Chapter 7 - Conceptual Framework

Question 1

Historical cost

Answer 1

Assets are stated in the statement of financial position at their cost less any amounts written off.

Advantages
1. Easy to understand.

2. Straightforward to produce.
3. Historical cost accounts are objective and free from bias.
4. Historical cost values are reliable and original values can be confirmed based on original invoices.
5. Historical cost accounts do not record gains until they are realised.

Disadvantages
1. Carrying amount of non current assets is often substantially below current value.

2. Inventory in the statement of financial position reflects prices at the date of purchase or manufacture rather than those current at the year end.
3. Statement of profit or loss expenses do not reflect the current value of assets consumed so profit in real terms is exaggerated.
4. If profit were distributed in full, the level of operations would have to be curtailed.
5. No account is taken of the effect of increasing prices on monetary items.
6. Overstatement of profits and the understatement of assets prevent a meaningful calculation of ROCE.

Question 2

Other asset values

Answer 2

1. Replacement cost
   The cost to the business of replacing the asset.
   For example the cost of replacing inventory.
2. NRV
   The estimated sales proceeds less any costs involved in selling the asset.
3. Economic value
   The present value of future cash flows from an asset.
4. Current cost
   The current value of an asset based on MV and age of asset.

Question 3

Constant purchasing power accounting

Answer 3

Accounts figures are adjusted to show all figures in terms of money with the same purchasing power.

A general price index is used for this.

Figures in the statement of profit or loss and statement of financial position are adjusted by the CPP factor.

CPP factor = (Index at the reporting date/ Index at date of entry in accounts)

Question 4

CCP advantages and disadvantages

Answer 4

Advantages
1. Simple and objective. Relies on a standard objective.

2. It adjusts for changes in the unit of measurement therefore is a true system of inflation accounting.
3. Measures the impact on the company in terms of shareholders purchasing power.

Disadvantages
1. Fails to capture economic substance when specific and general price movements diverge.

2. The unfamiliarity of information stated in terms of current purchasing power units.
3. CPP does not show the current values (value to the business) of assets and liabilities.
4. The general price index used is not necessarily appropriate for all assets in all businesses.
5. The physical capital of the business is not maintained.

Question 5

Current cost accounting

Answer 5

Based on deprival values or values of the business.

Inventory and non current assets are valued at deprival value.

Monetary assets are not adjusted. (Cash, receivables, payables, loans)

An additional charge to the statement of profit or loss reflect the deprival value of inventory. (Cost of sales)

An additional charge in the statement of profit or loss reflects deprival value of non current assets. (Depreciation)

Question 6

CCA advantages and disadvantages

Answer 6

Advantages
1. Relevance to users.

2. Assess the current state or recent performance of the business.
3. Physical capital is maintained.
4. Assets are stated at their value to the business.
5. Holding gains are eliminated from profit.

Disadvantages
1. Possibly greater subjectivity and lower reliability than historical cost.

2. Lack of familiarity.
3. Complexity.
4. Only adjusts values for non monetary assets.
5. Practical problems
   - not always easy to obtain an index which is perfectly suitable for measuring the movement in the current cost of a particular type of asset.
   - difficult to obtain a suitable MV for specialist items but indices may be constructed as an alternative.
   - may be no intention to replace an asset.
   - may be no modern equivalent asset due to the advance of technology.

Question 7

Capital maintenance

Answer 7

Physical capital maintenance (PCM)
Sets aside profits to allow the business o continue to operate at current levels of activity.
Adjusting opening capital by SPECIFIC price changes.

Financial capital maintenance (FCM)
Sets aside profits in order to preserve the value of shareholders funds in real terms.
Can measure increase in monetary terms or in terms of constant purchasing power.