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Suppose XY Co purchases a 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 eight years. What is its economic value?

Economic value = $4 000 × 8

= $32 000

The topic of deprival value will be covered in more detail in Chapter 7.

Question 2: Deprival value

On 1 January 20X1 a company bought plant costing $50 000. Its useful life was estimated to be ten years and it had no residual value.

At 31 December 20X3 it was estimated that the plant could be sold for $20 000 but it would have to be dismantled, which would cost approximately $2 000.

If the company continues to use the machine, management estimates that it will generate net cash inflows with a present (discounted) value of $25 000.

New plant of the same type would cost $60 000 at 31 December 20X3.

Calculate the deprival value of the asset. Explain why this amount is its value to the business.

(The answer is at the end of the chapter)

2.4 Fair value

Definition

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

Fair value is the amount an asset could be sold or a liability discharged in an arm’s length transaction. Fair value is the market value of an item in a hypothetical transaction. In IFRS it is normally taken to be open

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Question 3: Deprival value and fair value

A company has two properties.

I An office building that it is holding for its investment potential, rather than for its use in the business. II A specialised property: a school building.

For which of these properties is deprival value likely to be approximately the same as fair value?

A I only

B II only

C both properties D neither property

(The answer is at the end of the chapter)

2.5 Advantages of historical cost accounting

Historical cost accounting has several important advantages.

• It is objective. Cost is known and can be proved (e.g. by the invoice). If fair values or other forms of current value are used, these are necessarily subjective.

• It is easily understood by users. Profit is the amount by which selling price exceeds the (depreciated) original cost of the item sold or service provided.

• It is easy to apply. In contrast, most of the alternatives (deprival value, current cost and even fair value) can be difficult and time consuming to estimate or calculate. For example, arriving at deprival value may involve estimating future cash flows for a number of years and then discounting them to present value.

• It provides useful information to users. Users need reliable and faithfully represented information about past transactions in order to predict an entity’s future performance. Information about the current or fair value of assets may be useful to large institutional investors in listed companies, but is largely irrelevant for others.

• It is prudent. Until fairly recently, prudence (conservatism) was recognised as a fundamental accounting concept. Revenue and profits are not anticipated, but included in profit or loss only when it is reasonably certain that they will be realised in the form of cash or other assets. Where there is uncertainty, measuring non-current assets at historical cost is a cautious approach.

• It has stood the test of time. Some theorists argue that historical cost is worth retaining because it has been developed by trial and error by business owners and managers over several years. In contrast, systems of current cost accounting and fair value accounting are based on academic theories and have never really been proved to work in practice.

• If (for example) the current market prices of property or investments are very different from their historical cost, this information can be disclosed in the notes to the financial statements. There is no need to adjust the amounts in the statement of financial position or the other primary

statements.

Defenders of historical cost accounting argue that, although historical cost has shortcomings, there is no real evidence that current costs or fair values provide more useful information. Some advantages of historical cost accounting follow from the disadvantages of current value or fair value accounting: • Use of fair values and current values can encourage management to manipulate the

amounts in the financial statements, because current value can only be an estimate. Accounting standards and other forms of regulation can provide some protection against this, by, for example, requiring regular revaluations by qualified external valuers, but there will always be some scope for

LO 6.1

• Because market values can fluctuate, using fair value can cause volatility in the financial statements. IFRS require gains and losses on revaluation of investment property and some financial instruments to be recognised directly in profit or loss. When reported results fluctuate unexpectedly it can be difficult for users to make a fair assessment of an entity’s performance and to understand underlying trends. Some believe this volatility is acceptable because it reflects economic reality. However, unexpected losses can also have serious economic consequences; many believe that the use of fair values contributed to the global economic crisis in 2008.

Question 4: Objectivity

The main arguments in favour of historical cost accounting are that it is objective and that users generally find it easier to understand than the alternatives, such as fair value.

Briefly explain why this may not always be the case.

(The answer is at the end of the chapter)

2.6 Disadvantages of historical cost accounting

There are a number of disadvantages of historical cost accounting. Many of these arise in particular in times of rising prices (inflation). When inflation is low, historical cost accounting is usually satisfactory. However, when inflation is high the following problems can occur. Other disadvantages have arisen as business practice and transactions have become more complex.

2.6.1 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. In contrast unrealised holding losses are recognised in the form of impairment of assets.

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) Traditionally, generally accepted accounting practice has required that profits should only be recognised when realised in the form of either cash or other assets, the ultimate cash realisation of which can be assessed with reasonable certainty (prudence or conservatism). It may be argued that recognising unrealised holding gains on non-current assets is contrary to this convention. On balance, the weight of opinion held generally by the IASB and specifically by Australia and the UK 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 (e.g. in the case of property, by having independent expert valuations) and by not taking unrealised gains through profit or loss, but instead through reserves.

2.6.2 Depreciation is inadequate to finance the replacement of non-current assets

Depreciation is not provided for in order to enforce retention of profits and therefore ensure that funds are available for asset replacement. It is intended as a measure of the contribution of non-current assets to an entity’s activities in the period. However, an incidental effect of providing for depreciation is that not all

LO 6.1

2.6.3 Holding gains on inventories are included in profit

Another criticism of historical cost accounting is that it does not fully reflect the value of the asset consumed during the accounting year.

During a period of high inflation the monetary value of inventories held may increase significantly while they are being processed. The conventions of historical cost accounting lead to the unrealised part of this holding gain (known as inventoryappreciation) being included in profit for the year.

The following simple example is given to help your understanding of this difficult concept.