Chapter 21 · Beyond current cost accounting 689 Summary We started the chapter by reviewing the utility of current cost accounts and then, in the second section, explained and illustrated how to prepare and present a fully stabilised set of current cost accounts that take account of changes in the general price level as well as changes in specific prices. Next we examined an alternative approach based upon the use of net realisable value as the main basis of asset valuation and introduced the ICAS research publication, Making Corporate Reports Valuable, which, although published in 1988, remains a radical document full of fresh ideas. The final section of the chapter is concerned with the way the ASB’s thinking on the sub- ject of current cost accounting has developed over the last ten or so years. We explain how it has put into place a system capable of coping with a much more widespread use of current values, which will undoubtedly occur over the coming decades. Recommended reading Accounting Standards Committee, Accounting for the Effects of Changing Prices: a Handbook, ASC, London, 1986. W.T. Baxter, Inflation Accounting, Philip Allan, Deddington, 1984. Institute of Chartered Accountants of Scotland, Making Corporate Reports Valuable, P.N. McMonnies (ed.), Kogan Page, London, 1988. D.R. Myddleton, On a Cloth Untrue, Woodhead-Faulkner, Cambridge, 1984. D. Tweedie and G. Whittington, The Debate on Inflation Accounting, Cambridge University Press, Cambridge, 1984. G. Whittington, Inflation Accounting: an Introduction to the Debate, Cambridge University Press, Cambridge, 1983. Questions 21.1 (a) What do you consider to be the main weaknesses of historical cost accounting when prices are rising? (10 marks) (b) State two ways in which firms have adopted different accounting policies for specific items in historical cost accounts so that they partly reflect rising price levels. (4 marks) (c) The stewardship approach of traditional accounting has been said to have been replaced by a user-orientated approach. Briefly discuss this assertion in relation to historical cost accounts. (6 marks) ACCA Level 2, The Regulatory Framework of Accounting, June 1988 (20 marks) 21.2 In the ASC’s handbook, Accounting for the Effect of Changing Prices, accountants are faced with a choice of systems of accounting when dealing with the effects of inflation. 690 Part 3 · Accounting and price changes Requirements (a) Briefly describe the three factors which combine to make up these systems of accounting. (3 marks) (b) Explain the main advantages and disadvantages of two such systems. (6 marks) ICAEW, Financial Reporting II, May 1993 (9 marks) 21.3 (a) Explain the primary objective of current purchasing power accounting and outline the basic technique. (8 marks) (b) What do you consider are the advantages and disadvantages of current purchasing power accounting as a method of adjusting financial statements for price level changes? (12 marks) ACCA Level 2, The Regulatory Framework of Accounting, December 1988 (20 marks) 21.4 (a) Provide a definition of the deprival value of an asset. (2 marks) (b) For a particular asset, suppose the three bases of valuation relevant to the calculation of its deprival value are (in thousands of pounds): £12, £10 and £8. Construct a matrix of columns and rows showing all the possible alternative situ- ations and, in each case, indicate the appropriate deprival value. (6 marks) (c) Justify the use of deprival value as a method of asset valuation, using the matrix in (b) above to illustrate your answer. (12 marks) ACCA Level 2, The Regulatory Framework of Accounting, December 1988 (20 marks) 21.5 An assistant accountant of Changeling plc has been requested to prepare a profit and loss account using the CPP model for the year ended 31 March 1991. He has calculated the net operating profit for the year and the remaining entries are yet to be completed. The profit and loss accounts for the year ended 31 March 1991 are set out below, compris- ing the historic cost profit and loss account and partially completed CPP profit and loss account. Historic Index CPP units as cost factor at 31.3.91 £000 000 Sales 6500 2000/1875 6933 ––––– ––––– Opening stock 700 2000/1700 824 Purchases 4250 2000/1875 4533 ––––– ––––– 4950 5357 Closing stock (900) 2000/1937 (929) ––––– ––––– 4050 4428 ––––– ––––– ––––– ––––– Gross profit 2450 2505 Expenses 1150 2000/1875 1227 Depreciation: Original equipment 500 2000/1025 976 New equipment 50 2000/1813 55 –––– ––– Net operating profit 750 247 Tax 338 –––– c/f 412 Chapter 21 · Beyond current cost accounting 691 Historic cost £000 Profit (loss) after tax 412 Gain (loss) on net monetary assets – Gain (loss) on long-term loans – –––– Net profit (loss) for year 412 Dividends 187 –––– Retained profit (loss) for year 225 Retained profit brought forward 750 –––– Retained profit carried forward 975 –––– –––– Balance sheet as at 31 March 1990 Historic Index CPP units Index CPP units cost factor as at factor as at 31.3.90 31.3.91 £000 000 000 Capital 2500 1750 4605 2000 5263 ––––– ––––– Retained profit 750 950 1142 1750 1305 ––––– ––––– ––––– 3250 5747 6568 ––––– ––––– ––––– ––––– ––––– ––––– Fixed assets Equipment 5000 1750 8537 2000 9757 ––––– ––––– 1025 1750 Depreciation (1500) 1750 (2561) 2000 (2927) ––––– ––––– 1025 1750 Current assets Stock 700 1750 721 2000 824 ––––– ––––– 1700 1750 Debtors 1050 – 1050 2000 1200 ––––– 1750 Current liabilities Trade creditors (875) – (875) 2000 (1000) ––––– 1750 Non-current liabilities Loan (1125) – (1125) 2000 (1286) ––––– ––––– ––––– ––––– 3250 5747 1750 6568 ––––– ––––– ––––– ––––– ––––– ––––– ––––– ––––– 692 Part 3 · Accounting and price changes Balance sheet as at 31 March 1991 Historic Index CPP units as cost factor at 31.3.91 £000 000 Capital 2500 2000 5263 ––––– 950 Retained profit 975 – 1142 ––––– ––––– 3475 6405 ––––– ––––– ––––– ––––– Fixed assets Equipment 5000 2000 9757 –––––– 1025 Depreciation (2000) 2000 (3903) ––––– 1025 New equipment 500 2000 552 ––––– 1813 Depreciation (50) 2000 (55) ––––– 1813 Current assets Stock 900 2000 929 ––––– 1938 Debtors 1150 – 1150 ––––– ––––– 5500 8430 Current liabilities Trade creditors (400) – (400) Non-current liabilities Loan (1625) – (1625) ––––– ––––– 3475 6405 ––––– ––––– ––––– ––––– Assume that inflation index increased evenly throughout the year ended 31 March 1991. Required (a) Calculate the retained profit (loss) for the year using the CPP Model for the year ended 31 March 1991. (5 marks) (b) Explain what the method of indexing is attempting to deal with and discuss the process from the viewpoint of both the entity and the proprietors. (5 marks) (c) Write a brief report to the principal shareholder of Changeling Ltd who holds 20% of the issued share capital on the management of the company commenting on profitability, liquidity and financial structure. (10 marks) ACCA, Advanced Financial Accounting, December 1991 (20 marks) 21.6 ‘The recognition and correct treatment of holding gains in company financial statements are vital for a proper understanding of the position and performance of the business entity.’ You are required (a) to explain briefly the significance of the treatment of holding gains for the measure- ment of business profit; (5 marks) (b) to set out the arguments for and against the recognition or holding gains. (10 marks) CIMA, Advanced Financial Accounting, November 1994 (15 marks) Chapter 21 · Beyond current cost accounting 693 21.7 The accountant of Newsprint plc has produced three sets of accounts for the year ended 31 December 1988 using the historic cost, replacement cost with specific index adjust- ments and current purchasing power with general price index adjustments. The historic and replacement cost accounts are set out below: Profit and loss accounts for the year ended 31 December 1988 Historic cost Specific Replacement cost ££index ££ Sales 357 500 – 357 500 Opening stock 41 250 240/200 49 500 Purchases 178 750 – 178 750 ––––––– ––––––– 220 000 228 250 Closing stock 71 500 71 500 ––––––– ––––––– Cost of sales 148 500 156 750 ––––––– ––––––– Gross profit 209 000 200 750 Wages 17 875 17 875 Establishment and other charges 71 500 71 500 Depreciation Fixtures 5 500 160/140 6 286 Lease 5 500 220/160 7 563 –––––– –––––– 100 375 103 224 ––––––– ––––––– Net profit 108 625 Operating profit 97 526 ––––––– ––––––– ––––––– ––––––– Balance sheets as at 31 December 1988 Historic cost Specific Replacement cost ££index ££ Fixed assets Leasehold Premises 55 000 220/160 75 625 Amortisation 5 500 49 500 7 563 68 062 –––––– –––––– Fixtures 55 000 160/140 62 857 Depreciation 5 500 49 500 6 286 56 571 –––––– –––––– Current assets Stock 71 500 280/240 83 416 Cash 55 825 – 55 825 –––––––– –––––––– 226 325 263 874 –––––––– –––––––– –––––––– –––––––– Share capital Ordinary shares 90 200 90 200 Profit and loss account 108 625 97 526 11 099 1 37 549 2 Loan 27 500 27 500 –––––––– –––––––– 226 325 263 874 –––––––– –––––––– –––––––– –––––––– 694 Part 3 · Accounting and price changes Note 1 £ Stock 8250 Fixtures 786 Lease 2063 ––––– 11099 –––––– Note 2 Closing Stock (71500 × – 71500) 11916 Fixtures (49500 × – 49500) 7071 Lease (49500 × – 49500) 18562 –––––– 37 549 ––––––– The historic and current purchasing power accounts are set out below. Profit and loss accounts for the year ended 31 December 1988 Historic cost General ££index £CPP £CPP Sales 357500 160/130 440 000 Opening stock 41 250 160/100 66000 Purchases 178750 160/130 220 000 ––––––– –––––––– 220000 286000 Closing stock 71500 160/130 88000 ––––––– –––––––– Cost of sales 148 500 198000 ––––––– –––––––– Gross profit 209000 242000 Wages 17875 160/130 22000 Establishment and other charges 71500 160/130 88000 ––––––– –––––––– –––––––– –––––––– 89375 209000 110 000 242000 Depreciation Fixtures 5500 160/100 8800 Lease 5500 160/100 8 800 ––––––– ––––––– 100375 127600 –––––––– –––––––– Net profit 108625 Operating profit 114400 –––––––– –––––––– –––––––– –––––––– 220 ––– 160 160 ––– 140 280 ––– 240 Chapter 21 · Beyond current cost accounting 695 Balance sheets as at 31 December 1988 Historic cost General Fixed assets ££index £CPP £CPP Leasehold premises 55000 160/100 88000 Amortisation 5500 49 500 160/100 8800 79200 –––––– –––––– Fixtures 55000 160/100 88000 Depreciation 5500 49 500 160/100 8800 79200 –––––– –––––– Current assets Stock 71500 160/130 88000 Cash 55825 – 55825 ––––––– ––––––– 226325 302225 ––––––– ––––––– ––––––– ––––––– Share capital Ordinary shares 90200 160/100 144320 Profit and loss account 108 625 114 400 16005 3 Loan 27500 27500 ––––––– ––––––– 226325 302225 ––––––– ––––––– ––––––– ––––––– Note 3 Loan (27500 × 160/100 – 27500) 16500 Purchases (178750 × 160/130 – 178750) 41250 Fixtures (55000 × 160/100 – 55000) 33000 Lease (55000 × 160/100 – 55000) 33000 Expenses (89375 × 160/130 – 89375) 20625 Cash (76450 × 160/100 – 76450) (45870) Sales (357500 × 160/130 – 357500) (82500) Required (a) Explain briefly what the following amounts relate to and why they are in the balance sheets: (i) in the replacement cost model £11 099 £37 549; (ii) in the current purchasing power model £16 005. (6 marks) (b) Explain the case for and against the replacement cost model. (8 marks) (c) Consider the implication of the replacement cost model figures for 1988 to the man- agement of Newsprint plc. (8 marks) (d) Explain to a shareholder why the historic cost net profit is different from the CPP operating profit using the data in the question to illustrate your answer and explain which figure is to be regarded as the base for calculating earnings per share under each model. (8 marks) ACCA Level 3, Advanced Financial Accounting, June 1989 (30 marks) 696 Part 3 · Accounting and price changes 21.8 The Paraffin Supply Company Limited acquired freehold land as a depot for its delivery vans and started business on 1 January 1986. It collected sufficient paraffin from a whole- saler each day to satisfy known orders. The wholesaler was paid in cash and the customers paid cash on delivery. The opening balance sheet at 1 January 1986 showed the following: Balance sheet of Paraffin Supply Company Limited as at 1 January 1986 £ Freehold land for use as garage premises 100000 Delivery vehicles 96000 ––––––– 196000 ––––––– ––––––– Financed by: Share capital 150000 Long-term loan 46000 ––––––– 196000 ––––––– –––––– – The company traded for 2 years until 31 December 1987. All profits had been retained in the business. There were no creditors, debtors or stocks. At 31 December 1987 the direc- tors were considering whether to cease trading at31 December 1988. The accountant produced the following estimated accounts for the year ended 31 December 1988 with the 1986 and 1987 actual comparative figures: Profit and loss accounts for the years ended 31 December 1986 1987 1988 £££ Sales 140000 184 000 248000 Less: Purchases 70000 90000 124000 Administration expenses 21400 22000 27500 Selling expenses 21000 30000 42500 Depreciation 24000 24000 24000 ––––––– ––––––– ––––––– 3600 18000 30000 ––––––– ––––––– ––––––– ––––––– ––––––– ––––––– 1986 1987 1988 3600 18000 30000 Return on equity –––––– × 100 –––––– × 100 –––––– × 100 150000 153 600 171600 = 2.4% = 11.7% = 17.5% In preparing the accounts the following conventions and policies had been followed: (a) The capital maintenance concept is that capital will be maintained if the cost of assets representing the initial monetary investment is recovered against operations. (b) The concept of profit is that profit for the year is regarded as any gains arising during the year which may be distributed while maintaining the amount of the shareholders’ interest in the company at the beginning of the year. (c) The measurement unit used is the medium of exchange. (d) Depreciation of delivery vans is over 4 years using the straight-line method. The directors had recently attended a seminar on the treatment of inflation in financial reports and they required the profits to be calculated using the general purchasing power income model and the replacement cost model. Chapter 21 · Beyond current cost accounting 697 The accountant obtained the following information to allow him to redraft the profit and loss account using these two models: (a) The retail price index was as follows: 1 January 1986 100 31 December 1986 110 31 December 1987 120 31 December 1988 (Estimated) 130 (b) The replacement cost of the assets was: Garage premises Delivery vehicles ££ 31 December 1986 120 000 102000 31 December 1987 130 000 115000 31 December 1988 (Estimated) 141 000 128 000 Required (a) (i) Prepare the profit and loss account for the year ended 31 December 1988 using the general purchasing power income model and explain the following: The concept of capital maintenance used. The concept of profit used. The measurement unit used. (8 marks) (ii) Mention four criteria for selecting an appropriate unit of measurement for finan- cial reporting and briefly discuss whether the general purchasing power income model satisfies these criteria. (8 marks) (b) (i) Prepare the profit and loss account for the year ended 31 December 1988 using the replacement cost model to show reported income on the assumption that backlog depreciation is not deducted in arriving at this reported income and explain the following: The concept of capital maintenance used. The concept of profit used. The measurement unit used. (5 marks) (ii) Discuss the arguments for and against excluding backlog depreciation when cal- culating the reported income. (4 marks) ACCA Level 3, Advanced Financial Accounting, December 1988 (25 marks) 21.9 Air Fare plc is the subsidiary of an American parent company. It had been incorporated in the United Kingdom in 1985 to provide in flight packed meals for American airlines on return flights from the United Kingdom. The fixed assets in the annual accounts have been carried at cost less depreciation but the directors have been considering the production of supplementary statements that are based on current values and show a profit after maintaining the operating capital and also a profit that encompassed gains on holding assets to the extent that these were real gains after allowing for general/average inflation. The following information (i) to (vi) was available when preparing the supplementary statements for the year ended 31 December 1993. 698 Part 3 · Accounting and price changes (i) Draft profit and loss account for the year ended 31 December 1993 prepared under the historic cost convention. £000 Sales 11441 Cost of sales 10292 –––––– 1149 Loan interest 625 ––––– 524 Tax 124 ––––– 400 Less: Proposed dividend 100 ––––– 300 ––––– ––––– (ii) The current cost values of the net assets representing shareholders’ funds was £25 million at 1 January 1993. (iii) Freehold premises had cost £8 million in 1985 and were being depreciated over 40 years which was the group policy specified by the American parent. The current gross replacement cost was £14 million at 31 December 1993 and £13.8 million at 1 January 1993. Equipment had cost £12 million in 1991 and was being depreciated over 15 years. The gross replacement cost was £12.6 million at 31 December 1993 and £12.5 million at 1 January 1993. (iv) The cost of sales had increased by £412 000 during the year due to price increases. The costs and price increases occurred evenly during the year. (v) The retail price index had risen by 3% during the year. (vi) Stock at the beginning of the year was £660000 at cost and £670000 at current replace- ment cost and stock at the end of the year was £750000 at cost and £795000 at current replacement cost. The following information relates to a consideration not to provide for depreciation on the freehold property. The freehold property consisted of the premises where the meals were prepared and packed. When the directors were reviewing the information prepared for the current value supplementary statements they noted that the current value of the freehold property exceeded the book value and decided that it was appropriate not to provide for depreciation. The chief accountant advised them that it was probable that the auditor would qualify the accounts if depreciation were not provided in accordance with the provisions of SSAP 12 Accounting for Depreciation. The directors had been discussing the problem over lunch at the local hotel and were surprised when the owner of the hotel informed them that the auditor of the company that owned the hotel had not required depreciation to be provided on the hotel premises. Further enquiry by the directors established that there were a number of companies that were not providing depreciation on freehold properties from a range of industries that [...]... leaseback transactions, 234–5 financial accounting, see accounting financial capital maintenance, 66, 67, 642, 663–5, 672, 687 financial instruments, 160, 176–89, 191–201, 307 definitions, 176–7, 195 Financial Instruments Joint Working Group, 193, 194 Financial Reporting Council, 33 Financial Reporting Exposure Drafts, see FREDs Financial Reporting Review Panel, 33, 36, 38, 54 Financial Reporting Standard... 477, 488 ED 24 Current Cost Accounting, 622, 623 ED 27 Accounting for Foreign Currency Translations, 483, 488, 489 ED 35 Accounting for the Effects of Changing Prices, 622, 624 ED 46 Disclosure of Related Party Transactions, 309 ED 47 Accounting for Goodwill, 381–2 ED 48 Accounting for Acquisitions and Mergers, 367 ED 52 Accounting for Intangible Fixed Assets, 380 ED 55 Accounting for Investments,... FREDs ED 3 Accounting for Acquisitions and Mergers, 367, 371 ED 8 Accounting for Changes in the Purchasing Power of Money, 622, 623 ED 11 Accounting for Deferred Taxation, 348 ED 14 Accounting for Research and Development, 145 ED 16 Supplement to ‘Extraordinary Items and Prior Year Adjustments’, 477 ED 18 Current Cost Accounting, 622, 623 ED 19 Accounting for Deferred Taxation, 348 ED 21 Accounting. .. reports, 28, 527, 557–9 International Accounting Standards, see IASs International Accounting Standards Board, see IASB International Accounting Standards Committee, see IASC International Association of Financial Executives Institutes, 44 International Confederation of Free Trade Unions, 44 International Financial Reporting Interpretations Committee, 46 International Financial Reporting Standards (IFRSs),... 12 Accounting for Depreciation, 110, 116, 117 SSAP 13 Accounting for Research and Development, 97, 145–6, 149 SSAP 15 Accounting for Deferred Tax, 337, 338, 348–9 SSAP 16 Current Cost Accounting, 32, 622, 623–4, 644, 669 SSAP 17 Accounting for Post Balance Sheet Events, 300–3 SSAP 18 Accounting for Contingencies, 149, 165, 168 717 718 Index SSAP 19 Accounting for Investment Properties, 97, 110, 116–18... Intangible Assets, 383 Accounting Standards Committee (ASC), 10, 31–3, 34, 37, 382, 405, 623, 644 Accounting for the Effects of Changing Prices: A Handbook, 73, 620, 621, 624 and accounting for inflation, 73, 553, 620, 621, 624, 651, 667, 670 and reporting of profits, 83 Accounting Standards Steering Committee, 6, 31, 528, 623 The Corporate Report, 6, 74, 528, 554 accounts, see financial statements accruals... notes financial trading companies, 193, 194 financial wealth, statement of changes in, proposed, 679, 680–1, 684 financing treatment in cash flow statement, 534, 547 see also finance costs fixed asset investments, 463 flexibility, 30–1, 49, 127, 148 Flint, David, 27 ‘flow through’ approach to accounting for deferred taxation, 350, 355 foreign currency financial statements and historical cost accounting, ... 504, 553, 619–23, 672 and discount rates, 125 effects of, 74–5, 628–33, 640–2 financial capital maintenance bases and, 664–5 historical summary and, 553 taxation and, 76, 348–9 see also current cost accounting and current purchasing power accounting Inflation Accounting Committee, see Sandilands Committee/Report Inflation Accounting Steering Group, 623 information characteristics required, 15–17, 29–30... 676–88 theory/frameworks/principles, 5–12, 21, 23, 26–7, 28–30, 34, 83 see also Accounting Standards Board, Statement of Principles; see also individual principles accounting bases/policies, 30 changes in, 30, 281 Accounting for the Effects of Changing Prices: A Handbook, 73, 620, 621, 624 Accounting Regulatory Committee, 54 Accounting Standards Board (ASB), 33–6, 37, 527 and capitalisation of finance... 594 SORPs (Statements of Recommended Accounting Practice), 32 South Africa, 96 Special Purpose Entities, 408, 430 specialised/non-specialised buildings, 107–8 split accounting, 186, 199, 200 SSAPs (Statements of Standard Accounting Practice), see following entries; see also PSSAP SSAP 1 Accounting for the Results of Associated Companies, 447, 453 SSAP 2 Disclosure of Accounting Policies, 28–9, 30, 83, . 200 0 (2927) ––––– ––––– 1025 1750 Current assets Stock 700 1750 721 200 0 824 ––––– ––––– 1700 1750 Debtors 1050 – 1050 200 0 1200 ––––– 1750 Current liabilities Trade creditors (875) – (875) 200 0. Ltd who holds 20% of the issued share capital on the management of the company commenting on profitability, liquidity and financial structure. (10 marks) ACCA, Advanced Financial Accounting, . 160/130 220 000 ––––––– –––––––– 2200 00 286000 Closing stock 71500 160/130 88000 ––––––– –––––––– Cost of sales 148 500 198000 ––––––– –––––––– Gross profit 209 000 2 4200 0 Wages 17875 160/130 2200 0 Establishment