INTERMEDIATE FINANCIAL ACCOUNTING – M
Historical Cost Accounting V.S. Current Cost Accounting and Current Purchasing Power: Which is more effective?
Inflation on Accounting measures
Prepared for The Institute of Chartered Accountants in English & Wales
22nd September, 2014
The purpose of this report is to discuss the adoption of the types of accounting measurements for inflation. Kulkarmi (1979) describes shareholders as 'owners' of a company and the prime users of accounts. Being a shareholder that would be affected by these changes, this report draws up evidence relating to the events in the 1970s and 1980s. It has been shown that there was a number of non-supporting parties that discredit the implementation of SSAP 16. This included governments and accounting bodies that did not provide support and authority to Accounting Standards Steering Committee (ASC). Nevertheless, it is important not to overlook these measurements.
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There have been controversies regarding the types of accounting measurements used in financial reporting due to differences in accounting systems, manipulation in historical convention and inflationary environment. The primary objective of financial reporting is to provide useful information so users can make business and economic decisions. Moreover, the purpose of publishing accounts is to convey information to shareholders and potential shareholders (Thompson, 1979). Burton (1974) defined accounting information as being useful in providing information to users who seek to analyse the value of a firm without changing in wealth.
The adoption of historic cost figures ensures that the information provides a true and fair view, but it is distorted by inflation (Thompson, 1979). Hence, company’s financial results are obsolete, unrealistic, misleading, and will likely deter the effectiveness of the management. Therefore, it is crucial to adopt other measures that will provide more up-to-date figures. Only then can it provide a more realistic indication of trend information for decision-making purposes. (Presidents, 1986)
The development of SSAP 16 originated with concerns regarding the impact of rising inflation on financial reporting. The failure in SSAP 16 was because of three reasons. First is economic events. SSAP 16 was published in 1980 after a sustained decline in the rate of inflation in the U.K. This led to a growing number of companies discontinuing the practice. Thus, it became less important (Pong and Whittington, 1996).
Secondly, there were changes in the government policy in 1979. Initially, the government was the main supporter of CCA (Atchley, 1984), but due to changes in Labour government, the implementation of monetary policy reduced the reporting of high profits. The discharge of Price Commission resulted to the discontinuation of profit-reducing accounting policies by large companies. The publication of the Green Paper on Corporation Tax stated that CCA adjustments were not allowed for taxation purposes since they were subjective and vulnerable to manipulation by the taxpayers. Hence, tax reliefs were not given on the basis of CCA (Pong and Whittington, 1996). ICAEW Editorial (1977) commented that governments are the reason for inflation.
Thirdly, the lack of support and authority from key parties. ASC do not have formal authority, so they had to convince preparers of accounts to cooperate. There were also constraints attributed to the preparers of accounts and those who audited them. ASC had difficulties in meeting the needs of users, public, and preparers (Pong and Whittington, 1996). In Davison's speech, he explained that ASC standards do not have the force of the law; they can only publish standards with the support from accountants and business community.
De Jong (1984) wrote that managements prefer favourable figures because they set a better impression, which compromises users’ interest. Public accountants, Government, Financial Analyst and Academics should play their role in supporting the change. Incentives must be given to management to make the change, otherwise, it will only be an extra workload. This is because they need to understand the implementation of new systems, and no support and authority from other groups is enforced for the management to change the system.
Perrin (1976) stated that any restructuring of financial accounting should avoid income smoothing, profit anticipation and imprudently lower initial depreciation. The debates between the usage of CCA and Current Purchasing Power (CPP) had caused confusion for years. Kulkarmi (1979) stated that CCA uses specific price indices to maintain particular composition of physical assets that a company owns, while CPP uses a general index to sustain the value of shareholder’s interest. Baxter (1985) concluded that CCA works well for assets and CPP works well for income.
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Thompson (1979) stated that the adoption of CCA provides better decision-making as it portrays a truer view of the company’s progress during inflation period. Kulkarni (1979) assured that it is a helpful indicator valuing the company's resources. De Jong (1984) commented that CCA can be complex, time-consuming, and it requires new rules. He also added that it can cause confusion to users because historic convention is easily understood and has been adopted by major users. Furthermore, management could act according to self-interest as CCA does not portray higher profit attributable to shareholders as compared to historic conventions.
It is not recommended to use CCA alone because it will mismanage the measurement of income and loss or gain on monetary items; therefore, the implementation of a hybrid is better (Baxter, 1985). Myddelton (1976) states that CPP is recommended by accounting bodies for being more consistent, practical, workable and comprehensive. He also added that it can be implemented swiftly and had been used by a number of companies. Perrin (1976) proved that CPP had assisted in building confidence in savings and investments in Brazil.
Nevertheless, Woolf (1975) commented that CPP lacks credibility, certainty and accuracy when compared with HCA, and are mutually exclusive. He added that it is unhelpful for commodities companies that are facing liquidity issues. He also deemed it expensive to carry out, since teams of experts like cost accountants and engineers have to be involved. Besides, CPP ignores the qualitative character of managerial costs and flows (Perrin, 1976).
A hybrid of these two is needed if management wants inflation accounting to function properly (Baxter, 1985). CCA will be useful in measuring a company's 'wealth' and CPP will be useful in comparing opening and closing wealth of the company (Kulkarni, 1979). It is recommended to implement CCA and CPP in times of single and double digit inflation.
When adopting CCA, it is better that the profit figures are published first than publishing unaudited figures at the interim stage. Thompson (1979) stated that for users to find favour in CCA, there must be ease of analysis like the quality of presentation must be similar to the layout of HCA. He also recommended three guidelines for accountants to adopt in order to make sure that investors use CCA: highlight the current cost operating profit; publish the same time as the historic cost preliminary and interim statements, and comment on the trend of current cost figures.
For CPP, Woolf (1975) explained that management has to be cautious in identifying the 'monetary' and 'non-monetary' items in the accounts. Monetary items must be restated at balance sheet, and non-monetary items must be converted by referencing Retail Price Index. Perrin (1976) believed that whatever method is adopted, firms should crucially re-evaluate their fixed asset valuation bases and assessment methodology for annual depreciation charges in the future. Perrin (1976) commented that the use of accounting measurements is to ensure that information is monitored on management performance. Accountants must also provide standalone judgements of forecasted figures by management.
Before developing standards, there must be discussions of issues such as whether standards are really needed, and if so, whose needs they meet, and how appropriate they are. This is because standards are created for public good. Internal political conflicts among the key parties must be resolved. There must also be assurance that governments become reliable allies for standard setters. Pong and Whittington (1996) recommended that in order for standards to be attractive, they must be recognized for tax purposes; there must be legal backing and support from accountancy bodies and government. Furthermore, skilled and political judgement must be taken into consideration when setting standards.
Standard setters, companies and their auditors are the ones responsible for reporting financial information. For this reason, agreements must be made between them regarding which mode of measurement to adopt. Any conflict of interest creates confusion, and affects judgement in valuing companies. Other implementation options would include issuing CCA Guidance Notes to companies, providing guidance to companies (Boersema, 1979), and educating users.
If companies persistently adopt HCA, users will be the ones suffering the most since information is misrepresented by inflation. This will lead to impracticable and unusable outdated figures for valuing a company. Therefore, CCA and CPP measures must be adopted hand in hand to provide better decision-making that reflects a more accurate view of the company. However, governments and accounting bodies discouraged its use in the 1980s. But one must keep in mind that the preparation of financial reporting is for users, thus, it is crucial to consider the interest of users.
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Atchley, K. (March 1984) 'Son of SSAP 16; what chance of survival?', Accountancy, Wolters Kluwer UK, pp. 14-15.
Boersema, J. (July 1979) 'A flexible approach to price variation accounting', Accountancy, Wolters Kluwer UK, pp. 57-58.
Baxter, W. (September 1985) 'Inflation: a hybrid of CAA and CPP needed', Accountancy, Wolters Kluwer UK, pp. 119-120.
Christopher K. M. Pong and Geoffrey Whittington (1996) 'The Withdrawal of Current Cost Accounting in the United Kingdom: A Study of the Accounting Standards Committee ', ABACUS, Vol. 32 (No. 1), pp. 30-53.
de Jong, J (February 1984) 'Why management sees no merit in a CCA changeover', Accountancy, Wolters Kluwer UK, pp. 108-109.
Editorial (January 1977) 'CCA alone is not enough', Accountancy, Wolters Kluwer UK, pp. 1.
ICAEW (Institute of Chartered Accountants in England and Wales). (2006). Information for Better Markets: Measurement in Financial Reporting (London).
John C. Burton (1974) 'Financial Reporting in an Age of Inflation', Securities and Exchange Commission, speech given at the Accounting Day of the University of California at Berkeley, pp. 2-9.
Kulkarmi, D. (November 1979) 'A shareholder's view of CCA (or why the debate must go on)', Accountancy, Wolters Kluwer UK, pp. 135-136.
Myddelton, D.R. (Feburary 1976) 'Inflation and the unreal world of Sandilands', Accountancy, Wolters Kluwer UK, pp. 34-35, 37.
Perrin, J. (May 1976) 'Why CPP is not the answer', Accountancy, Wolters Kluwer UK, pp. 56, 58, 60
Presidents from five of the leading accountancy bodies (November 1986) 'Accounting for the effects of changing prices', Accountancy, Wolters Kluwer UK, pp. 153-154, 156, 158.
Thompson, P. (April 1979) 'What investors need from CCA', Accountancy, Wolters Kluwer UK, pp. 64-66
Woolf, E. (June 1975) 'CPP accounting is no answer', Accountancy, Wolters Kluwer UK, pp. 90, 92-93
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