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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 (contd)

Example:
Purchase cost: 10 Replacement cost: 12 Selling price: 15 HC profit: 5

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Operating profit: 3 Holding gain: 2 Both elements are realized

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Capital maintenance (contd)

Normally, both realized and gains will be involved
Example: 1 October 20X1 1 November 20X1 31 December 20X1 31 January 20X2 HC profits are: Year 1 50 - 30 = 20 Year 2 60 - 30 = 30

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unrealized

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Buy 2 at 30 Sell 1 at 50, when RC is 35 RC is 38 Sell 1 at 60, when RC is 40

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Capital maintenance (contd)

A fuller analysis:

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Year 1:
Operating profit Realized holding gain 5 Unrealized holding gain 8 (38-30) 20 0 15

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Year 2:
Operating profit Realized holding gain 10 Unrealized holding gain

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Capital maintenance (contd)

HC profit consists of two of three elements: the

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HC profit = Operating profit + Realized holding gains Year 1: 20 = 15 + 5 Year 2: 30 = 20 + 10

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Capital maintenance (contd)

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 (contd)

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 (contd)

Edwards and Bells current entry approach includes all the holding gains recognized in the period as being included in income Criticisms:

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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 (contd)

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

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Balance sheet position year 1:

Cost (RC) Depreciation (25%) Balance sheet 120 30 90

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Replacement cost accounting and depreciation (contd)

Balance sheet position year 2:
From P&L account view
RC Depreciation (25%) Accumulated depreciation Balance sheet figure 140 35 65 75 140 70 (50%) 70

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Balance sheet view

RC Accumulated depreciation Balance sheet figure

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In P&L 35 charge and 40 charge a in balance sheet

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Replacement cost accounting and depreciation (contd)

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)

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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 (contd)

Balance sheet position year 2:
Fixed assets RC 140 Depreciation Net book value 70 Holding gain reserve b/f 20 add 20 less 5 35

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70

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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 (contd)

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

(contd)

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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

(contd) Example:
NRV (work in progress, today): 10 NRV (finished product, today): 20 NRV (finished product, when finished): 22 Forced sale (current existing state): 6

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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

(contd) 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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Current exit value accounting

(contd)

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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

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Current exit value accounting

(contd)

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Capital in cash = 15.000

NRV fixed assets Sales Cost of sales

Fixed assets = 10.000

Year 1 () 6.000 20.000 11.000 Year 2 () 4.000 25.000 12.000

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Closing inventory: cost NRV

2.000 2.500

3.000 3.800

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Year 1 () Exit value revenue statements Sales Cost of sales 20.000 11.000 9.000 Depreciation 4.000 5.000 Less operating gain included in previous year 5.000 Add unrealized operating gain Realizable income Exit value balance sheets Fixed assets Inventory Cash 6.000 2.500 12.000 20.500 Capital Realizable income 15.000 5.500 20.500 500 5.500

Year 2 ()

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25.000 12.000 13.000 2.000 11.000 500 10.500 800 11.300

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4.000 3.800 24.000 31.800 15.000 16.800 31.800

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Current exit value accounting

(contd)
1 January year 7 Introduced capital of 25.000 and purchased 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 a

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Current exit value accounting

(contd)

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Information about machine:

31.12.7
Replacement cost Realizable value Cost of realization 10.000 8.000 1.000

31.12.8
12.000 6.000 1.000

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Current exit value accounting

(contd)
P&L account
31.12.7 Sales Cost of sales Gross profit Rent Expenses Depreciation Gross profit Holding gain 1.000 1.000 2.000 (4.000) 500 3.000 3.500 9.000 (4.500) 4.500 1.100 1.200 2.000 (4.300) 4.100 (1.400) 2.700 31.12.8 16.500 (8.100) 8.400

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Current exit value accounting

(contd)
Balance sheet
31.12.7 31.12.8 5.000 3.300 22.900 21.500 28.500 Share capital Profit 25.000 3.500 28.500 26.200 31.200 25.000 6.200 31.200

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Fixed assets
Machine at NRV Current assets Inventory at NRV Bank 6.000 15.500 7.000

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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 nonaccountant 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 (contd)

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 (contd)

Expected values: values expected to be received in the future for output sold according to the firms 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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Current exit values: preliminary appraisal (contd)

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

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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 (contd)

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

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