Marco conceptual

It must seem strange, given the criticisms levelled at it, that modified historical cost accounting is still in such widespread use. There are various reasons for this, not the least of which is resistance to change in the conservative accounting profession.

Modified historical cost accounts are easy to prepare, easy to read and easy to understand. While they do not reflect current values, the revaluation of non-current assets is seen as one of the most important items requiring such an adjustment, and therefore the value of the accounts is improved enormously by such revaluations taking place.

In periods of low inflation, historical cost accounts are viewed as a reasonable reflection of the reality of the given situation.

These alternatives are considered in Chapter 7.

Key chapter points

x A basic principle of accounting (some writers include it in the list of fundamental accounting concepts) is that transactions are normally stated in accounts at their historical amount.

x There are a variety of other possible methods of measurement:

–– Current cost

–– Fair value

–– Deprival value

–– Replacement cost

–– Net realisable value.

x The advantage of historical cost accounting is that the cost is known and can be proved. There is no subjectivity or bias in the valuation. There are also a number of disadvantages and these usually arise in times of rising prices (inflation).

Quick revision questions

1 Which statement is true of the historic cost convention?

A it fails to take account of changing price levels over time B it records only past transactions

C it values all assets at their cost to the business, without any adjustment for depreciation D it has been replaced in accounting records by a system of current cost accounting

2 Valuation (or measurement) is the process of determining the monetary amounts at which items are included in the financial statements. Which of the following is a basis of valuation?

A business entity B money measurement C historical cost D going concern

3 What is the accounting convention which, in times of rising prices, tends to understate asset values and overstate profits?

A going concern concept B prudence concept C historical cost D deprival value

4 Under what basis are assets usually valued?

A replacement cost B historical cost C net realisable value D deprival value

5 Which of the following statements about accounting concepts are correct?

I The money measurement concept is that only items capable of being measured in monetary terms can be recognised in financial statements

II The prudence concept means that understating of assets and overstating of liabilities is desirable in preparing financial statements

III The historical cost concept is that assets are initially recognised at their transaction cost IV The substance over form convention is that, whenever legally possible, the economic

substance of a transaction should be reflected in financial statements rather than simply its legal form

A I, II and III B I, III and IV C II and IV D II, III and IV

6 In times of rising prices, what effect does the use of the historical cost concept have on a company’’s asset values and profit?

A asset values and profit both understated B asset values and profit both overstated C asset values understated and profit overstated D asset values overstated and profit understated

7 Korbin Co buy a machine for $50 000. It will generate income of $8 000 per annum for seven years.

What is its economic value?

A $50 000 B $8 000 C $56 000 D $42 000

8 Ladybird Co are considering scrapping a machine for proceeds of $1 000. Alternatively, they can spend $800 on the machine and receive sales proceeds of $1 900. What is the net realisable value of the machine?

A $1 100 B $1 900 C $1 000 D $200

Answers to quick revision questions

The answers to these quick revision questions can be found in the Answers to quick revision questions at the end of the Study Manual.

Self-assessment questions

1 Consider the following statements:

I The measurement of items in the financial statements only affects the statement of financial position

II The measurement of items in the financial statements is concerned with attributing a monetary value to those items

Which statements are correct?

A I only B II only

C both statements D neither statement

2 What type of cost does the following definition describe?

'Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired now.'

A historical cost B realisable value C settlement value D current cost

3 What does the following describe?

'A current estimate of the present discounted value of the future net cash flows in the normal course of business.'

A realisable value B present value C settlement value D historical value

4 What is one of the main advantages of using historical cost as a measurement basis?

A it is a reasonable estimate B it is subjective

C it can use a formula for calculation D it is objective

5 Which of following does this definition describe?

'The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction'.

A residual value B fair value C current value D economic value

6 What is meant by modified historical cost?

A assets valued at cost but liabilities valued at current value B assets valued at current value but liabilities valued at cost

C non-current assets and non-current liabilities valued at valuation rather than cost D non-current assets valued at valuation rather than cost

Answers to self-assessment questions

The answers to these self-assessment questions can be found in the Answers to self-assessment questions at the end of the Study Manual.

Answer to chapter question

1 The accounting concepts mainly involved are accruals and prudence.

The accruals concept states that income and expenditure should be matched in the same period if reasonably possible, whereas the prudence concept dictates that revenue should not be anticipated.

However, you are reasonably certain of selling the mugs, so you would value them in the statement of financial position at the beginning of the year at cost, as an asset (rather than treating them as an expense in the income statement for that earlier year).

At 31 December 20X2 you have 200 spare, whose selling price is less than the cost of making them.

The prudence concept would dictate therefore that they are valued in the statement of financial position at the lower of these two amounts (i.e. sales value if it is lower than cost).

You could argue that valuing them at a lower amount means a conflict with the accruals concept, because the loss is accounted for before the sale. This is true. However, the loss is certain to occur, and this should be reflected in the accounts.

As a consequence, at 31 December 20X1, the mugs would be valued at 40 cents each. At 31 December 20X2, the remaining mugs would be valued at 30 cents each.

Learning objectives Reference

Alternative theories of accounting LO7

Define positive accounting theory LO7.1

Define normative accounting theory LO7.2

Identify financial capital maintenance and operating capital maintenance and how this can affect calculated profits

LO7.3

Describe operating and financial capital maintenance as alternatives to historical cost and identify the impact on reported profit

LO7.4

Calculate profit or loss using the financial capital maintenance and operating capital maintenance models

LO7.5

Chapter 7

Alternative theories of