FAR661 Topic 4 Merged PDF

The conceptual Framework Part 1(A) DEVELOPMENT, THEORIES AND ACCOUNTING POSTULATES SAM/UITM/PA  The definition….. … a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards and that prescribes the nature, fun...

The conceptual Framework Part 1(A) DEVELOPMENT, THEORIES AND ACCOUNTING POSTULATES SAM/UITM/PA  The definition….. … a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards and that prescribes the nature, function and limits of financial accounting and reporting. SAM/UITM/PA Development of a Conceptual Framework For Financial Reporting SAM/UITM/PA SAM/UITM/PA SAM/UITM/PA International Accounting Standard Board (IASB) Framework SAM/UITM/PA SAM/UITM/PA The development of conceptual frameworks is Developing a influenced by two key issues: 1. principles versus rules-based approaches to conceptual standard setting framework 2. information for decision making and the decision-theory approach  IASB mostly produces consistent, coherent principles- based standards Rule-based standards may increase comparability and verifiability and may reduce earnings management Principles-based and rule-based The standards of the FASB have traditionally been rule-based standard setting Emphasis now being given to principles Timely given the IASB/FASB convergence program SAM/UITM/PA SAM/UITM/PA Information for decision making and the decision-theory approach Accounting data are required for decision making or accountability purposes Information for decision making / stewardship Information for decision making implies more than information on stewardship i. The users of financial information are greatly expanded to include all resource providers, recipients of goods and services and parties performing a review or oversight function ii. Accounting information is seen as input data for the prediction models of users; What kind of accounting information is relevant to the prediction models of users iii. Stewardship is mainly concerned with the past in order to assess what has been accomplished, prediction look towards the future. For external users is based on past events What is the most relevant value for decision making ? Historical cost, current value?  The debates: SAM/UITM/PA SAM/UITM/PA SAM/UITM/PA … POSTULATE & THEORY SAM/UITM/PA The structure of an accounting theory The structure of an accounting theory contains the following elements: a statement of the objectives of financial statements a statement of the postulates and theoretical concepts of accounting concerned with the environmental assumptions and the nature of the accounting unit a statement of the basic accounting principles a body of accounting techniques SAM/UITM/PA  Objectives of financial statements The The postulates of theoretical accounting concepts of accounting The principles of accounting The accounting techniques SAM/UITM/PA  Important terms Formulating the objectives of accounting depends on resolving the conflict interest that exist in the information market Accounting postulates are self-evident statements or axioms, generally accepted by virtue of their conformity to the objectives of financial statements, that portray the economic, political, sociological and legal environments in which accounting must operate Postulates mean held as true/assumptions SAM/UITM/PA  The theoretical concepts of accounting are also self-evident statements or axioms, also generally accepted by virtue of their conformity to the objective of financial statements, that portray the nature of accounting entities operating in a free economy characterized by private ownership of property. The accounting principles are general decision rules, derived from both the objectives and theoretical concepts of accounting, that govern the development of accounting techniques. The accounting techniques are specific rules derived from the accounting principles that account for specific transactions and events faced by accounting entity. SAM/UITM/PA  Formulating the objective of accounting- Conflicts of interest Financial statements result from the interaction of three groups: firms, which by their operational, functional and extraordinary activities, justify the production of financial statements users, which include investors, financial analysts, bankers, creditors, consumers, employees, suppliers and government agencies. Production of accounting information based on their interest and needs the accounting profession, which acts principally as ‘auditor’ in charge of verifying that financial statements conform to generally accepted accounting principles SAM/UITM/PA  The entity postulates The The going concern postulate Accounting The unit of measure postulate Postulate The accounting period postulate SAM/UITM/PA  Accounting measures the results of the operation of specific entities which are separate and distinct from owners of entity This postulate hold that each enterprises is an accounting unit separate and distinct 1)The Entity from its owners and other firms Postulate Report the entity’s transaction rather than personal transaction Recognize the fiduciary duties of management to shareholders SAM/UITM/PA  This postulate holds that the business entity will continue its operations long enough to recognize its projects, 2) The commitments and ongoing activities going- concern The postulate assumes that the entity is not expected to postulate be liquidated in the foreseeable future or that the entity will continue for an indefinite period of time SAM/UITM/PA  Accounting is a measurement and communication process of the activities of the firm that are measurable in monetary terms 3) The unit Limitations apply: of measure accounting is limited to the prediction of information postulate expressed in terms of the monetary unit accounting does not record or communicate other relevant information Should units of money or units of general purchasing power be used? SAM/UITM/PA  This postulate holds that financial reports depicting 4) The changes in the wealth of a firm should be disclosed periodically accounting- period postulate This postulate imposes accruals and deferrals SAM/UITM/PA  The proprietary theory The Theoretical Concept The entity theory The fund theory SAM/UITM/PA  The entity is the ‘agent, representative or arrangement through which the individual entrepreneurs (proprietaries) or shareholders operate’ The proprietor group as the centre of interest is reflected in the ways in which accounting records are kept and financial statements are prepared The proprietary theory Assets – Liabilities = Proprietor’s Equity (eg of implication- For example, ‘net income’ of a company, which is arrived at after treating interest and income taxes as expense, represents “net income to equity share holders” rather than to all providers of capital. Similarly, terms such as “earnings per share”, “Book value per share,” and “dividend per share” indicate a proprietary emphasis. SAM/UITM/PA  This theory views the entity as something separate and distinct from those who provide capital to the entity This view sees the business unit, rather than the proprietor, as the centre of accounting interests The entity theory Assets = Liabilities + Shareholders’ Equity Implication - income earned is the property of the entity until distributed as dividends to the shareholders. Because the business unit is held responsible for meeting the claims of the equity holders, the entity theory is said to be income centered and consequently, income statement oriented. Accountability to the equity holders is accomplished by measuring the operating and financial performance of the firm. (wealth maximization) SAM/UITM/PA The fund theory Under the fund theory, the basis of accounting is neither the proprietor nor the entity, but a group of assets and related obligations and restrictions called a ‘fund’ Fund theory is useful primarily to government and non-profit organizations SAM/UITM/PA  The conceptual Framework Title Lorem Ipsum PA R T 1 ( B ) - T H E ACCOUNTING PRINCIPLES SAM/UITM/PA  The Accounting Principle ❑ The cost principle ❑ The revenue principle ❑ The matching principle ❑ The objectivity principle ❑ The consistency principle ❑ The full disclosure principle ❑ The conservatism principle ❑ The materiality principle ❑ The uniformity and comparability principle SAM/UITM/PA  The cost principle The acquisition cost or historical cost is the appropriate valuation basis for recognition of the acquisition of all goods and services, expenses, costs and equities The cost principle is justified both in terms of its objectivity and the going-concern postulate: acquisition cost is objective, verifiable information the entity will continue indefinitely, therefore current values or liquidation values for asset valuation are not necessary SAM/UITM/PA  The revenue principle The revenue principle specifies: 1. the nature and components of revenue 2. the measurement of revenue 3. the timing of revenue recognition SAM/UITM/PA  The nature and components of revenue An inflow of net assets resulting from the sale of goods or services An outflow of goods or services from the firm to its customers A product of the firm resulting from the mere creation of goods or services by an enterprise during a given period of time SAM/UITM/PA  The measurement of revenue Measured in terms of the value of the products and services exchanged in an arms-length transaction Two interpretations: cash discounts and any reductions in the fixed prices should be deducted when computing revenue for non-cash transactions, the exchange value is set equal to the fair market value of the consideration given or received SAM/UITM/PA  Timing of revenue recognition According to the American Accounting Association Committee on Concepts and Standards, specific criteria for revenue and income recognition are: it must be earned in one sense or another it must be in distributable form it must be the result of a conversion brought about in a transaction between the enterprise and someone external to it it must be the result of a legal sale or similar process SAM/UITM/PA  Timing of revenue recognition (cont’d) it must be severed from capital it must be in the form of liquid assets both its gross and net effects on shareholder equity must be estimable with a high degree of reliability SAM/UITM/PA  The matching principle Expenses should be recognized in the same period as the associated revenues The association between revenues and expenses depends on one of four criteria: 1. direct matching of expired costs with a revenue 2. direct matching of expired costs with the period 3. allocation of costs over periods benefited 4. expensing all other costs in the period incurred, unless they have future benefit SAM/UITM/PA  The objectivity principle This principle holds that the usefulness of financial information depends on the reliability of the measurement procedure used There are different interpretations of this objectivity: an objective measurement is an impersonal measure an objective measurement is a very viable measurement an objective measurement is the result of consensus among a given group of observers the size of the dispersion of the measurement distribution may be used as an indicator of the degree of objectivity SAM/UITM/PA  The consistency principle This principle holds that similar economic events should be recorded and reported in a consistent manner from period to period The consistency principle makes financial statements more comparable and more useful. SAM/UITM/PA  The full-disclosure principle This principle holds that no information of substance or of interest to the average investor will be omitted or concealed This principle is enforced by various disclosure requirements within the national and international accounting standards setters. SAM/UITM/PA  The conservatism principle This principle holds that when choosing between two or more acceptable accounting techniques, some preference is shown for the option that has the least favorable impact on shareholders’ equity. At present, the emphasis on objective and fair presentation has lessened the reliance on conservatism. SAM/UITM/PA  The materiality principle Transactions and events having insignificant economic effects need not be disclosed According to AAS 5, an item of information is material ‘if its omission, non-disclosure or mis-statement would cause the financial statements to mislead users when making evaluations or decisions. SAM/UITM/PA  Two basic criteria for determining materiality The size approach relates the size of the item to another relevant variable such as net income The change criterion approach evaluates the impact of an item on trends or changes between accounting periods SAM/UITM/PA  The uniformity and comparability The consistency principles refers to the use of the same procedures for related items by a given firm over time The uniformity principles refers to the use of the same procedures by different firms. The objective of this approach is to achieve comparability of financial statements by reducing the diversity created by the use of different accounting procedures by different firms. SAM/UITM/PA  Principle supports for uniformity Principal supports for uniformity are that it: Diversification reduces the diverse use of accounting procedures and the inadequacies of accounting practices Comparability allows meaningful comparisons of the financial statements of different firms Confidence restores the confidence of users in the financial statements Regulation leads to governmental intervention and the regulation of accounting practices SAM/UITM/PA  Principle supports for flexibility Principal supports for flexibility are that: the use of uniform accounting procedures poses the risk of concealing important differences among cases comparability is a utopian goal that ‘cannot be achieved by the adoption of firm rules that do not take adequate account of different factual situations’ ‘differences in circumstances’ or ‘circumstantial variables’ call for different treatments so that corporate reporting can respond to circumstances in which transactions and events occur. SAM/UITM/PA  ⮚ May be useful for financial assets/liabilities but not to conventional assets, such as property, plant, equipment and intangible assets with no open market values or traded in open market. ⮚ For self-generated financial assets and liabilities such as debtors and creditors, measurement of fair values based on market prices or discounted cash flows would appear to be at odds with the contractual arrangements between contracting parties. ⮚ In less efficient or thinly traded market, prices may not reflect fair values and are also likely to fluctuate widely. ⮚ Introduce volatility in reporting performance due to external and market forces. SAM/UITM/PA  DISCUSSION ON CONCEPTUAL FRAMEWORK PART : THE DEFINITION AND THE DEVELOPMENT SMA/UITM/PA The definition ◦ …… CF is a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards and the prescribes the natures, function and limits of financial accounting and reporting SMA/UITM/PA The need for conceptual framework Assist accounting standards setter in standard setting Provide a basis for selection of alternative principles Provide a basis for reconciling any differences Assist preparers in absence of standards Assists auditors in forming opinions Assist users in interpreting financial statements Provide transparency in standard setting Facilitate communication SMA/UITM/PA The need for conceptual framework According to standard setters, the following situations demonstrate the need for a conceptual framework: ⚫ Two or more methods of accounting are accepted for the same facts ⚫ Less-conservative accounting methods are used rather than earlier, more conservative methods ⚫ Reserves are used to artificially smooth earnings fluctuations ⚫ Financial statements fail to warn of impending liquidity crunches ⚫ Deferrals are followed by ‘big bath’ write-offs ⚫ There is unadjusted optimism in estimates of recoverability ⚫ Off balance-sheet financing is common ⚫ An unwarranted assertion of immateriality has been used to justify non-disclosure of unfavourable information or departures from standards ⚫ Form is relevant over substance Basically these are creative accounting issues SMA/UITM/PA  Recognition, measurement and disclosure concepts Third level ASSUMPTIONS PRINCIPLES CONSTRAINTS QUALITATIVE ELEMENTS – of CHARACTERISTIC financial S – of accounting statements Second level information An Overview of OBJECTIVE of financial Conceptual reporting First level Framework SMA/UITM/PA Malaysia Conceptual Framework Similar to Conceptual Modified to suit Developed by MASB Framework for Malaysian economic in November 2011 Financial Reporting as environment and issued by IASB needs SMA/UITM/PA Established under Financial Reporting Act 1997 Develops an and issues accounting and financial reporting standards in Malaysia Takes over the accounting standards setting responsibility from the local accounting professional bodies SMA/UITM/PA SMA/UITM/PA International Accounting Standard Board Operates under Develops and the oversight of Formed in 2001 approves IFRs the IFRS to replace IASC foundation Guided by IASB Framework SMA/UITM/PA Important Findings on Malaysia Conceptual Framework Objective of Financial Reporting Qualitative Characteristics of useful Financial Information SCOPE Definition, Recognition and Measurement of The Elements from which Financial Statements are constructed Concept of Capital and Capital maintenance SMA/UITM/PA Important Findings on Malaysia Conceptual Framework Objective of general purpose financial reporting Information Objective about reporting usefulness and entity economic limitations recourses claims SMA/UITM/PA Objective of general purpose financial reporting ◦ OB1: The objective of general purpose financial reporting forms the foundation of the CF. Other aspects of the CF- a reporting entity concept, the qualitative characteristics of, and the constraint on, useful information, elements of financial statements, recognition, measurement, presentation and disclosure- flow logically from the objectives Assumptions Qualitative Characteristics Constraints Objectives Recognition elements Measurement SMA/UITM/PA Objective, usefulness and limitations of general purpose financial reporting: 1. To provide financial information about the reporting entity that is useful to existing and potential investors 2. To assess and entity’s prospects for future net cash inflows, existing and potential investors, lendors and other creditors 3. To help them assess the prospects for future net cash inflows to an entity 4. Decisions by existing and potential lenders and other creditors about providing or settling loans and other forms of credit depend on the principal and interest payments or other returns that they expect SMA/UITM/PA Information about reporting entity’s economic recourses, claims, and changes in recourses and claims ◦ General purpose financial reports provide information about the financial position of a reporting entity which is information about entity’s economic recourses and the claims against the reporting entity ◦ Financial reports also provide information about the effects of transactions and other events that change a reporting entity’s economic resources and claims ◦ Both types of information provides useful input for decisions about providing resources to an entity SMA/UITM/PA Material Elements to be considered ◦ Economic resources and claims ◦ Changes in economic recourses and claims ◦ Financial performance reflected by accruals accounting ◦ Financial performance reflected by past cash flows ◦ Changes in economic recourses and claim not resulting from financial performance SMA/UITM/PA QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION SMA/UITM/PA Types of information that are most useful: Relevant Faithfully represent what is purports to represent The usefulness of information is enhanced if it is: Comparable Verifiable Timely and Understandable Provide information about the reporting entity’s Economic recourses Claims against the reporting entity and; The effects of transactions SMA/UITM/PA  (1)RELEVANCE Relevant financial information are capable of making as difference in the decisions made by the users if it has: Predictive Value Confirmatory value It can be used as an input to predict It provides feedback about(outcome or future outcomes changes) of previous evaluations Employed by users in making their own predictions Interrelated Information that have predictive value often have confirmatory value Foe example, revenue information for the current year SMA/UITM/PA  2) FAITHFUL REPRESENTATION I) Must have these 3 characteristics: COMPLETE NEUTRAL FREE FROM ERRORS Includes all information that Information are not bias in No errors or omissions in the are necessary for users to terms of selection/presentation description of the understand the phenomenon of financial information phenomenon and the process illustrated ii) A faithful representation, by itself, does not necessarily results in useful information SMA/UITM/PA  ◦ STEP 1: ◦ Identify an economic phenomenon that ahs the potential to be useful to user of the reporting APPLYING THE entity’s financial information FUNDAMENTAL ◦ STEP 2: QUALITATIVE ◦ Identify the type of information about that CHARACTERISTICS phenomenon ◦ STEP 3: ◦ Determine whether that information is available and can be faithfully represented SMA/UITM/PA  ENHANCING QUALITATIVE CHARACTERISTICS 1)COMPARABILITY 2) VERIFIABILITY 1. Involves choosing between alternatives 1. It means that different konowledgable and 2. More useful if it can be compared independent observes could reach 3. Enables users to identify and understand consensus similarities and differences 2. Two types: 4. Comparability -consistency direct- direct observations Indirect- checking the inputs through methods 3) TIMELINESS 4) UNDERSTANDABILITY 1. It means having information available to 1. Classifying, characterizing and presenting decision –makers in the time to be capable information clearly and concisely of influencing their decisions 2. Even well-informed and diligent users may 2. The older the information, the less useful it is have trouble to understand information about complex economic phenomenon SMA/UITM/PA THE COST CONSTRAINT ON USEFUL FINANCIAL REPORTING Costs are justified by the benefits of reporting information The Board assesses whether the benefits justify the costs incurred to provide and use that information The Board seeks information about the expected nature & quantity of the benefits and costs Different individuals’ assessments of the costs and benefits will vary Therefore, the Board seeks to consider costs and benefits in relation to financial reporting generally SMA/UITM/PA  DEFINITION, RECOGNITION AND MEASUREMENT OF THE ELEMENTS FROM WHICH FINANCIAL STATEMENTS ARE CONSTRUCTED OF FIANNCIAL STATEMENTS STATEMETS ELEMENT OF FINANCIAL RECOGNITON OF THE ELEMENTS MEASUREMENTS Financial Position Probability of the Historical costs Assets future economic benefit Current Costs Liabilities Realisable value Reliability of Equity measurements Present Value Recognition of assets Performance: Recognition of Income liabilities Expenses Recognition of income Capital Maintenance Recognition of expenses Adjustments SMA/UITM/PA  FINANCIAL POSITION Attention needs to be given to its underlying substance and economic reality and not merely its legal form Assets: cash and cash equivalent LIABILITIES- Giving up resources How? 1. Payment of cash 1. Production of goods/services to be sold 2. Transfer of other assets 2. Exchanged for other assets 3. Provision of services 3. Used to settle liability 4. Replacement of that obligation with 4. Distributed to the owners of the entity another obligation 5. Conversion of the obligation to equity Physical form not essential to existence of assets EQUITY – sub classification Associated with legal rights, but right of 1. Decision making for users ownership not essential 2. Indicate legal or other restrictions on the ability of the entity to distribute or otherwise apply its equity SMA/UITM/PA  PERFORMANCE 1. Profit frequently used as a measure of performance, eg: ROI, EPS 2. Elements directly related to measurement of profit – income & expenses 3. Recognition and measurement of profit depends in part on the concepts of capital and capital maintenance Capital Maintenance Adjustments Revaluation/restatement of assets and liabilities gives rise to increases/decreases in equity SMA/UITM/PA  RECOGNITION OF THE ELEMENTS OF FINANCIAL STATEMENTS Recognition – Process of incorporating in the balance sheet or income statement and item that meets the definition of an element and satisfies the criteria for recognition An item that meets the definition of an element should be recognize if: 1. It is probably that any future economic benefit associated with the item will flow to or from the entity 2. The item has a cost or value that can be measured with reliability In assessing whether an item meets these criteria, therefore qualifies for recognition in the financial statements, regards needs to be given to the materiality considerations Interrelationship between elements means that an item that meets the definition and recognition criteria for particular elements requires the recognition or another element. Eg: Assets-→ income/liability SMA/UITM/PA Probability of future Economics Benefit Recognition of Assets: Recognized when it is probable that the future Degree of uncertainty that future economic economic benefits will flow to the entity and the benefits associated with the item will flow to or assets has a cost/value that can be measured from the entity reliably Eg: When it is probable that a receivable owed to Recognition of Liabilities an entity will be paid, it is then justifiable, to Recognized when it is probable that an outflow of recognize the receivables as an assets recourses embodying economic benefits will result from the settlement of the present obligation and the amount at which the settlement will take place can be measured reliably Reliability of Measurement Recognition of income Second criterion for the recognition of an items is Increase in future economic benefits related to an that can be measured with reliability increase in asset/decrease of that liability can be Use of reasonable estimates is an essential part of measured reliably the preparation of financial statements and does not undermine their reliability Recognition of Expenses When a reasonable estimate cannot be made, Decrease in future economic benefits related to the item is not recognised in the balance sheet/ decrease in asset/increase of liability can be income statement measured reliably Matching concept SMA/UITM/PA  MEASUREMENT OF THE ELEMENTS OF FINANCIAL STATEMENTS Measurement – process of determining the monetary amounts at which the elements of the financial statements are to be recognized and carried in the balance sheet and income statement Historical cots Assets recorded at amount of cash/ equivalent paid or fair value of consideration given during acquisition Liabilities recorded at the amount of proceeds received in exchange for obligation Current cots Assets carried at amount of cash/equivalent that would have be paid if the same or equivalent assets was acquired currently Liabilities carried at the undiscounted amount of cash/equivalent that would be required to settle the obligation currently SMA/UITM/PA  MEASUREMENT OF THE ELEMENTS OF FINANCIAL STATEMENTS Realisable (settlement) value Assets carried at amount of cash/equivalent that could currently be obtained by selling the asset in an orderly disposal Liabilities carried at their settlement values; the undiscounted amounts of cash/equivalent expected to be paid to satisfy the liabilities in the normal course of business Present Value Assets carried at present discounted value of the future net cash flows that the item is expected to generate in the normal course of business Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business SMA/UITM/PA  CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE Financial Concept of Capital-(invested money/purchasing power) CONCEPTS OF CAPITAL Physical concept of capital(operating capability) Capital regarded as the productive capacity of the entity SMA/UITM/PA  CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE Financial capital maintenance- (Profit is earned only if the financial amount of the net assets at the end of the period exceeds the financial amount of net assets at the beginning of the period, after excluding distributions to and contributions from owners during the period) CONCEPTS OF CAPITAL MAINTENANCE Physical capital maintenance (Profit is earned only if the physical productive capacity of the entity at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions from owners during the period) SMA/UITM/PA Similarities between Malaysia and IASB Conceptual Framework ◦ In 2008- MASB issued a statement 1. As a basis for financial reporting about their plan to bring Malaysia to 2. “convergence’ rather than “adopt” full convergence with IFRS by January 2021 3. Dual framework SMA/UITM/PA THE CONCEPTUAL FRAMEWORK PART 3: MEASUREMENT AND RECOGNITION MEASUREMENT AND RECOGNITION  The measurement basis most commonly adopted by entities in preparing their financial statements is historical cost. This is usually combined with other measurement bases. For example, inventories are usually carried at the lower of cost and net realisable value, marketable securities may be carried at market value and pension liabilities are carried at their present value. Furthermore, some entities use the current cost basis as a response to the inability of the historical cost accounting model to deal with the effects of changing prices of non-monetary assets. MEASUREMENT AND RECOGNITION SMA/UITM/PA  Historic cost accounting Current cost accounting financial capital maintenance (the purchasing power of the financial capital) physical capital maintenance (the physical ability to produce goods and services) Exit price accounting THREE MAIN INCOME AND CAPITAL MEASUREMENT SYSTEMS SMA/UITM/PA  Measurement of assets and liabilities is important because it affects decisions made by the users of financial statements.  Measurement affects the users’ assessment of the financial performance and position of the company.  Management compensation plans that specify that management is to be rewarded for meeting profit targets. Measurement affects the levels of profit-based bonuses paid to the managers.  Managers might try to reduce expenditure on research and development, on maintenance, or on advertising to boost current period reporting profits. Alternatively, managers might delay the purchase of assets in order to retain liquid resources to meet debts. MEASUREMENT SMA/UITM/PA WHAT DO WE MEASURE? Value characteristic of each asset and liability for accounting purposes. Several monetary values used to value the characteristics of assets and liabilities – Basically, the choice of measurement base will depend on whether the  historical cost, measurement is in terms of:  current cost and  exit price level. (a) Cost; or (b) Value. SMA/UITM/PA  Cost of acquisition of an asset is the fair value of whatever is given in exchange for the asset plus any cost incidental to the acquisition.  Fair value is defined as the amount for which an asset could be exchanged in an arm’s length transaction between a willing buyer and a knowledgeable, willing seller.  Thus, if the firm thinks that cost should provide the most reliable and relevant accounting information to the users, then the measurement bases to use would be historical cost and current cost accounting. A) COST SMA/UITM/PA Historical cost refers to the cost at the time the asset is incurred.  Objective measurement since it can be measured according to a variety of assumptions.  Example, valuation of inventory, several assumptions can being used, such as first-in-first-out, last-in-first-out and weighted average cost. Current cost refers to the amount that would be paid now to acquire the best asset available to undertake the function of the asset owned.  Focuses on cost of a currently available asset that is expected to replace the existing asset, adjusted for the value of any operating advantages or disadvantages of the assets owned. A) COST…CONT SMA/UITM/PA Refers to preference people have for some items over others because of perceived benefits to themselves. It relates to the consumer’s willingness to give up something to obtain it.  True economic value is the most useful value to the users of financial statements. However, it is a subjective concept as it relates to preference or desirability people have for one item as opposed to others.  Difficult to ascertain because there are many variables that affect the people’s preference and the value they place on the particular assets and liabilities. B) VALUE SMA/UITM/PA (b) Value  Measurement methods commonly used are exit price and net realizable value.  Exit price refers to the amount received from selling an asset either to a market for new commodity or to a second-hand market.  Net realizable value is defined as the expected selling price less expected costs of disposition. B) VALUE SMA/UITM/PA HISTORICAL COST ACCOUNTING (HCA) Accepted measuring system in published financial statement throughout the financial history. More objectively determinable and better understood than are competing valuation systems. Principal Assumptions of Historical Cost Accounting (a) Flow of Costs Trace the movement of costs attached to the goods and services as they flow through the business. Decide which costs have expired and therefore are to be matched against revenues in the profit and loss statement, and which costs remain ‘unexpired’ and are to be placed on the balance sheet statement as assets. SMA/UITM/PA (b) Stewardship Objective of HCA emphasises the “contractual relationship” between a firm and those who provide resources to it (separation of ownership and control). Function - entrusted with the firm’s assets and operating activities, “management”, are accountable for the application of assets to operations and subsequent impact on the net value of assets from these operations. Financial statements are key communication mechanisms designed to report on the stewardship functions of management. SMA/UITM/PA  REASONS FOR DOMINANCE OF HISTORICAL COST ACCOUNTING SMA/UITM/PA (a) Objectivity of Accounting is Too Narrow Objective of HCA - provide information on the stewardship function of management as rather narrow interpretation. Critics of HCA - decision-usefulness approach calls for a “forward-looking” position rather than preoccupation with the past. Investors are interested to know about the original amounts invested directly or indirectly by the equity holders, as well as the increases and decreases in value of their investment as represented by the net assets of the company. Recording, measurement and reporting of information using the historical cost system is also opened for manipulation CRITICISMS OF HISTORICAL COST ACCOUNTING SMA/UITM/PA (b) Information for Decision Making HCA is insufficient for evaluation of business decisions. When assets are acquired, their historical cost is useful because it refers to current events. However, once the period of acquisition passes, it is no longer current and therefore no longer relevant. (c) Basis of Historical Cost  HCA has ‘going concern assumption’, i.e. the life of the firm is indefinite. Inventory can be expected to be sold and non-current assets to be fully used in the business.  Therefore, historical cost of assets is the appropriate amount to be matched with revenues. However, critics say that it is the use of the non-current assets, not their possible sale or purchase that is relevant. SMA/UITM/PA  (d) Matching  No established concept exists to ascertain proper matching.  Process calling for random decisions to be made, rather than consistent analysis. There is no way to select one method over another except arbitrarily.  Sprouse (1973) argues that “traditional accounting complicate the evaluation of the financial position (balance sheet) of the company when the statement of financial position (balance sheet) is considered mainly as ‘a dumping ground for balances that someone has decided should not be included in the statement of financial performance (profit and loss statement).”  Conventional matching concept is to relegates the balance sheet to a secondary position. A summary of balances after applying the rules to determine profits, i.e. an unamortised cost. SMA/UITM/PA  (e) Notion of Investor Needs  Many investors are more concerned with psychology of market and its effect in the short term on share prices.  Conventional accounting takes for granted these aspects of the investors needs. Conventional accounting practices also emphasises current rates of return rather than long-term profitability.  Thisencourages creative accounting. There is an incentive to produce financial information that contains misleading data such as overstated revenues and assets or understated expenses and liabilities. SMA/UITM/PA CURRENT COST ACCOUNTING Replacement cost model. Basic concept of CCA - firm is a going concern and is continuously replacing its assets. Assumed that cost of consuming the assets in the profit generation process is equivalent to the cost of their replacement. Nature of Current Cost Accounting (CCA) Current cost is based on the entity concept of maintaining intact the ability of the firm to continue to deliver the same amount of goods and services - firm’s operating capacity. Assets are valued at current market buying prices SMA/UITM/PA  However, market values are often unavailable for unique fixed assets such as land, building, and heavy equipment specially designed for a particular firm, and also for used fixed assets that are not unique (even though second-hand market may exist for these assets). Therefore,in the absence of market price, CCA can be estimated by appraisal or specific index adjustment. NATURE OF CURRENT COST ACCOUNTING (CCA) SMA/UITM/PA Valuation Principles Under CCA SMA/UITM/PA Criticisms of CCA SMA/UITM/PA  Based on current buying price of assets; i.e. expensing and matching resource usage using current replacement value.  CCA values assets at their current market buying price and profit is determined using matching expense allocations based on the current cost to buy  Based on assumption : manager of the firm want to know how they should allocate the firm’s resources in order to maximise profits ( asset should held, form of assets and how assets be financed)  Budgeted (previous data) and actual (current data); to consider as useful information need to adjust future decision  Price movement in a given period are events that are important to management OBJECTIVE OF CURRENT COST ACCOUNTING SMA/UITM/PA  Manager’s decision;  Holding ; hold assets/liabilities or to dispose them  Operating decision; how to use and finance them  Managers will examine  the current operating profit  the excess of the current value of the output sold over the current cost of the related inputs  realisable cost savings  increases in the current cost of assets held by firm in the current period.  holding gains/losses  realised/unrealised  Holding certain composition of assets and liabilities is one way of management tries to enhance firm’s market position. Manager wants to know if holding activities are successful or not OBJECTIVE OF CURRENT COST ACCOUNTING SMA/UITM/PA  Under H.C.A  gains are recorded only when assets are disposed off unless disposed and purchase in the same period  comparing efficient firm may be misled ;  Mixing holding gains and operating gains confuses the evaluation of management decisions and hinders the allocation of resources in the economy.  Therefore C.C.A ; separation of holding gains and operating profit.  Why holding gain are a components of profit?= cost saving  Example: Assets was acquired in advance, firm will benefit now since there should be increase in price now. Cash saving compare to price of at the time of purchase rather than later price (now) when the price more higher HOLDING GAIN/LOSS SMA/UITM/PA  2 concepts of Financial capital maintenance capital maintenance Physical capital are; maintenance CONCEPT OF CAPITAL Main difference is financial capital include holding gain but physical MAINTENANCE capital maintenance exclude holding gain Inclusion of holding They are cost saving They represent gain as profit is increase in the future based mainly on 2 cash flow expected to be generated from arguments the use of assets SMA/UITM/PA  Financial Capital Maintenance Physical Capital Maintenance A profit is earned only if the financial or money A profit is earned only if the physical productive capacity (or amount of the net assets at the end of period exceeds operating capability) of the entity (or the resources or funds the financial (or money) amount of net assets at the needed to achieve that capacity) at the end the period beginning of the period after excluding any exceeds the physical productive capacity at the beginning distributions to or from owners during the period of the period , after excluding any distributions to or from owners during the period Capital represents the cash invested by the owners Capital maintenance involves maintaining the firm’s plus profits reinvested by retention in the business – operating capacity to replace the assets the firm had at the relate to general price level start of the period Profit is the amount of cash available to the owners Profit is only earned after the firm’s ability to replace the after maintaining the purchasing power of the opening assets has been maintained business i.e. If at the beginning of the year can buy 1000 units, any amount above being able to buy 1000 units at end of the year is profit Proprietary theory – company’s purpose is to increase Entity view, the main requirement is to maintain the ability of owner’s wealth SMA/UITM/PA the entity to carry out its functions i.e. operating capacity Nature of Exit Price Accounting (EPA) Exit price refers to the amount received from selling an asset either to a market for new commodity or to a second-hand market. EPA system uses market value/selling price to measure the firm’s financial position and financial performance. Assets are valued at net realisable amounts that the firm would expect to obtain for them if they are disposed of in the normal course of operations. Liabilities would be similarly valued at the amounts it would take to pay them off as of the statement date. Income statement for the period would be equal to the change in the net realisable value of the firm’s net assets occurring during the period, excluding the effect of capital transactions. EXIT PRICE ACCOUNTING SMA/UITM/PA Support of EPA  Providing Useful Information According to MacNeil (1970), accountants should report all profits and losses and values as determined in competitive markets. Marketable assets should be valued at market price (exit price), Non-marketable reproducible assets at replacement costs Occasional non-marketable, non-producible assets at historical costs. Income should include all profits and losses, whether realised or not. SMA/UITM/PA  Profit Concept  Exitprice, which is the opportunity cost, does not provide the relevant data to match against revenues to measure the performance of the firm.  Accounting must measure past events, those that actually happened, rather than those that might happen. Similarly, the exit price also fails in regard to comparability because it is based on “what might happen.”  Weston (1971) says that EPA provides relevant information only if the company plans to liquidate its assets. If the plan is to continue business, then the information is not relevant.  Argues that EPA has more of a forward looking, decision-usefulness objective rather than a stewardship objective. CRITICISMS OF EPA SMA/UITM/PA (b) Value in Use versus Value in Exchange Ignores the concept of value in use & adopts value in exchange. Value in exchange (market value) represents the firm’s capability to buy things and pay debts at a given date. Determined by the market, not the owner of the firm. Thus, it is objective and easily understood by people. Value in use - a calculated amount of a present expectation. Personal to the owner of the firm. Subjective and not interpretable or understandable by others without a full explanation of the expectation. SMA/UITM/PA