week 3 current entry, exit and mixed value accounting
DESCRIPTION
Financial Reporting AnalysisTRANSCRIPT
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Current entry , exit and mixed value accounting
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Contents
• Capital maintenance
• Replacement cost accounting and depreciation
• Current entry values: preliminary appraisal
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Capital maintenance
Profit is defined as the amount generated by the business over and above that necessary to replace the assets
Capital maintenance is defined as the maintenance of the capacity to replace the resources of the business
HC profit split into: Operating profit (revenue – current replacement cost)
Holding gain (current replacement – original purchase cost)
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Capital maintenance (cont’d)
•Example: • Purchase cost: € 10
• Replacement cost: € 12
• Selling price: € 15
HC profit: 5
•Operating profit: 3
•Holding gain: 2
Both elements are realized
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Capital maintenance (cont’d)
Normally, both realized and unrealized gains will be involved
Example:
1 October 20X1 Buy 2 at €30
1 November 20X1 Sell 1 at €50, when RC is €35
31 December 20X1 RC is €38
31 January 20X2 Sell 1 at €60, when RC is €40
HC profits are:
Year 1 50 - 30 = €20
Year 2 60 - 30 = €30
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Capital maintenance (cont’d)
• A fuller analysis:
• Year 1: • Operating profit €15
• Realized holding gain €5
• Unrealized holding gain €8 (38-30)
• Year 2: • Operating profit €20
• Realized holding gain €10
• Unrealized holding gain €0
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Capital maintenance (cont’d)
•HC profit consists of two of the three elements:
HC profit = Operating profit + Realized holding gains
Year 1: € 20 = 15 + 5
Year 2: € 30 = 20 + 10
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Capital maintenance (cont’d)
Edwards and Bell (1961):
Business income =
Operating profit
+ realized holding gains recognized in the period
+ unrealized holding gains recognized in the period
Business income Year 1 = 15 + 5 + 8 = 28
Business income Year 2 = 20 + 2 + 0 = 22
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Capital maintenance (cont’d)
Accounting income includes:
realized holding gains of the period recognized in the period (1)
plus realized holding gains of the period recognized in previous periods (2)
Business income includes:
realized holding gains of the period recognized in the period (3)
plus unrealized holding gains recognized in the period (4)
Accounting income = business income – 4 + 2
Year 1: €20 = 28 - 8 + 0
Year 2: €30 = 22 - 0 + 8
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Capital maintenance (cont’d)
Edwards and Bell’s current entry approach includes all the holding gains recognized in the period as being included in income
Criticisms:
No unrealized gains included
All the holding gains, whether realized or unrealized, need to be retained in the business in order to enable it to replace resources as they are used
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Capital maintenance (cont’d)
Operating profit is the gain after having retained sufficient resources to enable us to do those things that we originally had the capacity to do
Operating profit should be regarded and reported as income. Holding gains, whether realized or not, should be excluded
The central profit figure under a current entry value system should consist of the operating profit alone
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Replacement cost accounting and depreciation
•Example:
• Fixed asset costs = €100
• Useful life of 4 years
• Zero scrap value
• RC of new asset rises by €20 each year
•Balance sheet position year 1:
Cost (RC) €120
Depreciation (25%) €30
Balance sheet €90
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Replacement cost accounting and depreciation (cont’d)
Balance sheet position year 2: From P&L account view
RC €140
Depreciation (25%) €35
Accumulated depreciation €65
Balance sheet figure €75
Balance sheet view RC €140
Accumulated depreciation €70 (50%)
Balance sheet figure €70
In P&L €35 charge and €40 charge a in balance sheet
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Replacement cost accounting and depreciation (cont’d) Problem solved: backlog depreciation Year 2 balance sheet deduction: The proper annual charge (€35) The extra figure necessary to bring the accumulated
depreciation at the beginning of year 2 up to what it would have been if the current (end of year 2) RC had been prevailing earlier (€5)
Bookkeeping: Credit of €40 to depreciation provision Debit of €35 to P&L account Debit of €5 to holding gain account
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Replacement cost accounting and depreciation (cont’d)
•Balance sheet position year 2:
• Fixed assets
RC 140
Depreciation 70
Net book value 70
• Holding gain reserve
b/f 20
add 20
less 5 35
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Current entry values: preliminary appraisal
Advantages: More useful data for decision-making purposes Proper maintenance of operating capacity – the
“business substance” A balance sheet based on current value Consistent with accounting concepts Holding gains are recognized and reported when they
occur Comparisons over time and performance analysis are
more valid and meaningful Feasible in practical application
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Current entry values: preliminary appraisal (cont’d)
•Disadvantages
• More subjectivity
• Use of replacement cost figures for assets that the firm does not intend to replace
• It fails to give an indication either of the current market value of most assets in their present state or of the business as a whole
• It fails to take account of general inflation, of changes in the purchasing power of money
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Current exit value accounting
•Edwards and Bells (1961) suggested two current exit value concepts: • Current values defined as values actually realized during the
current period for goods or services sold
• Opportunity costs defined as values that could currently be realized if assets were sold (without further processing) outside the firm at the best prices immediately obtainable
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Current exit value accounting (cont’d)
•Net realizable value (NRV): the proceeds after deducting these additional unavoidable expenses or disposal, defined as:
Yr = D + (Re – Rs)
Yr = exit value income
D = distributions (less new capital inputs)
Re = NRV of the assets at the end of the period
Rs = NRV of the assets at the start of the period
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Current exit value accounting (cont’d)
Example: NRV (work in progress, today): €10
NRV (finished product, today): €20
NRV (finished product, when finished): €22
Forced sale (current existing state): €6
Generally, exit values refer to assets in their existing state sold in the normal course of business, so the exit value for the work in progress would be €10
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Current exit value accounting (cont’d)
•Exit value capital: the amount of money that the business could obtain from its assets on a particular date
•Exit value is seen as opportunity cost concept, i.e. the amount of cash that the business could obtain if it did not keep the asset
•Exit value accounting does not conform to the going concern convention
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•Exit value income (Yr) =
Realized operating gains
+ unrealized operating gains
+ realized non-operating gains
+ unrealized non-operating gains
•P&L account also value based and not cost based
• e.g. Depreciation = loss in value of the asset
Current exit value accounting (cont’d)
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Capital in cash = €15.000 Fixed assets = €10.000
Year 1 (€) Year 2 (€)
NRV fixed assets 6.000 4.000
Sales 20.000 25.000
Cost of sales 11.000 12.000
Closing inventory: cost 2.000 3.000
NRV 2.500 3.800
Current exit value accounting (cont’d)
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Year 1 (€) Year 2 (€)
Exit value revenue statements
Sales 20.000 25.000
Cost of sales 11.000 12.000
9.000 13.000
Depreciation 4.000 2.000
5.000 11.000
Less operating gain included in previous year - 500
5.000 10.500
Add unrealized operating gain 500 800
Realizable income 5.500 11.300
Exit value balance sheets
Fixed assets 6.000 4.000
Inventory 2.500 3.800
Cash 12.000 24.000
20.500 31.800
Capital 15.000 15.000
Realizable income 5.500 16.800
20.500 31.800
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1 January year 7
Introduced capital of €25.000 and purchased a machine for €9.000
Purchased 500 items of inventory for €15 each
31 December year 7
Sold 300 items of inventory for €30 each
Paid rent for the year of €1.000
Paid other expenses for the year of €1.000
1 January year 8
Purchased 400 items of inventory for €17 each
31 December year 8
Sold 500 items of inventory for €33 each
Paid rent for the year of €1.100
Paid expenses for the year of €1.200
Current exit value accounting (cont’d)
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• Information about machine: 31.12.7 31.12.8
Replacement cost 10.000 12.000
Realizable value 8.000 6.000
Cost of realization 1.000 1.000
Current exit value accounting (cont’d)
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P&L account
31.12.7 31.12.8
Sales 9.000 16.500
Cost of sales (4.500) (8.100)
Gross profit 4.500 8.400
Rent 1.000 1.100
Expenses 1.000 1.200
Depreciation 2.000 2.000
(4.000) (4.300)
Gross profit 500 4.100
Holding gain 3.000 (1.400)
3.500 2.700
Current exit value accounting (cont’d)
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Balance sheet
31.12.7 31.12.8
Fixed assets
Machine at NRV 7.000 5.000
Current assets
Inventory at NRV 6.000 3.300
Bank 15.500 22.900
21.500 26.200
28.500 31.200
Share capital 25.000 25.000
Profit 3.500 6.200
28.500 31.200
Current exit value accounting (cont’d)
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Current exit values: preliminary appraisal
•Advantages:
• It follows the economic “opportunity cost” principle
• Exit values facilitate comparisons
• The concept of realizable value is easy for the non-accountant to understand
• Useful information about assets is provided to outsiders
• It is already widely used, e.g. debtors, inventory at lower of historical cost (HC) and NRV, revaluation of land and buildings
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Current exit values: preliminary appraisal (cont’d)
•Disadvantages:
• It is highly subjective, more so than the replacement cost accounting
• It fails to follow the going concern assumption, fails to recognize that firms do not usually sell all their assets
• It fails to concentrate attention on long-run operational effectiveness
• It fails to give realistic information about the internal usefulness of assets
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Current exit values: preliminary appraisal (cont’d)
•Expected values: “values expected to be received in the future for output sold according to the firm’s planned course of action” (Edwards and Bell, 1961)
•Expected values give useful information, but are more subjective, less consistent in evaluation and fail to reflect the current reality
•Current exit values are a more useful concept to prepare statements of the current position
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Exit value NRV accounting focuses more on the balance sheet than current entry value RC accounting
Profit or gain are more determined by a consideration of changes in output values of resources
Current exit value is a short run concept
Current exit values: preliminary appraisal (cont’d)
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Mixed values – ad hoc methods
•Some accounting systems are flexible as regards the valuation policy companies wish to adopt
•No requirement for any consistency of approach as between one asset and another
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Mixed value – Deprival value
•Deprival value (DV) is a more theoretically defensible approach for using different valuation bases for assets in different circumstances
•DV of an asset is the loss that the rational businessman or businesswoman would suffer if he or she were deprived of the asset
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Deprival value (DV): appraisal
•Advantages: • All the advantages of RC accounting can be claimed here also
• As a “mixed value” system it is more realistic and relevant than either RC or NRV. It values resources at RC if it is profitable to replace them and at the expected proceeds if they would not be replaced
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Deprival value (DV): appraisal (cont’d)
•Disadvantages: • Disadvantages 1, 3 and 4 of RC accounting can be claimed here too
• It is more subjective than RC
• If the balance sheet is expressed in “mixed values”, what do the asset and capital employed totals mean? Can mixed values be validly added at all?
• Firms are not in practice being continually deprived of their assets