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3: Accounting conventions Part B The qualitative characteristics of financial information and the fundamental bases of accounting
(c)
The accrual assumption is about getting the income statement figure right. This is an admirable
aim in itself, but it may mean that the
statement of financial position contains rather arbitrary
figures. For example, when an asset is depreciated, the statement of
financial position figure is
simply the unexpired cost to be allocated to future accounting periods. In other words, it is what is
left over after matching has taken place, not in itself a meaningful figure.
5 Bases of valuation
Items in the financial statements can be valued under a number of bases. For your syllabus, you need to
know the following bases.
Historical
cost
Replacement
cost
Net realisable value
Economic
value
5.1
Historical cost
A basic principle of accounting (some writers include it in the list of fundamental accounting assumptions)
is that items are normally stated in accounts at historical cost, ie at the amount which the business paid to
acquire them. An important advantage of this procedure is that the objectivity of accounts is maximised:
there is usually documentary evidence to prove the amount paid to purchase an asset or pay an expense.
Historical cost means that transactions are recorded at the cost when they occurred.
In general, accountants prefer to deal with costs, rather than with 'values'. This is because valuations tend
to be subjective and to vary according to what the valuation is for.
5.2 Replacement cost
Replacement cost means the amount needed to replace an items with an identical item.
Example: Replacement cost
XY Co bought a machine five years ago for $15,000. It is now worn out and needs replacing. An identical
machine can be purchased for $20,000.
Historical cost is $15,000
Replacement cost is $20,000
5.3 Net realisable value
Net realisable value is the expected price less any costs still to be incurred in
getting the item ready for
sale and then selling it.
Example: Net realisable value
XY Co's machine from the example above can be restored to working order at a cost of $5,000. It can then
be sold for $10,000. What is its net realisable value?
Net realisable value = $10,000 – $5,000
=
$5,000
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Part B The qualitative characteristics of financial information and the fundamental bases of accounting
3: Accounting conventions
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5.4 Economic value
Economic value is the value derived from an asset's ability to generate income.
A machine's economic value is the amount of profits it is expected to generate for the remains of its useful
life.
Example: Economic value
Suppose XY Co buy the new machine for $20,000. It is estimated that the new machine will generate
profits of $4,000 per year for its useful life of 8 years. What is its economic value?
Economic value = $4,000 × 8
=
$32,000
5.5 Advantages and disadvantages of historical cost accounting
The
advantage of historical cost accounting is that the cost is known and can be proved (eg by the
invoice). There is no subjectivity or bias in the valuation.
There are a number of
disadvantages and these usually arise in times of rising prices (inflation). When
inflation is low, then historical cost accounting is usually satisfactory. However, when inflation is high the
following problems can occur.
5.5.1 Non-current asset values are unrealistic
The most striking example is property. Although some entities have periodically updated the statement of
financial position values, in general there has been a lack of consistency in the approach adopted and a
lack of clarity in the way in which the effects of these changes in value have been expressed.
If non-current assets are retained in the books at their historical cost,
unrealised holding gains are not
recognised. This means that the total holding gain, if any, will be brought into account during the year in
which the asset is realised, rather than spread over the period during which it was owned.
There are, in essence, two contradictory points to be considered.
(a)
Although it has long been accepted that a statement of financial position prepared under the
historical cost concept is an historical record and not a statement of current worth, many people
now argue that the statement of financial position should at least give an indication of the current
value of the company's tangible net assets.
(b)
The prudence concept requires that profits should only be recognised when realised in the form
either
of cash or of other assets, the ultimate cash realisation of which can be assessed with
reasonable certainty. It may be argued that recognising unrealised holding gains on non-current
assets is contrary to this concept.
On balance, the weight of opinion is now in favour of restating asset values. It is felt that the criticism
based on prudence can be met by ensuring that valuations are made as objectively as possible (eg in the
case of property, by having independent expert valuations) and by not taking unrealised gains through the
income statement, but instead through reserves.
5.5.2 Depreciation is inadequate to finance the replacement of
non-current assets
Depreciation is not provided for in order to enforce retention of profits and thus ensure that funds are
available for asset replacement. It is intended as a measure of the contribution of non-current assets to the
company's activities in the period. However, an incidental effect of providing for depreciation is that not all
liquid funds can be paid out to investors and so funds for asset replacement are on hand. What is
important is not the replacement of one asset by an identical new one (something that rarely happens) but
the replacement of the operating capability represented by the old asset.
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