,*** 4,4** ,*,4** Eear 1 A ',*** %1*,***) 14,*** 1,,*** 1,,***

Eear , A ,",*** .,-** ",*** .1,-** 14,*** 1&,-** .1,-** Eear , A 1,,***

1,,*** 1,,*** ,",***

.& 8tatements of realisable income for the years ending !ash inflow from operations Increase in readily realisable assets Inventory <ecrease in not readily realisable assets +on current asset 5ealisable income for the year 5etained earnings brought forward 5etained earnings carried forward 8tatements of changes in financial position for the years ending Increase in realised assets Increase in readily realisable assets <ecrease in not readily realisable assets 5ealisable income for year Eear 1 A ',*** ,,4** %",***) 4,4** 4,4** Eear 1 A ',*** ,,4** %",***) 4,4** 4,4** Eear , A 1,,*** 1,.** %,,***) 11,.** 4,4** 1&,-** Eear , A 1,,*** 1,.** %,,***) 11,.** 11,.**

The use of the above !95 formats highlights a fundamental error in the textbook solution to this example. The error in the textbook relates to the treatment of inventory and, more particularly, the reporting of realised and unrealised operating gains on this asset. If this were a set of 5! accounts, both of these gains %A4** in year 1 and A-** in year ,) would be reported as unrealised holding gains in the year in which they arose because both relate to the gain on closing inventory. The textbook fails to explain why they are treated as operating gains under the illustrated !95 system. 9urthermore, both of these gains are calculated with reference to the original 2! of the closing inventory. 7ut, why are original 2!s relevant when all assets are valued at +5$L Iriginal 2! does not appear to be relevant for the non current asset. This inconsistency is not explained in the textbook.

.' In the more correct version above, the statement of realisable income reports in year 1 an increase in the value of inventory of A,,4**, being the difference between the year end closing inventory +5$ of A,,4** and the opening inventory +5$ of Sero %because no inventory was then held). The year , statement of realisable income reports an increase in the +5$ of inventory of A1,.** being the difference between the closing inventory +5$ of A.,-** and the opening inventory +5$ of A,,4**. +o 2!s are involved in these calculations.

3ctivity &., %pp. (- (()

7onds /lc 7alance sheets as at the end of 5ealised assets !ash and cash e0uivalents 5eadily realisable assets Inventory +ot readily realisable assets +on current asset #0uity 8hare capital 5etained earnings %balancing figure)

Eear ' A 14,4** &,*** ',*** ,-,4** ,4,*** .,4** ,-,4** Eear ' A %4**) %(,***) ,4,*** 14,4** 14,4**

Eear - A ,,,(** .,.** 4,*** .1,,** ,4,*** &,,** .1,,** Eear - A ',"**

7onds /lc 8tatements of cash flow for the years ending !ash flow from operations !ash flow on investing activities +on current asset !ash flow on financing activities Issue of share capital Increase in cash and cash e0uivalents Ipening cash and cash e0uivalents !losing cash and cash e0uivalents

',"** 14,4** ,,,(**

.7onds /lc 8tatements of realisable income for the years ending !ash inflow from operations Increase in readily realisable assets Inventory <ecrease in not readily realisable assets +on current asset 5ealisable income for the year 5etained earnings brought forward 5etained earnings carried forward 7onds /lc 8tatements of changes in financial position for the years ending Increase in realised assets Increase in readily realisable assets <ecrease in not readily realisable assets 5ealisable income for year

Eear 1 A %4**) &,*** %,,***) .,4** .,4** Eear 1 A %4**) &,*** %,,***) .,4** .,4**

Eear , A ',"** %,,'**) %,,***) ,,'** .,4** &,,** Eear , A ',"** %,,'**) %,,***) ,,'** ,,'**

In the textbook answer to this 0uestion further confusion is introduced through the use of the term @holding gain1 with regard to the difference between the +5$ and the 2! of the closing inventory. In the previous example in the textbook, this difference was termed an @operating gain1. 8uch confusion in terminology is easily avoided by using the !95 formats as above.

That a mere change in reporting format can result in accounting numbers that are intellectually bankrupt is revealed by the final sentence in 3ctivity &., %p. (() highlighting the reporting of a @holding loss1 of A%1,"**) on inventory in the income statement. Where has this loss come fromL This 0uestion arises because, according to the 7onds /lc 0uestion, the cost of an item of inventory has increased from A14 per unit in year ' to A1' per unit in year -. 3t the same time, the +5$ of an item of inventory has also increased from A.* per unit in year ' to A.. per unit in year -.

.( Kiven this background of rising prices %even rent and expenses have gone up) it seems to say the least counter intuitive for the year - financial statements to be reporting a holding loss.

/art of the reason for this is the fact that there has been a volume change in the number of units of closing inventory between the beginning and end of year - which the calculation in note . of 3ctivity &., fatefully ignores. 3 further problem is that the gains are calculated in the textbook with reference to two different costs, A14 in year ' and A1' in year -. 3 reconciliation between the holding gains reported in 3ctivity &., is presented below.

>nits Eear - opening inventory holding gains $olume decrease at A14 per unit Increase in year - +5$ per unit %.. .*) Increase in year - 2! per unit %1' 14) Eear - closing inventory holding gains ,** %1**) 1** 1**

A .,*** %1,4**) 1,4** .** %,**) 1,&**

9rom the above analysis it is clear that only A1** of the reported holding loss is attributable to pure price changes and that this A1** is actually a gain. The remainder of the so called @holding loss1 is in fact attributable to the volume change in inventory. 7y whatever stretch of the imagination, this is not a @holding loss1 in the normal sense of the term.

The first paragraph on page 1*1 states that financial reporting in practice %the example of I958 is used explicitly) does not contain a re0uirement for any consistency of approach as between the valuation of one asset and another. This assertion may be

"* challenged. The valuation principle which underlies I958 may be characterised as modified recoverable historical cost accounting %;52!3). The 52!3 principle which underlies I958 is reproduced below.

5ecoverable 2istorical !ost 3ccounting %52!3) <ecision Tree

5ecoverable historical cost C lower of

2istorical cost

5ecoverable amount C 2igher of

$alue in use

+et realisable value

8ource: I!3#W %,**&): 9igure ..1.

The term @modified1 which is added to 52!3 takes into account those circumstances in which I958 allow the revaluation of assets with the surplus being disclosed in a revaluation reserve. It is a pity that the above diagram is not reproduced here in the textbook because it bears a marked similarity to the procedure used for determining the deprival value of an asset, as introduced in the next paragraph of the text and illustrated in 9igure &.1.

"1 3lso, note that in the section of fair values %pp. 1*" 1*') the textbook is not up to date as it does not reconcile deprival value bases to the fair value basis in the manner illustrated by van Tijl and Whittington %,**&).

#xercises &.1 and &.,

The chapter contains sufficient discussion of principles and illustrations of both methods. +ote that the above notes do not agree with the textbook1s principles of !95 as outlined in 3ctivity &.1.

#xercise &..

3 suggested solution to this exercise is to be found on the student side of the textbook1s companion website 6 www.cengage.co.uk=abj"e.

#xercise &."

The significant disadvantages of 5!3 are listed in 3ctivity 4.-. The main one removed by the use of <$3 is +o. ,.

", #xercise &.4

%a) 8ee 9igure &.1.

%b) 1 , . " 4 &

#$ 1, 1, 1* 1*

+5$ 1* 1* 1, 1, -

5! 1, 1* 1* 1,

<$ ( 1* 1* 1* 1*

%b) The main justifications for the use of the <$3 system is that asset valuation in the balance sheet accurately reflects the most rational course of action management should take in relation to its asset and the fact that, in each of the situations, the existence of a typical asset to which the valuations apply may be easily imagined.

8ituation 1 , . " 4 &

Typical asset 3 new general non current asset 8urplus, old non current asset due to be scrapped 3 new entity specific non current asset +ew entity specific inventory +ew general inventory 8tandby older non current asset

". #xercise &.& 8teward /lc Eear 1 3ccounts

8tatement of realised cash flow for the period ending Eear 1 Iperating cash flow Investing cash flow 9inancing cash flow +et realised cash flow 8tatement of financial position as at the end of Eear 1 5ealised assets !ash and cash e0uivalents 5eadily realisable assets Inventory +ot readily realisable assets +on current asset #0uity 8hare capital 5etained realisable earnings Total e0uity H%-** x A14) 6 %1,*** x A1*) 6 A1,***)J H8ales minus purchases less expensesJ H/urchase of non current asset machineJ HIssue of share capitalJ A 1,*** %1*,***) .*,*** ,1,*** A ,1,*** %,** x A14) %1*,*** 6 1,***) .,*** (,*** ..,*** .*,*** .,*** ..,*** A 1,*** .,*** %1,***) .,***

%balancing figure)

8tatement of realisable earnings for the period ending year 1 !ash flow from operations 5eadily realisable assets inventory +ot readily realisable asset 6 non current asset 5ealisable earnings for the period %.,*** 6 *) %(,*** 6 1*,***)

8tatement of changes in financial position for the period ending Eear 1 5ealised cash inflow Increase %decrease) in realised assets Iperating cash flow 5eadily realisable cash inflow Inventory +ot readily realisable cash inflow +on current asset Gong term cash outflow 5etained realisable earnings of the period

1,*** %.,*** 6 *) %1*,*** 6 (,***) .,*** %1,***) .,*** .,***

""

8teward plc Eear , accounts

8tatement of realised cash flow for the period ending Eear , !ash inflows Iperating cash flow +et realised cash flow 8tatement of financial position as at the end of Eear , 5ealised assets !ash and cash e0uivalents 5eadily realisable assets Inventory +ot readily realisable assets +on current asset #0uity 8hare capital 5etained realisable earnings Total e0uity %,1,*** 6 1,&**) %4** x A,*) %(,*** 6 1,***) H%4** x A,*) 6 %-** x A1.) 6 A1,,**J H8ales minus purchases less expensesJ A %1,&**) %1,&**) A 1(,"** 1*,*** -,*** .',"** .*,*** ',"** .',"** A %1,&**) ',*** %1,***) ","** .,*** ',"** A %1,&**) ',*** %1,***) ","** ","**

%.,*** F ","**)

8tatement of realisable earnings for the period ending Eear , Iperating cash flow 5eadily realisable assets inventory +ot readily realisable assets 6 non current asset 5ealisable earnings for the period 5ealisable earnings brought forward 5ealisable earnings carried forward %1*,*** 6 .,***) %-,*** 6 (,***)

8tatement of changes in financial position for the period ending Eear , 5ealised cash inflow <ecrease in realised assets %cash and cash e0uivalents) 5eadily realisable cash inflow Increase in readily realisable assets %closing inventory) +ot readily realisable cash inflow <ecrease in non current assets Gong term cash outflow 5etained earnings of the period %1(,"** 6 ,1,***) %1*,*** 6 .,***) %-,*** 6 (,***)

"4 #xercise &.' %a) 2! income statements for the period ending .* 8eptember 5evenues /urchases !losing inventory !ost of sales /rofit 2! 7alance sheets as at .* 8eptember Inventory !ash #0uity !apital 5etained earnings 1.* 4* 1-* 1** -* 1-* 1** 1** 1** 1** %1.* F 1"* F 14*) %1** F 114 F 1,4 F 1.*) 8tan ",* "'* %1.* ) ."* -* Iliver 1** %1**)

%a) 5! income statements for the period ending .* 8eptember 5evenues !ost of sales Iperating profit 5ealised holding gains >nrealised holding gains 7usiness income 5! 7alance sheets as at .* 8eptember Inventory !ash #0uity !apital 5etained earnings %1.* F 1"* F 14*) %. x 1.*) %.(* ."*)

8tan ",* .(* .* 4* -*

Iliver

.* .*

1.* 4* 1-* 1** -* 1-*

1.* 1.* 1** .* 1**

"& %c) !95 balance sheets as at .* 8eptember !ash Inventory #0uity 8hare capital 5etained earnings

8tan 4* 1&* ,1* 1** 11* ,1*

Iliver 1&* 1&* 1** &* 1&*

8tatements of cash flow for the period ending .* 8eptember Iperating cash flow Investing cash flows 9inancing cash flows Increase in cash and cash e0uivalents 8tatements of realisable income for the period ending .* 8eptember Iperating cash flows Increase in inventory value 5ealisable income 4* &* 11* &* &* H/urchase inventory of opening 4* %1** ) 1** 4* %1**) 1**

!hapter ': !urrent /urchasing /ower 3ccounting %111 1,()

<espite its title, this chapter not only deals with !//3 %pp.111 11'), covered in week . of the module, but also introduces the 5T3 system %pp. 11' 11(), covered in week 4 of the module, and the !!3 system %pp. 1,1 1,4) covered in week ' of the module. Intellectually, this is therefore the most challenging of the chapters in this section of the textbook.

The textbook solution to the !haplin Gtd !//3 0uestion %pp.11" 114) incorrectly reports the gain on net monetary liabilities in the balance sheet, which is formatted so

"' as to begin with share capital and end with debtorsR 3 better solution is presented below.

!haplin Gtd !// balance sheet as at end of year A +on current assets Gand and buildings /lant and e0uipment !urrent assets Inventory Trade receivables #0uity 8hare capital 5etained earnings Gong term loan Trade payables 11*,*** x 1,*=1** .&,*** x 1,*=1** (*,*** x 1,*=11* (-,1-, (*,*** A 1.,,*** ".,,** 1'4,,** 1--,1-, .&.,.-, ,"*,*** ,.,.-, ,&.,.-, 4*,*** 4*,*** 1**,*** .&.,.-,

,**,*** x 1,*=1** 7alancing figure

Income statement for the year ended .1 <ecember 5evenue !ost of sales <epreciation ;onetary gain (*,*** x 1,*=11* &*,*** x 1,*=1** ",*** x 1,*=1** 7alancing figure (-,1-, ',,*** ,&,1-, ",-** ,1,.-, ,,*** ,.,.-,

!onstruction of opening year 2! balance sheet for !haplin Gtd %8ee 3ctivity 4.&) Gand and buildings /lant and e0uipment Ipening inventory Total identified assets #0uity Gong term loan Ipening cash and cash e0uivalents Kiven Kiven Kiven Kiven Kiven <erived ,**,*** 4*,*** 11*,*** "*,*** &*,*** ,1*,*** ,4*,*** "*,***

"/roof of monetary gain Ipening net monetary liabilities in end of year monetary units %4* 6 "*) x 1,*=1** !hange in net monetary liabilities !losing net monetary liabilities ;onetary gain 4* F 4* (* 1, 1, 1* ,

3ctivity '.,

;ushroom Gtd !//3 7alance sheet as at .1 <ecember ,*O" A Gand #0uipment Inventory !ash #0uity 8hare capital 5etained earnings &,*** x 1,*=1** .,*** x 1,*=1** .,*** x 1,*=114 .,1.* 1,*** A ',,** .,&** 1*,-** ",1.* 1",(.* 1","** 4.* 1",(.*

1,,*** x 1,*=1** 7alancing figure

!//3 Income statement for the year ending .1 <ecember ,*O" 5evenues !ost of sales Ipening inventory /urchases !losing inventory <epreciation ;onetary loss 5etained income for year 11,*** x 1,*=11* ,,*** x 1,*=1** 1*,*** x 1,*=11* .,*** x 1,*=114 1,*** x 1,*=1** 7alancing figure ,,"** 1*,(*( 1.,.*( .,1.* 1,,***

1*,1'( 1,-,1 1,,** &,1 %(1) 4.*

"( /roof of monetary loss Ipening net monetary assets H+one in opening balance sheet) 1,*(1 1,*(1 1,*** %(1)

Increase in net monetary assets in end of year monetary units 1,*** x 1,*=11* !losing net monetary assets +et monetary loss !ash only

!haplin Gtd 6 5eal terms accounting %5T3 !// superimposed on 5!)

Income statement for the year ending .1 <ecember using closing 5! 5evenues %(*,*** x 1,*=11*) !ost of sales %&*,*** x 1.*=1**) Kross profit <epreciation %",*** x 11*=1**) 5eplacement cost operating profit Kain on net monetary liabilities %see !//3 !haplin Gtd accounts above ) Iperating profit including monetary gain 2olding gains 5eal realised holding gain on inventory %'-,*** 6 ',,***) 5eal realised holding loss on plant and e0uipment %","** 6 ",-**) 5eal unrealised holding gain on inventory %1*1,'"* 6 (-,1-,) 5eal unrealised holding loss on plant and e0uipment %.(,&** 6 ".,,**) 5eal unrealised holding gain on land and buildings %1.4,*** 6 1.,,***) +et profit 7alance sheet as at .1 <ecember +on current assets Gand and buildings /lant and e0uipment !urrent assets Inventory Trade receivables ,*O1 A ,*O1 A (-,1-, '-,*** ,*,1-, ","** 14,'-, ,,*** 1','-, &,*** %"**) .,44%.,&**) .,***

-,44,&,."* ,*O1 A 1.4,*** .(,&** 1'",&**

,*O1 A

H$aluationJ %.&,*** x 11*=1**) %(*,*** x 1.*=114) 1*1,'"* (*,*** 1(1,'"* 4*,***

!urrent liabilities +et current assets Total assets less current liabilities +on current liabilities #0uity Irdinary share capital !apital maintenance adjustment to maintain financial capital in real terms H%,**,*** x 1,*=1**) 6 ,**,***J 5etained earnings

1"1,'"* .1&,."* 4*,*** ,&&,."* ,**,*** "*,*** ,"*,*** ,&,."*

4*
Total e0uity 3lternative calculation of real holding gains using indices 5eal realised holding gain on inventory 5eal realised holding loss on plant 5eal unrealised holding gain on inventory 5eal unrealised holding loss on plant 5eal unrealised holding gain on land Total real holding gains 5! 6 %&*,*** x 1.*=1**) !// 6 %&*,*** x 1,*=1**) 5! 6 %",*** x 11*=1**) !// 6 %",*** x 1,*=1**) 5! 6 %(*,*** x 1.*=114) !// 6 %(*,*** x 1,*=11*) 5! 6 %.&,*** x 11*=1**) !// 6 %.&,*** x 1,*=1**) 5! 6 %valuation) !// 6 %11*,*** x 1,*=1**) A '-,*** ',,*** ","** ",-** 1*1,'"* (-,1-, .(,&** ".,,** 1.4,*** 1.,,*** ,&&,."* A &,*** %"**) .,44%.,&**) .,*** -,44-

The calculations above differ from those presented in the suggested solution on pp 1,( 6 1.* of the textbook. The only numbers that are in complete agreement as between the two analyses of real holding gains are the figures for the gain on net monetary liabilities of A,,***, the real unrealised holding gain on land and buildings of A.,*** and %given the rounding error of A1) the real unrealised holding gain on closing inventory of A.44- %textbook A.44').

Ine of the reasons for the differences between the two suggested solutions is because the textbook has decided to determine 5! operating income on the basis of average replacement cost for both the inventory and the plant and e0uipment. This results in significant differences in the reported holding gains for these assets.

41

Income statement for the year ending .1 <ecember using average 5! 5evenues %(*,*** x 1,*=11*) !ost of sales H%&*,*** x 114=1**) x 1,*=11*J Kross profit <epreciation PH%"*,*** x 1*4=1**) x 1*BJ x 1,*=11*Q Iperating profit based on average replacement cost Kain on net monetary liabilities Iperating profit including monetary gain 2olding gains 5eal realised holding gain on inventory %'4,,'. 6 ',,***) 5eal realised holding loss on plant %",4-, 6 ",-**) 5eal unrealised holding gain on Inventory %1*1,'"* 6 (-,1-,) 5eal unrealised holding loss on plant %.(,&** 6 ".,,**) 5eal unrealised holding gain on land and buildings %1.4,*** 6 1.,,***) +et profit

,*O1 A

,*O1 A (-,1-, '4,,'. ,,,(*( ",4-, 1-,.,' ,,*** ,*,.,'

.,,'. %,1-) .,44%.,&**) .,***

&,*1. ,&,."*

+otice that because the costs charged against sales are lower using average rather than closing replacement costs, the operating profit is higher and the holding gains reported are lower.

The reason for the adjustment headed @<epreciation1 in the textbook in note , on page 11- is obscure. In any case, as the figures stand, the number computed turns out to be A %&") and not A1-, as stated. 7ecause the preceding calculation is done on original cost and not net book value, this additional depreciation adjustment is unnecessary in this calculation. In any case, the suggested solution in the textbook seems to be using average replacement costs in the fully stabilised accounts although the textbook solution to the !haplin 0uestion for the replacement cost accounts calculated the realised holding gain relevant to depreciation using closing replacement costs %see page --).

4, The cost of sales adjustment in the core text %p. 11-) with reference to the real realised holding gain on opening inventory is incorrect computationally. The textbook1s intention would seem to be to uplift the opening inventory figure to average replacement cost: in order to do so, however, the index re0uired is 114=1** and not 114=11* as printed. Ince uplifted, the real realised holding gain %at average) is determined by deducting the opening inventory adjusted to average !//. If this is computed correctly, the figure at this point would be A.,***. The final fraction uplifts this real realised holding gain on inventory from average into closing pounds and results in the figure of A.,,'. shown.

!haplin Gtd 6 8uggested 8olution to !urrent !ost 3ccounts

Income statement year ending .1 <ecember HextractJ +otes 2istorical cost profit !urrent cost operating adjustments !ost of sales <epreciation ;onetary working capital !urrent cost operating profit Kearing adjustment !urrent cost operating profit attributable to shareholders ,*O1 A ,*O1 A ,&,*** 1 , . " (,*** ,** ",&14

1.,-14 1,,1-4 ,,.,1",41.

7alance sheet as at .1 <ecember +on current assets Gand and buildings /lant and e0uipment !urrent assets Inventory Trade receivables

,*O1 A

,*O1 A 1.4,*** .(,&** 1'",&**

%valuation) %.&,*** x 11*=1**) %(*,*** x 1.*=114) 1*1,'"* (*,*** 1(1,'"* 4*,***

!urrent liabilities +et current assets Total assets less current liabilities +on current liabilities #0uity

1"1,'"* .1&,."* 4*,*** ,&&,."*

4.
Irdinary share capital 5etained earnings !urrent cost reserve Total e0uity +ote 1 !ost of sales adjustment !ost of sales at average replacement cost %&*,*** x 114=1**) !ost of sales on an historical cost basis !ost of sales adjustment %!I83) , <epreciation adjustment <epreciation at average replacement cost %",*** x 1*4=1**) 2istorical cost depreciation <epreciation adjustment %<3) +ote that the suggested solution in the textbook calculates the depreciation adjustment as A"** based upon year end replacement costs. The Kuidance +otes to 883/ 1& calculate the depreciation adjustment using average replacement cost. . ;onetary working capital adjustment Ipening monetary working capital %trade receivables less trade payables) !losing monetary working capital %(*,*** 6 4*,***) Increase in monetary working capital Ipening ;W! at average replacement cost %nil x 114=1**) Increase in ;W! at average replacement cost %"*,*** x 114=114) !losing ;W! at average replacement cost should be U !losing ;W! at average replacement cost is actually U %"*,*** x 114=1.*) ;onetary working capital adjustment " Kearing adjustment Ipening e0uity capital !losing e0uity capital 3verage e0uity capital %,**,*** F ,&&,."*) divided by , 3verage loan capital %4*,*** F 4*,***) divided by , 3verage gearing percentage H4*,***=%4*,*** F ,..,1'*)J x 1** Kearing adjustment %1.,1-4 x 1'.&&B) 4 !urrent cost reserve !urrent cost operating adjustments Kearing adjustment >nrealised holding gain on land and buildings %1.4,*** 6 11*,***) >nrealised holding gain on plant and e0uipment %.(,&** 6 .&,***) >nrealised holding gain on inventory %1*1,'"* 6 (*,***) !urrent cost reserve A nil "*,*** "*,*** nil "*,*** "*,*** .4,.-4 ",&14 A ,**,*** ,&&,."* ,..,1'* 4*,*** 1'.&& ,,.,A 1.,-14 %,,.,-) ,4,*** .,&** 11,'"* 41,-,' ",,** ",*** ,** &(,*** &*,*** (,*** ,**,*** 1",41. 41,-,' ,&&,."* A

%note 4)

4"

#xercise '.1 3 suggested solution to this exercise is to be found on the student side of the textbook1s companion website 6 www.cengage.co.uk=abj"e.

#xercise '.,

Keneral indices are certainly more useful than specific indices when it comes to adjusting for price changes in the 4 and 1* year summaries of financial performance disclosed by listed companies in their published accounts. 5emember that the use of a general index is not an asset valuation techni0ue.

#xercise '..

The figure of A,"*,*** represents the e0uivalent in end of year monetary units of the same amount of purchasing power commanded by A,**,*** start of year monetary units.

#xercise '."

To no extent whatsoever. !//3 is not a valuation system. +ote however that !// balance sheet figures are re0uired to be adjusted downwards when +5$ figures are lower %see /883/ ().

44

#xercise '.4

The adjustments are just as hard to apply %e.g. the proof of the monetary gain or loss arising for the year) as they are to explain and interpret. This is because !//3 adopts a different unit of measurement to the more commonly used monetary unit, i.e. the purchasing power unit. This change of measuring unit is implicit rather than explicit but nevertheless underlies the use of the general price indices to adjust the 2! amounts to their e0uivalent !// amounts in both the income statement and the balance sheet.

#xercise '.&

/age plc 6 !urrent /urchasing /ower 3ccounts

Income statement year ending .1 <ecember 5evenues !ost of sales Ipening inventory /urchases !losing inventory Kross profit #xpenses <epreciation +et operating profit ;onetary loss +et profit %1,-4* x ,"*=,.*) %1** x ,"*=,14) %1,.4* x ,"*=,.*) %14* x ,"*=,.4) %.** x ,"*=,.*) %1** x ,"*=1-*) %see below)

,*OA***s

,*OA***s 1,(.*

11, 1,"*( 1,4,1 14. .1. 1..

1,.&4&, ""& 11& 1. 1*.

4&

7alance sheet as at .1 <ecember +on current assets !urrent assets Inventory Trade receivables !ash and cash e0uivalents !urrent liabilities +et current assets #0uity brought forward %balancing figure) 5etained earnings for the ,*O- financial year %see above) Total e0uity /roof of monetary loss Ipening net monetary assets %,** F 14* 6 .**) !losing net monetary assets %.** F .4* 6 "**) Increase in net monetary assets %1** x ,"*=1-*) %see above)

,*OA***s

,*OA***s 1..

14. .** .4* -*. "** "*. 4.& ".. 1*. 4.& A***s A***s 4* ,4* ,**

Ipening net monetary assets at closing index %4* x ,"*=,,*) Increase in net monetary assets at closing index %,** x ,"*=,.*) !losing net monetary assets should be U !losing net monetary assets are actually U ;onetary loss

4" ,*( ,&. ,4* 1.

The lack of information in the 0uestion prevents further analysis of the !// e0uity figure brought forward 6 we are not told when the capital was first introduced or how retained earnings have accrued prior to ,*O-. 2owever, the figure of ".. can be proved in total in a manner which verifies it as correct independently of the ,*Oincome figure by using the data in the ,*O' balance sheet together with the appropriate indices.

4'

!alculation of net assets in !// terms as at .1 <ecember +on current assets Inventory +et monetary assets %,** x ,,*=1-*) HroundingJ %1** x ,,*=,14) %,** F 14* 6 .**)

,*O' A***s ,"4 1*, 4* .(' "..

+et assets as at .1 <ecember ,*O' in pounds of .1 <ecember ,*O' +et assets as at .1 <ecember ,*O' in pounds of .1 <ecember ,*O- %.(' x ,"*=,,*)

The net assets figure is of course e0uivalent to the e0uity figure. The ".. is no longer merely a balancing figure and has been proved independently of the ,*O- !// income.

#xercise '.'

!algary plc 6 8uggested 8olution to !urrent !ost 3ccounts

!algary plc is a very demanding !!3 0uestion compared to the previous !haplin Gtd example. 2aving said that, the procedure for the construction of a set of accounts on a current cost basis is relatively formulaic in that it will always start with the calculation of the current cost operating adjustments for depreciation, cost of sales and monetary working capital. 3t this point a preliminary income statement may be calculated to provide a check figure for current year retained income. The next adjustment re0uired to be calculated is the gearing adjustment but in order to compute this we need to calculate the average gearing ratio for the year on a current cost basis. This re0uires the preparation of opening and closing balance sheets on a current cost basis %an abbreviated form will suffice at this stage), together with an analysis, as far as

4possible, of the current cost reserve. Ince this has been done, the gearing adjustment may be calculated and the final accounts prepared.

+ote 1 <epreciation adjustment <epreciation charge at average replacement cost %,"* x &&1=&1*) 2istorical cost depreciation for the ,*O" year %"-* 6 ,"*) <epreciation adjustment , !ost of sales adjustment Ipening inventory at average replacement cost %&4* x "",=",.) !losing inventory at average replacement cost %(** x "",="4&) Increase in value of inventory due to volume of activity Total increase in value of inventory %(** 6 &4*) !ost of sales adjustment %increase in value of inventory due to price changes) . ;onetary working capital adjustment Ipening monetary working capital %-.* 6 '(*) !losing monetary working capital %1,.** 6 1,*&*) Increase in monetary working capital Ipening ;W! at average replacement cost %"* x "",=".1) Increase in ;W! at average replacement cost %,** x "",="",) !losing ;W! at average replacement cost %,"* x "",="&,) ;onetary working capital adjustment

A***s

,&*.1 ,"*.* ,*.1

&'(., -',." 1(.., ,4*.* 4&.-

"*.* ,"*.* ,**.* "1.* ,**.* ,"1.* ,,(.& 11."

Income statement year ending .* Vune %before gearing adjustment) /rofit before interest and tax !urrent cost operating adjustments <epreciation !ost of sales ;onetary working capital !urrent cost operating profit Interest payable Tax <ividends 5etained income %check figure)

,*O" A***s

,*O" A***s 1,4&*.*

,*.1 4&.11." 1"*.* .**.* .**.*

--.. 1,"'1.' '"*.* '.1.'

4(

7alance sheet as at .* Vune ,*O. %opening in abbreviated form) Gand /lant and machinery %1,4** x ,"1=,1.) %(&* x &"(=&1*)

,*O. A***s

,*O. A***s 1,&('., 1,*,1." ,,'1-.&

Inventory %&4* x ".1=",.) Ither net current assets %-.* F 1* 6 '(*) Total assets less current liabilities Goan #0uity Irdinary share capital 5etained earnings !urrent cost reserve Total e0uity

&&,.. 4*.*

'1,.. .,".*.( '**.* ,,'.*.( 1,*"*.* 1,",*.* ,'*.( ,,'.*.( A***s 1('., &1." 1,.. ,'*.(

%see below)

!alculation of current cost reserve as at .* Vune ,*O. Gand %1,&('., 6 1,4**.*) /lant and machinery %1,*,1." 6 (&*.*) Inventory %&&,.. 6 &4*.*) !urrent cost reserve as at .* Vune ,*O. 7alance sheet as at .* Vune ,*O" %closing in abbreviated form) Gand /lant and machinery %1,4** x ,-(=,1.) %',* x &(1=&1*) (11.-&*.* ,*O" A***s

,*O" A***s ,,*.4., -14.& ,,-4*.1,''1.",&,,.& '**.* .,(,,.& 1,*"*.* ,,141.' '.*.( .,(,,.&

Inventory %(** x "&,="4&) Ither net current assets %1,.** F &,* 6 1,*&*) Total assets less current liabilities Goan #0uity Irdinary share capital 5etained earnings !urrent cost reserve Total e0uity

%1,",*.* F '.1.') %check figure) %see below)

!alculation of current cost reserve as at .* Vune ,*O" %before gearing adjustment) Gand %,,*.4., 6 1,4**.*) /lant and machinery %-14.& 6 ',*.*) Inventory %(11.- 6 (**.*) !urrent cost operating adjustments %,*.1 F 4&.- F 11.") !urrent cost reserve as at .* Vune ,*O" %before gearing adjustment)

A***s 4.4., (4.& 11.--.. '.*.(

&*

!alculation of gearing adjustment Ipening and closing e0uity at current cost <educt cash and cash e0uivalents 3djusted shareholders1 interest at current cost 3verage shareholders1 interest at current cost Ipening and closing non current liabilities loan <educt cash and cash e0uivalents +et borrowings 3verage net borrowings 3verage gearing ratio HP.-4.*=%.,*11.- F .-4.*)Q x 1**J Kearing adjustment %--.. x 11..B)

A***s .,(,,.& &,*.* .,.*,.&

A***s ,,'.*.( 1*.* ,,',*.( .,*11.-

'**.* &,*.* -*.*

'**.* 1*.* &(*.* .-4.* 11.. 1*.*

!urrent cost income statement year ending .* Vune %extract) /rofit before interest and tax !urrent cost operating adjustments <epreciation !ost of sales ;onetary working capital !urrent cost operating profit Interest payable Kearing adjustment !urrent cost profit attributable to shareholders Tax /rofit after tax <ividends 5etained earnings for year 5etained earnings brought forward 5etained earnings carried forward

,*O" A***s

,*O" A***s 1,4&*.*

,*.1 4&.11." 1"*.* 1*.*

--.. 1,"'1.' 1.*.* 1,."1.' .**.* 1,*"1.' .**.* '"1.' 1,",*.* ,,1&1.'

&1

!urrent cost balance sheets as at .* Vune +on current assets Gand /lant and machinery at gross current cost 3ccumulated depreciation on plant and machinery !urrent assets Inventory Trade receivables !ash and cash e0uivalents !urrent liabilities +et current assets Total assets less current liabilities +on current liabilities #0uity Irdinary share capital 5etained earnings !urrent cost reserve %'.*.( 6 1*.*) Total e0uity

,*O" A***s

,*O" A***s ,,*.4.,

,*O. A***s

,*O. A***s 1,&('.,

1,.4(.. 4"..'

-14.& ,,-4*.-

1,,'&.' ,44..

1,*,1." ,,'1-.&

(11.1,.**.* &,*.* ,,-.1.1,*&*.* 1''1.",&,,.& '**.* .,(,,.& 1,*"*.* ,,1&1.' ',*.( .,(,,.&

&&,.. -.*.* 1*.* 1,4*,.. '(*.* '1,.. .,".*.( '**.* ,,'.*.( 1,*"*.* 1,",*.* ,'*.( ,,'.*.(

3nalysis of current cost reserve 6 method of updating brought forward balance 7alance brought forward 1 Vuly ,*O. #liminate gain on opening inventory sold during the year 5eplace with gain on closing inventory >pdate gain on land %gross !! value) %,,*.4., 6 1,&('.,) >pdate gain on plant and machinery %gross !! value) %1,.4(.. 6 1,,'&.') Gess current year depreciation on plant and machinery %at average current cost) 7acklog depreciation 6 current year H,"* x %&(1 6 &&1)=&1*J 7acklog depreciation 6 previous year H,"* x %&(1 6 &"()=&1*J !urrent cost operating adjustments ,*O" Kearing adjustment ,*O" !urrent cost reserve as at .* Vune ,*O"

A***s

A***s ,'*.(

%1,..) 11...-.* -,.& %,*.1) %11.-) %1&.4) --.. %1*.*)

"4*.* ',*.(

The adjustment of the brought forward current cost reserve to the carried forward current cost reserve using the above method will always involve the calculation of backlog depreciation. 2owever, its correct computation will always be challenging,

&, especially where the depreciation adjustment has been based on average current cost as the calculations below illustrate.

3nalysis of movements on accumulated depreciation at current cost 7rought forward depreciation at current ,*O. cost %1,,'&.' x ,*B) 3dd previous year1s backlog depreciation %see above) >pdated brought forward depreciation at current ,*O" cost %1,.4(.. x ,*B) !urrent year1s historical cost depreciation charge %1,,** x ,*B) !urrent year1s depreciation adjustment at average current cost !urrent year1s backlog depreciation %see above) !arried forward depreciation at current cost %1,.4(.. x "*B)

A***s

A***s ,44.. 1&.4 ,'1.-

,"*.* ,*.1 11.-

,'1.( 4"..'

The difference between the ,*O. and ,*O" depreciation figures is a rounding error of *.1. #xercise '.-

Kiven the indices in the 0uestion, the report should at least mention the following possible methods of accounting for price level changes: !//3, 5!3, 5T3 and !!3 %as far as the <3 and the !I83).

In general the indices reveal that prices are rising but that they are rising faster for the company1s machinery and raw materials. In the 2! income statement reported profits are likely to be overstated because, although selling prices are keeping pace with general inflation, the cost charged against these current selling prices in the cost of sales and in the depreciation charge are not current but are based on outdated 2!s. This is especially true for the depreciation charge. 9or example, with reference to a machine originally costing A1**,***, the company only charges annual 2!

&. depreciation in the income statement of A,*,***. 2owever, the current replacement cost of this machine new, according to the machine price index, would be "*B higher at A1"*,***. Therefore, in order to ensure that the business has sufficient resources to replace the old asset with a new one, the annual depreciation charge should be at least A,-,*** 6 2! profit would be lower and the dividend correspondingly reduced, depending on the payout ratio %which the data seem to indicate is well in excess of 4*B).

2owever, the above analysis assumes that the company wishes to maintain intact its physical capital, defined as the current replacement cost of its machinery and raw materials. 3n alternative to this is financial capital maintenance which concept consists of maintaining the value of shareholders1 e0uity defined in terms of spending power as measured by the 5/I. 9or example, assume that . years ago e0uity was A1**,***. Kiven that the major portion of the annual profit is paid out as a dividend, it may be assumed that e0uity is currently at a similar monetary amount. 2owever, although similar in monetary terms, the two amounts are far from comparable in real terms because the 5/I has risen by 1,B over the intervening period. The number of today1s monetary unit e0uivalent to the spending power embodied in A1**,*** . years previously is hence A11,,***. 8etting aside an extra A1,,*** reduces reported 2! profit and the dividend.