Chapter 2 ACCOUNTING CONCEPTS

AND POLICIES
Qualification ACCA
Paper F7 INT
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Chapter Learning Objectives Common to this chapter

Upon completion of this chapter you will be able to: Common to this chapter

 Distinguish between an accounting policy and an accounting

estimate
 Distinguish between a change in accounting policy and a change
in accounting estimate
 Describe how IAS 8 applies the principle of comparability where
an entity changes its accounting policies
 Account for a change in accounting policy
 Recognise a prior period error
 Account for a prior period adjustment
 Describe the underlying assumptions of financial statements –
the accruals concept and going concern
 Define historical cost
 Compute an asset value using historical cost
 Define fair value/current value
 Compute fair value/current value
 Define net realisable value
 Compute the net realisable value of an asset
 Define present value of future cash flows
 Compute the present value of future cash flows
 Describe the advantages and disadvantages of historical cost
accounting
 Discuss whether the use of current value accounting overcomes
the problems of historical cost accounting

REPORTINGCH2ACCAF7INTJCV1 -1-
  Describe the concepts of financial and physical capital
maintenance
 Explain how the use of financial or physical capital maintenance
affects the determination of profits
 Describe what is meant by financial statements achieving a
faithful representation
 Discuss whether faithful representation constitutes more than
compliance with accounting standards
 List the circumstances where a true and fair override may apply
 Explain the disclosures required where a true and fair override
applies

IAS 8

ACCOUNTING
ACCOUNTING CONCEPTS
POLICIES

MEASUREMENT

HISTORICAL PRESENT
COST NET VALUE
FAIR REALISABLE
VALUE VALUE

HISTORICAL COST

ALTERNATIVES
LIMITATIONS CAPITAL
MAINTANANCE
FAITHFUL
REPRESENTATION

MEANING DISCLOSURES
EXEMPTIONS

REPORTINGCH2ACCAF7INTJCV1 -2-
1 IAS 8 Accounting policies, changes in accounting
estimates and errors

Qualification ACCA
Paper F7 INT
Chapter 2
Content Objective Distinguish between an accounting
policy and an accounting estimate
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 INT Ch 7

Qualification ACCA
Paper F7 INT
Chapter 2
Content Objective Distinguish between a change in
accounting policy and a change in
accounting estimate
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 INT Ch 7

Qualification ACCA
Paper F7 INT
Chapter 2
Content Objective Account for a change in accounting
policy
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 INT Ch 7

1.1 Introduction

IAS 8 governs the following topics:

 selection of accounting policies
 changes in accounting policies
 changes in accounting estimates
 correction of prior period errors.

REPORTINGCH2ACCAF7INTJCV1 -3-
1.2 Accounting policies

Accounting policies are the principles, bases, conventions, rules and practices applied by an
entity which specify how the effects of transactions and other events are reflected in the
financial statements.

IAS 8 requires an enterprise to select and apply appropriate accounting policies complying
with IFRSs and Interpretations to ensure that the financial statements provide information that
is:
 relevant to the decision making needs of users
 reliable in that they:
– represent faithfully the results and financial position of the
enterprise
– reflect the economic substance of events and transactions
and not merely the legal form
– are neutral, that is free from bias
– are prudent
– are complete in all material respects.

Illustration 1
The accounting policy for the cost of computers might be to depreciate them on a straight line
basis over four years to a nil residual value.

1.3 Selection of accounting policies

Accounting policies should be chosen according the following rules:

. when an IFRS or an IFRIC Interpretation applies to a transaction, an accounting policy
should be selected that complies with the Standard/Interpretation, unless the effect of non-
compliance would be immaterial.
. In the absence of a Standard or Interpretation that applies, select an accounting policy in
compliance with the principles of the Framework,
. in such circumstances they should seek to maximise the relevance and reliability of the
information that is presented.
. applicable concepts in the decision will include substance over form, freedom from bias,
and prudence.
. management may wish to refer to standards issued by other standard-setting bodies,
or accounting literature in general, when making their decision.

REPORTINGCH2ACCAF7INTJCV1 -4-
 Qualification ACCA
Paper F7 INT
Chapter 2
Content Objective Describe how IAS 8 3 applies the
principle of comparability where an
entity changes its accounting policies
Content, illustration and TYU 1 – 2.5 GBR text Ch 1
TYU included?
Source (esp. vital) Text 2.5 INT Ch 7

1.3 Changing accounting policies

The general rule is that:

. accounting policies are normally kept the same from period to period to ensure
comparability of financial statements over time.

IAS 8 requires accounting policies to be changed only if the change:

 is required by IFRSs; or
 will result in a reliable and more relevant presentation of
events or transactions.

IAS 8 prohibits changes in any other circumstances, so management wishing to make a

change must justify it under one or other of these two headings.

1.4 Accounting for a change in accounting policy

The required accounting treatment is that:

. the change should be applied retrospectively, with an adjustment to the opening balance
of retained earnings in the statement of changes in equity
. comparative information should be restated unless it is impracticable to do so.
. there will be a prior period adjustment to the balance of retained earnings brought forward
in the statement of changes in equity.
. if the adjustment to opening retained earnings cannot be reasonably determined, the
change should be adjusted prospectively – ie. included in the current period’s income
statement.

1.4 Disclosure requirements

When a change in accounting policy has a material effect on the current period or any prior
period presented, or may have a material effect in subsequent periods, the following
disclosures should be made:

 the reasons for the change

 the amounts of the adjustments recognised in the current period and the previous
period presented (i.e. the comparative figures)

REPORTINGCH2ACCAF7INTJCV1 -5-
 the amount of the adjustment relating to periods prior to those included in the
financial statements.

1.5 Accounting estimates

An estimation technique is a method adopted by an entity to arrive at estimated amounts for

the financial statements.

Most figures in the financial statements require some estimation:

. the exercise of judgement based on the latest information available at the time
. at a later date, estimates may have to be revised as a result of the availability of new
information, more experience or subsequent developments.

Illustration 2
If a non-current asset has a depreciable amount of $5,000 to be written off over five years,
different depreciation methods such as straight line, reducing balance, sum of the digits, etc,
all represent different estimation techniques.

The choice of method of depreciation would be the estimation technique whereas the policy of
writing off the cost of non-current assets over their useful lives would be the accounting
policy.

Estimation techniques therefore implement the measurement aspects of accounting policies.

1.6 Changes in accounting estimates

The requirements of IAS 8 in this regard are:

 the effects of a change in accounting estimate should be included in the income statement
in the period of the change and, if subsequent periods are affected, in those subsequent
periods
 the effects of the change should be included in the same income statement classification
as was used for the original estimate.
. If the effect of the change is material, its nature and amount must be disclosed.

Examples of changes in accounting estimates are changes in:

REPORTINGCH2ACCAF7INTJCV1 -6-
 the useful lives of non-current assets
 the residual values of non-current assets
 the method of depreciating of non-current assets
. warranty provisions, based upon more up to date information about claims frequency.

Test your understanding 1

Which of the following is a change in accounting policy as opposed to a change in estimation

technique?
1 An entity has previously charged interest incurred in connection with the construction of
tangible non-current assets to the income statement. It now capitalises this interest.
2 An entity has previously depreciated vehicles using the reducing balance
method at 40% per year. It now uses the straight line method over a period of five
years.
3 An entity has previously shown certain overheads within cost of sales. It now shows
those overheads within administrative expenses.

4 An entity has previously measured inventory at weighted average cost. It now

measures inventory using the FIFO method.

Solution

For each of the items, ask whether this involves a change to:
 recognition?
 presentation?
 measurement basis?
If the answer to any of these is yes, the change is a change in accounting policy.
1 This is a change in recognition and presentation. Therefore this is a change in
accounting policy.
2 The answer to all three questions is no. This is only a change in estimation technique.
3 This is a change in presentation and therefore a change in accounting policy.
4 This is a change in measurement basis and therefore a change in accounting policy.

Qualification ACCA
Paper F7 INT
Chapter 2
Content Objective Recognise a prior period adjustment
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 INT Ch 7

REPORTINGCH2ACCAF7INTJCV1 -7-
 Qualification ACCA
Paper F7 GBR
Chapter 2
Content Objective Account for a prior period adjustment
Content, illustration and Illustration 3 – 2.5 GBR Text Ch 13
TYU included? TYU 2 – new
Source (esp. vital) Text 2.5 INT Ch 7

1.7 Prior period errors

Prior period errors are omissions from, and misstatements in, the financial statements for one
or more prior periods arising from a failure to use information that:
. was available when the financial statements for those periods were authorised for issue;
and
. could reasonably be expected to have been taken into account in preparing those
financial statements
. such errors include mathematical mistakes, mistakes in applying accounting policies,
oversights and fraud
. current period errors that are discovered in that period should be corrected before the
financial statements are authorised for issue.

1.8 Correction of prior period errors

Prior period errors are dealt with by:

 restating the opening balance of assets, liabilities and equity as if the error had never
occurred, and presenting the necessary adjustment to the opening balance of retained
earnings in the statement of changes in equity; and
 restating the comparative figures presented, as if the error had never occurred.

Illlustration 3
During 20X1 a company discovered that certain items had been included in inventory at 31
December 20X0 at a value of $2.5 million but they had in fact been sold before the year end.

The original figures reported for year ending 31 December 20X0 and the figures the current
year 20X1 are given below:
20X1 20X0
$000 $000
Sales 52,100 48,300
Cost of sales 33,500 30,200
Gross profit 18,600 18,100

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Tax 4,600 4,300
Net profit 14,000 13,800

The cost of goods sold in 20X1 includes the $2.5 million error in opening inventory. The
retained earnings at 1 January 20X0 were $11.2 million. (Assume that the adjustment will
have no effect on the tax charge).

Show the 20X1 income statement with comparative figures and the retained earnings for each
year.

Solution

Income statement

20X1 20X0
$000 $000
Sales 52,100 48,300
Cost of sales
(20X1 (33,500 – 2,500) 31,000
(20X0 (30,200 + 2,500) 32,700
Gross profit 21,100 15,600
Tax 4,600 4,300
Net profit 16,500 11,300

Retained earnings
Opening retained earnings
As previously reported (11,200 + 13,800) 25,000 11,200
Prior period adjustment (2,500) -
As restated 22,500 11,200
Net profit for the year 16,500 11,300
Closing retained earnings 39,000 22,500

1.8 Disclosure
In applying these rules, the enterprise should disclose in the notes:
 the nature of the prior period error
 the amount of the correction to each financial statement line item presented for the prior
periods
 the amount of the correction at the beginning of the earliest prior period presented.

Test your understanding 2

What is the accounting treatment for a change in accounting policy?

REPORTINGCH2ACCAF7INTJCV1 -9-
Solution
. the change should be applied retrospectively, with an adjustment to the opening balance
of retained earnings in the statement of changes in equity
. comparative information should be restated unless it is impracticable to do so.
. there will be a prior period adjustment to the balance of retained earnings brought forward
in the statement of changes in equity.
. if the adjustment to opening retained earnings cannot be reasonably determined, the
change should be adjusted prospectively – ie. included in the current period’s income
statement.

1.9 Underlying assumptions

The Framework identifies the underlying assumptions governing financial statements – the
accrual basis and going concern.
 The accrual basis of accounting means that the effects of transactions and other events
are recognised as they occur and not as cash or its equivalent is received or paid.
 The going concern basis assumes that the enterprise has neither the need nor
the intention to liquidate or curtail materially the scale of its operations.

1.10 Other accounting concepts and conventions

There are a number of other accounting concepts and conventions upon which the
preparation of financial statements are based:
. Consistency - a business should be consistent in its accounting treatment of similar items,
both within a particular accounting period, and between one accounting period and the next.
. Prudence - means exercising a degree of caution in making judgements about
estimates required under conditions of uncertainty, such that gains and assets are not
overstated and losses and liabilities are not understated.
. Separate entity - for accounting purposes the business is a separate entity quite apart
from the owners of the business.
. Objectivity convention - financial statements should be as objective as possible
. Substance over form – the commercial substance of a transaction should be recorded
not necessarily its legal form (see later chapter).
. Offsetting - assets and liabilities, and income and expenses, should not be offset (i.e. only
the net figure is reported) except when required or permitted by an IFRS or an IFRIC
Interpretation.

REPORTINGCH2ACCAF7INTJCV1 - 10 -
2 Measurement in financial statements

Qualification ACCA
Paper F7 INT
Chapter 2
Content Objective Define historical cost
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 2

Qualification ACCA
Paper F7 INT
Chapter 2
Content Objective Compute an asset value using
historical cost
Content, illustration and Illustration 4 – 2.5 GBR text Ch 2
TYU included? TYU 3 – 2.5 GBR text Ch 2 Act 1
TYU 4 – 2.5 GBR text Ch 2 Act 2
Source (esp. vital) Text 2.5 GBR Ch 2

Qualification ACCA
Paper F7 INT
Chapter 2
Content Objective Define fair value/current cost
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 2

Qualification ACCA
Paper F7 INT
Chapter 2

Content Objective Compute an asset value using fair

value/current cost
Content, illustration and Illustration 4 – 2.5 GBR text Ch 2
TYU included? TYU 3 – 2.5 GBR text Ch 2 Act 1
TYU 4 – 2.5 GBR text Act 2

REPORTINGCH2ACCAF7INTJCV1 - 11 -
 Source (esp. vital) Text 2.5 GBR Ch 2

Qualification ACCA
Paper F7 INT
Chapter 2
Content Objective Define net realisable
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 2

Qualification ACCA
Paper F7 INT
Chapter 2

Content Objective Compute an asset value using net

realisable value
Content, illustration and Illustration 4 – 2.5 GBR text Ch 2
TYU included? TYU 3 – 2.5 GBR text Ch 2 Act 1
TYU 4 – 2.5 GBR text Act 2
Source (esp. vital) Text 2.5 GBR Ch 2

Qualification ACCA
Paper F7 INT
Chapter 2
Content Objective Define present value of future cash
flows
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 2

Qualification ACCA

REPORTINGCH2ACCAF7INTJCV1 - 12 -
 Paper F7 INT
Chapter 2

Content Objective Compute an asset value using present

value of future cash flows
Content, illustration and Illustration 4 – 2.5 GBR text Ch 2
TYU included? TYU 3 – 2.5 GBR text Ch 2 Act 1
TYU 4 – 2.5 GBR text Act 2
Source (esp. vital) Text 2.5 GBR Ch 2

2.1 Historical cost

Traditionally, accounts have been presented using the historical cost convention:
. assets are stated in the balance sheet at their cost,
. less any amounts written off (e.g. for depreciation in the case of tangible fixed assets)

However it can be argued that other valuations of assets are more relevant, for example:
. fair value
. replacement cost
. net realisable value
. economic value

Expandable text
The objective of financial statements is to provide information about the reporting entity’s
financial performance and position that is useful to a wide range of users for assessing the
stewardship of management and for making economic decisions.

What is wrong with the traditional historical cost basis of measurement used by
accountants? Whilst being both easy to ascertain and objective, it fails to relate
directly to any of the three decisions that might reasonably be made about an asset:

 Another, similar asset might be purchased. Management need to know the current
replacement cost which might have changed substantially since the present asset was
purchased at its historical cost.
 The asset might be sold. Management need to know the amount which would be realised
from sale, less any costs involved in disposal, i.e. the net realisable value. Again, this may
bear no relationship to historical cost.
 The asset might be used in the business. Management need to estimate the future cash
flows arising from the asset and discount these to their present value, i.e. their ‘economic
value’. Clearly, there is no direct link with historical cost in this case.

A further method of valuing assets which is relevant particularly to financial assets (see later
chapter) is that of fair value.

REPORTINGCH2ACCAF7INTJCV1 - 13 -
2.1 Fair value

Fair value is the amount at which an asset or liability could be exchanged in an arm’s length
transaction between informed and willing parties, other than in a forced or liquidation sale’.
. fair value is sometimes known as current value

Illustration 4
Some examples might help with this:
 If the item is quoted on an active market, then its fair value is its market value on that
market. For example, the shares in large public companies are quoted on stock
exchanges. The fair value of 1,000 shares in Company AB quoted at $2 each would be
$2,000.
 If the item is not quoted on an active market, but similar items are, then the item’s fair
value should be determined by reference to these similar items. For example, a company
might own 1,000 shares in an unquoted company CD. If CD is identical in every way to the
quoted company AB which has a share price of $2 each, then perhaps the fair value of the
shares held in CD is $2,000.
. If the item is not quoted on an active market, and no similar items can be identified that
are quoted, then the fair value must be estimated using a valuation model. For example, a
holding of all the shares of EF, a company with net assets on its balance sheet of $10,000,
might also be estimated to have a fair value of $10,000. That would apply the valuation
model of valuing a company at the total net value of the net assets on its balance sheet.

Test your understanding 3

How would the fair value of the following items be determined?
(a) An investment holding of 5,000 shares in XYZ, a large company quoted on a stock
exchange.
(b) An office block bought for $2m ten years ago. There are few such office buildings being
sold at the moment.
(c) A herd of 200 dairy cows.

Solution

REPORTINGCH2ACCAF7INTJCV1 - 14 -
(a) Since XYZ is quoted on an active market, the current share price is an accurate measure
of the fair value. The holding of 5,000 shares should be valued in total as 5,000 times the
current share price.
(b) There is currently no active market for such office blocks, so some method of estimation
is required. Perhaps a local estate agent or surveyor could give a reasonable estimate of
current market value; perhaps there is a government index of price movements on such
buildings that could be applied.
(c) There probably is an active market for cows of the age and
type that are owned. Each cow can then be valued at its own market value.

2.3 Definitions of other asset values

Replacement cost is the cost to the business of replacing the asset.

Net realisable value is the estimated sales proceeds less any costs involved in selling the
asset.

Economic value is the present value of the future cash flows from an asset.

Illustration 5
A company owns a machine which it purchased four years ago for $100,000. The
accumulated depreciation on the machine to date is $40,000. The machine could be sold to
another manufacturer for $50,000 but there would be dismantling costs of $5,000. To replace
the machine with a new version would cost $110,000. The cash flows from the existing
machine are estimated to be $25,000 for the next two years followed by $20,000 per year for
the remaining four years of the machines life.

The relevant discount factor for this company is 10% and the discount factors are:
Year 1 0.909
Year 2 0.826

REPORTINGCH2ACCAF7INTJCV1 - 15 -
Years 3 to 6 inclusive 2.619

Calculate the following values for the machine:

a) Historical cost
b) Net realisable value
c) Replacement cost
d) Economic value

Solution
a) Historical cost
$
Cost 100,000
Less: depreciation (40,000)
60,000

b) Net realisable value

$
Selling price 50,000
Less: costs to sell (5,000)
45,000

c) Replacement cost
$
110,000

d) Economic value
$
$25,000 x 0.909 22,725
$25,000 x 0.826 20,650
$20,000 x 2.619 52,380
95,485

2.4 Deprival value

Deprival value (value to the business) is defined as the loss a business would suffer if
deprived of an asset.

REPORTINGCH2ACCAF7INTJCV1 - 16 -
2.5 Calculation of deprival value
To calculate deprival value we need to identify:
. replacement cost
. net realisable value, and
. economic value.

Then we can identify two important relationships between values:

 the higher of net realisable value (NRV) and economic value (EV) – if management own
an asset, they have control over the choice between use and disposal, and if it is
economically rational they will choose the option having the highest value – this is known
as the recoverable amount
 the lower of replacement cost (RC) and recoverable amount.

This may be portrayed diagrammatically as follows:

Value to the business

= lower of

Replacement cost and Recoverable amount

= higher of

Economic value and Net

Realisable
Value

If they are deprived of an asset, management have a choice as to whether or not to replace it.
If they are economically rational, they will replace the asset only if they can generate a
surplus either by resale or by use.

Expandable text
Advantages and disadvantages of deprival value
The main advantage of using ‘deprival value’ is that the implicit assumptions that assets will
be replaced or liquidated are avoided. However, there are a number of arguments against
deprival value, including the following.
 The balance sheet may include the total of a number of different valuation bases
(RC, NRV, EV), so that the significance of the total assets figure is unclear.
 The basis of this approach is a hypothetical deprival which has not taken place, and
there is some debate as to whether this is a satisfactory basis for measuring actual
past events.

REPORTINGCH2ACCAF7INTJCV1 - 17 -
In the situation where economic value emerges as a measure of deprival value, then this
measure is subject to all the practical difficulties involved in the measurement of economic
income ie present values of future cash flows.

REPORTINGCH2ACCAF7INTJCV1 - 18 -
Illustration 6
Using our asset from the previous example it had the following values:
Net realisable value $45,000
Replacement cost $110,000
Economic value $95,485

What is the deprival value or value to the business?

Solution
The higher of net realisable value ($45,000) and economic value ($95,485) is $95,485.
Therefore management would prefer to keep and use the asset in the business rather than
sell it. This is the recoverable amount.

The lower of replacement cost ($110,000) and recoverable amount ($95,485) is the deprival
value or value to the business - $95,485.

Test your understanding 4

a)
A company owns a machine with a five-year useful life and no residual value.
At 31 December 20X2 the machine is two years old. To buy a brand new machine of the
same type at that date would cost $100,000.
If the machine were sold it would fetch about $30,000 but there would be dismantling costs of
about $5,000.
It is estimated that the machine could generate cash flows of $40,000 per annum if it were
used in the business for the next three years. The net present value of these cash flows is
$99,000.
Calculate the deprival value of the asset.

b)
Assume that the facts are as in (a) above but that the business is in such a poor state that
there are no positive cash flows to be obtained from continuing to use the asset.
Calculate the deprival value of the asset.

c)
Assume that the facts are as in (a) above but that the net present value of the cash flows
associated with the continued use of the asset is $55,000.
Calculate the deprival value of the asset.

Solution
a)

REPORTINGCH2ACCAF7INTJCV1 - 19 -
 $
RC = Gross replacement cost 100,000
2
Less: Accumulated depreciation 5 40,000
_____
60,000
_____
NRV = Sale proceeds 30,000
Less: Costs to sell 5,000
_____
25,000
_____
NPV = 99,000
_____
DV = lower of $60,000 and (higher of $25,000 and
$99,000)

Deprival value is the replacement cost of $60,000

b)
$
RC as before 60,000
NRV as before 25,000
NPV when there are no cash flows Nil
DV = lower of $60,000 and (higher of $25,000 and nil)
Deprival value is the net realisable value of $25,000.

c)
$
RC as before 60,000
NRV as before 25,000
NPV 55,000
DV = lower of $60,000 and (higher of $25,000 and
$55,000)
Deprival value is the net present value of $55,000.

3 Historical cost accounting and alternative models

Qualification ACCA
Paper F7 INT
Chapter 2
Content Objective Describe the advantages and
disadvantages of historical cost
accounting
Content, illustration and Ill 7 2.5 GBR text Ch 4
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 4

REPORTINGCH2ACCAF7INTJCV1 - 20 -
 Qualification ACCA
Paper F7 INT
Chapter 2

Content Objective Discuss whether the use of current

value accounting overcomes the
problems of historical cost accounting
Content, illustration and TYU 5 – 2.5 GBR text Ch 4 Act 2
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 4

3.1 Historical cost accounting

The traditional approach to accounting has the following features.

 Accounting transactions are recorded at their original historical monetary cost.
 Items or events for which no monetary transaction has occurred are usually ignored
altogether.
 Income for each period is normally taken into account only when revenue is realised
in the form of cash or in some form which will soon be converted into cash.
 Profit for the period is found by matching income against the cost of items consumed in
generating the revenue for the period (such items include non-current assets which
depreciate through use, obsolescence or the passage of time).

These features of accounting have served users well over many years in accounting for the
stewardship of the directors.

REPORTINGCH2ACCAF7INTJCV1 - 21 -
3.2 Deficiencies of historical cost accounts

In periods in which prices change significantly, historical cost accounts have grave
deficiencies:

 net book value of non-current assets is often substantially below current value
 inventory in the balance sheet reflects prices at the date of purchase or manufacture
rather than those current at the year end
 income statement expenses do not reflect the current value of assets consumed so profit
in real terms is exaggerated
. ff this profit figure were distributed in full, the level of operations would have to be
curtailed.
 no account taken of the effect of increasing prices on monetary items.
 the overstatement of profits and the understatement of assets prevents a meaningful
calculation of return on capital employed.
. As a result of the above, users of accounts find it extremely difficult to assess a
company’s progress from year to year or to compare the results of different operations.

Illustration 7
Company A acquires a new machine in 20X4. This machine
costs $50,000 and has an estimated useful life of ten years.
Company B acquires an identical machine in 20X5, except that it
buys a machine exactly one year old, with an estimated useful
life of nine years. The cost of the machine is $48,000.
Depreciation charges (straight-line basis) in 20X5 are as follows.
Company A $50,000/10 = $5,000
Company B $48,000/9 = $5,333

Net book values at the end of 20X5 are:

Company A $50,000  (2  $5,000)= $40,000
Company B $48,000  $5,333 = $42,667
Both companies are using identical machines during 20X5, but
the income statements will show quite different profit figures
because of adherence to historical cost. Is the comparison of
balance sheets and income statements for the two companies in
20X5 meaningful?

REPORTINGCH2ACCAF7INTJCV1 - 22 -
3.3 Historical cost accounting and subjectivity

The principal advantage for historical cost accounting:

. is that it reduces subjectivity to a minimum
. subjectivity is where the accounts can be affected by personal opinion as opposed to
verifiable factual information.

However subjective opinions are extremely important in conventional accounting for example:
 Revaluation of non-current assets
 Depreciation charges require subjective estimates of useful life and estimated scrap value
 Inventory may be stated at net realisable value where this is estimated to be less than
cost
 Provision for doubtful debts and obsolete and slow-moving inventory often require
subjective opinion
 Treatment of construction contracts requires subjective estimations of, for example,
expected cost to complete the contract.

3.4 Possible alternatives to historical cost accounting

The alternative to historical cost accounting is a form of current value accounting, either:
. constant purchasing power (CPP), or
. current cost accounting (CCA)

Expandable text
Deficiencies of the traditional historical cost approach
 Adherence to original historical costs leads inevitably to the misstatement of asset values
and profitability. Balance sheets no longer represent a meaningful picture of the economic
state of affairs of a business.
 Disregarding items and events for which no monetary transaction has occurred may mean
that accounts do not portray the actual economic factors determining the success or
failure of the business.

 By recognising only revenue which is realised, changes in wealth that are of

benefit to shareholders will be indefinitely disregarded.
 The process of matching expenses with revenue is inevitably subjective and possibly
pointless, as it is the level and timing of cash flows which determine economic values.
 By taking a biased view of the uncertainty associated with a business, its strength and
performance are deliberately misrepresented (albeit prudently).

Possible alternatives to historical cost accounting

Despite these limitations, historical cost accounts still prevail because of the past difficulties in
finding a suitable alternative.
One alternative to strict historical cost accounting (HCA) is to revalue certain assets, such as
property, to its current value but to account for all other assets using HCA as before. This is
called the modified historical cost convention and produces arguably more relevant
information for users. However the basis of asset valuation is inconsistent (some at current
value and others at historical cost), so it is not a comprehensive solution to the problem.

REPORTINGCH2ACCAF7INTJCV1 - 23 -
The argument for an alternative to historical cost accounting has revolved around the
question of whether accounting for the effects of inflation should be directed towards:
1 presenting accounts in the same real terms from one year to another
(current purchasing power or CPP)
2 protecting the operating capabilities of companies (current cost accounting or CCA)
. some combination of the two.

Option 1 involves accounting for general price changes. The

owners of the business are shareholders who may suffer from
general inflation as the purchasing power of their investment in
the business declines. Changes in general prices are thus used
to record the effect.
Option 2 involves the consideration of specific price changes.
Here the perspective of the business as a separate entity is
paramount. The effects of price changes on the specific assets
owned by the business are therefore used.
The dispute is made more complex by a lack of basic agreement
on a definition of ‘profit’.
This is best illustrated by a simple example.

Example
Alan sets up in business on 1 January with $1,000, which he
immediately uses to buy goods for resale. On 31 January he
sells these goods for $1,500. At this date the replacement price
of the goods to Alan is $1,200. During January the general price
index has risen by 30%.

Solution
In historical cost terms the results of his trading are as follows:
$
Sales 1,500
Cost of goods sold 1,000
____
Profit 500
____
However, if Alan wishes to continue in business at the same
level, he must presumably replace the goods he has sold with
new inventory costing $1,200. If the Income statement is to show
the amount which can be reasonably distributed while
maintaining the operating capability of his business, the profit
could more sensibly be stated on a current cost basis as follows:
$
Sales 1,500
Cost of goods sold (replacement cost) 1,200
____
Profit 300
____
But in real terms how much better off is Alan? He began with
$1,000 in cash. To maintain his general purchasing power ability
he would have needed to have increased this by 30% (rise in the
general price index 1 January to 31 January) to $1,300 by 31
January. In fact, he has $1,500. He is therefore $200 better off in
terms of his general purchasing power ability on 31 January than
when he started.

REPORTINGCH2ACCAF7INTJCV1 - 24 -
 The profit could variously be argued to be $500 (historical
cost), $300 (current cost) or $200 (current purchasing
power). The decision as to which (if any) is the correct figure
requires basic agreement as to a definition of profit.

3.5 Current purchasing power accounting

Key features:

. 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
. all figures in income statement and balance sheet adjusted by CPP factor
Index at the balance sheet date
. CPP factor =
Index at date of entry in accounts

Expandable text

CPP accounting
Under CPP accounting, the accounts are adjusted so that all figures are shown in terms of
money with the same purchasing power. It is thus necessary to adjust items by means of a
general price index.

Key features
In converting the figures in the basic historical cost accounts into those in the CPP statement,
a distinction is drawn between:
 monetary items
 non-monetary items.
Monetary items are those whose amounts are fixed by contract or otherwise in terms of
numbers of dollars, regardless of changes in general price levels. Examples of monetary
items are cash, receivables, payables and loan capital.
Holders of monetary assets lose general purchasing power during a period of inflation to the
extent that any income from the assets does not adequately compensate for the loss in
purchasing power; the converse applies to those having monetary liabilities.
Non-monetary items include such assets as inventory and non-current assets. Retaining the
historical cost concept requires that holders of non-monetary assets are assumed neither to
gain nor to lose purchasing power by reason only of changes in the purchasing power of the
unit of currency.
The owners of a company’s equity capital have the residual claim on its net monetary and
non-monetary assets. The equity interest is therefore neither a monetary nor a non-monetary
item.

REPORTINGCH2ACCAF7INTJCV1 - 25 -
Preparation of CPP accounts
You will not be required to prepare CPP or CCA accounts in the exam so we will simply
summarise the approach to preparing such accounts which will help you to understand the
underlying concepts.
CPP accounts are prepared by adjusting all the amounts in the accounts to reflect the value of
money at one point in time. The unit of measurement is the ‘CPP unit’ rather than the monetary
unit. In principle, the CPP unit can be based on the value of money at any point in time. In
practice, the value of money at the balance sheet date is used.
CPP accounts are prepared by updating all items in the income statement, and all non-
monetary items in the balance sheet, by the CPP factor:

Index at the balance sheet date

CPP factor =
Index at date of entry in accounts
Depreciation is adjusted by reference to the date of acquisition of the related non-current
asset item.
Monetary items in the balance sheet are not adjusted, because their value in CPP units is
their monetary amount.
In the CPP accounts it is necessary to compute a gain or loss from holding monetary items in
times of inflation. In principle, this can be found by adjusting all entries in the accounts for
each monetary item by the CPP factor, so that the difference between the ‘CPP balance’ and
the actual monetary balance represents the gain or loss on holding that item.

3.6 Advantages and disadvantages of CPP accounts

Advantages of CPP are:

 CPP accounting is both simple and objective - it relies on a standard index
 it adjusts for changes in the unit of measurement therefore is a true system of inflation
accounting.
 It measures the impact on the company in terms of shareholders’ purchasing power.

However there are disadvantages to CPP as well:

 its complexity
 its failure to capture economic substance when specific and
general price movements diverge
 the unfamiliarity of information stated in terms of current
purchasing power units.

 CPP does not show the current values (value to the business)
of assets and liabilities;
 the general price index used is not necessarily appropriate for
all assets in all businesses;
 the physical capital of the business is not maintained.

REPORTINGCH2ACCAF7INTJCV1 - 26 -
 3.7 Current cost accounting

Key features:

. based on deprival values or value to the business

. inventory and non-current assets valued at deprival value
. monetary assets (cash, receivables, payables, loans) are not adjusted
. additional charge in income statement to reflect deprival value of inventory (cost of sales)
. additional charge in income statement to reflect deprival value of non-current assets
(depreciation)

Expandable text
Current cost accounting
Current cost (or replacement cost) accounting is not a single system of accounting – there are
several variants. We will concentrate on general principles, in particular those relating to
inventory and non-current assets.
 The current cost income statement is charged with the value to the business of assets
consumed during the period. In particular, the charges for consuming inventory (cost of
sales) and non-current assets (depreciation) are based on current rather than historical
values.
 The current cost balance sheet reflects the current value of inventory and non-current
assets.

Non-current assets
Balance sheet
The general rule is that non-current assets should be included in the balance sheet at their
value to the business, i.e. the amount of compensation a company would require if it were
deprived of the asset.
In most cases, the value to the business of property is its market value on an existing use
basis, while for plant and machinery it is net current replacement cost.
How is net current replacement cost of plant and machinery calculated? There are three
basic stages:
 Stage 1: Calculate the gross replacement cost (GRC) of a new but
otherwise identical asset at the balance sheet date.
 Stage 2: Allowing for the age of the asset, calculate a depreciation
provision based on GRC.
 Stage 3: Net current replacement cost equals 1 less 2, and is shown
in the current cost balance sheet.

If GRC cannot be calculated by reference to suppliers’ price lists, an alternative is to use specific
price indices.

Example

REPORTINGCH2ACCAF7INTJCV1 - 27 -
 A company bought an item of plant on 30 June 20X3 at a cost of
$4,000. Its expected useful life was ten years, with a nil value at
the end. An identical model of plant is no longer available, but
you have obtained the following specific price indices which you
think are suitable for the purpose:
30 June 20X3 Index = 132
31 December 20X8 Index = 195
Calculate net current replacement cost at 31 December 20X8,
assuming the estimated useful life of the asset has not been
revised.

Solution
$
195
Gross replacement cost at 31 Dec 20X8: $4,000  5,909
132
5.5
Accumulated depreciation:  $5,909 3,250
10
____
Net current replacement cost: 2,659
____

Income statement
The depreciation charge for the current cost income statement
must now be calculated. For simplicity, the depreciation charge
will be based on the year-end replacement cost of the non-
current asset. Current cost depreciation can be based on the
average replacement cost during the year, but the arithmetic is a
little more complex.

Example
A company acquired a fixed asset on 1 January 20X4 at a cost
of $800. Its estimated useful life was five years, with a nil
residual value. A new, but otherwise identical, asset would cost
$800 and $960 on 31 December 20X4 and 20X5 respectively.
You are required:
 to prepare the current cost (CCA) and historical cost (HCA)
balance sheet extracts at each year end in respect of non-
current assets
 to calculate the relevant depreciation charges
 to prepare the relevant non-current asset ledger accounts for
20X5.

Solution
Balance sheets at 31 December
20X4 20X5
HCA CCA HCA CCA
$ $ $ $
Cost 800 800 800 960
Accumulated depreciation 160 160 320 384
(2/5  $960) ___ ___ ___ ___
640 640 480 576
___ ___ ___ ___
Income statements

REPORTINGCH2ACCAF7INTJCV1 - 28 -
 20X4 20X5
HCA CCA HCA CCA
$ $ $ $
Depreciation charge 160 160 160 192
(1/5  $960)

REPORTINGCH2ACCAF7INTJCV1 - 29 -
 Inventory and cost of sales
The essence of CCA is that, when an item of inventory is sold,
the proceeds of sale are matched against the current cost of the
inventory at the date of sale (representing the value to the
business of inventory consumed).

Example
A company purchased some goods on 31 January 20X2 at a
cost of $250. These goods were sold on 31 March 20X2 for
proceeds of $320 when the cost of replacing the goods was
$272.

Historical cost accounting

Under HCA, proceeds of sale ($320) would be compared with
historical cost ($250) to show profit on sale of $70.

Current cost accounting (CCA)

Under CCA accounting, when an item of inventory is sold, the proceeds of sale are matched
against the current cost of the inventory at the date of sale.
$
Proceeds of sale 320
Current cost of sales 272
___
Current cost (or operating) profit 48
___
Current cost of sales 272
Historical cost of sales 250
___
Realised ‘holding gain’ 22
___

3.8 Advantages and disadvantages of current cost accounting

Advantages of CCA:
. the most important advantage of CCA is its relevance to users
. users will be able to assess the current state or recent performance of the business.
physical capital is maintained
. assets are stated at their value to the business, and
. holding gains are eliminated from profit.

Disadvantages of CCA:

. possibly greater subjectivity and lower reliability than historical cost.

. lack of familiarity
. complexity
. only adjusts values for non-monetary assets not all assets/liabilities
. practical problems:
 It is 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.

REPORTINGCH2ACCAF7INTJCV1 - 30 -
  It is often difficult to obtain a suitable market value for
specialist items, but indices may be constructed as an
alternative.
 There may be no intention to replace an asset
 There may be no modern equivalent asset due to the
advance of technology.

Test your understanding 5

Describe the types of business that would be most heavily affected by the replacement of
historical cost accounting with a system based on current values.

Solution

Businesses with the following characteristics will be most heavily affected by the change to
current value accounting:
 large quantities of inventory held for long periods of time – the resulting adjustments will
impact heavily on the income statement;
 high levels of non-current assets acquired a long time ago – the resulting depreciation
adjustment will adversely affect profit;
 large reserves of monetary assets – a charge is made to the income statement to reflect
their fall in value when prices are rising;
 large borrowings – a credit is made in the income statement to reflect the beneficial effect
of holding borrowing in inflationary times.

4 Capital maintenance

Qualification ACCA
Paper F7 INT
Chapter 2
Content Objective Describe the concepts of physical and
financial capital maintenance
Content, illustration and ILL 8 and 9 – 2.5 GBR text Ch 4
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 4

Qualification ACCA
Paper F7 INT

REPORTINGCH2ACCAF7INTJCV1 - 31 -
 Chapter 2

Content Objective Explain how the use of financial or

physical capital maintenance affects
the determination of profits

Content, illustration and

TYU included?
Source (esp. vital) Text 2.5 GBR Ch 4

4.1 Introduction

How are gains and losses measured?

. total gains and losses accruing to the owners = the difference between the net assets at the
beginning and end of the accounting period
. the valuation method for recording the net assets therefore determines total gains and
losses
. important to distinguish ‘profit’ from other gains and losses
. how this profit is determined is affected by the capital maintenance concept which is
adopted.

4.2 Capital maintenance concepts

Capital maintenance concepts can be classified as follows:

 physical capital maintenance (PCM), alternatively known as operating capital maintenance
(OCM) – PCM is associated with CCA
 financial capital maintenance (FCM).
. FCM can be further divided into ‘Money’ FCM and CPP FCM. CPP FCM is
CPP accounting.

Illustration 8

A company begins with share capital of $100 and cash of $100. At the beginning of the year
one item of inventory is bought for $100. The item of inventory is sold at the end of the year
for $150. Its replacement cost at that time is $120 and general inflation throughout the year is
10%. Any ‘profit’ is distributed to shareholders at the end of the year

REPORTINGCH2ACCAF7INTJCV1 - 32 -
 .
Financial Physical
capital capital

maintenance maintenance
‘Money’ CPP
$ $ $
Sales 150 150 150
Less: cost of sales 100 100 120
___ ___ ___
Operating profit 50 50 30
Less: inflation adjustment (alternatively
shown by increasing cost of sales to
$110) - 10 -
___ ___ ___
Profit for year 50 40 30
Dividend 50 40 30
___ ___ ___
- - -
___ ___ ___
Capital and non-distributable reserves
at year end 100 110 120
___ ___ ___
The increase in capital and reserves of $10 for CPP is the credit
entry for the $10 inflation adjustment. The $20 for PCM is the
credit entry for the increased cost of sales. The $20 is known as
a ‘realised holding gain’.
 It is a gain (the inventory was worth more in money terms
when it was used in the business compared to when it was
purchased).
 It arose purely from holding onto the inventory in a period of
rising prices.
 It is realised as the product has been sold by the firm.
Under ‘money’ FCM there is no attempt to adjust for inflation, i.e.
the accounts are historical cost accounts.
Under CPP FCM the emphasis is on maintaining the purchasing
power of the opening capital. The shareholders require funds of
$110 in order to maintain their purchasing power. ($110 buys the
same quantity of goods at the year end as $100 at the beginning
of the year.)

Note
 The PCM adjustment is based on the specific price changes
affecting inventory. This can be calculated by reference to an
index for the industry, but strictly the company should
calculate its own index based on its purchases of inventory
items during the year. Thus the calculations can be very
complex and time consuming (and hence expensive) to
perform.
 The PCM balance sheet total figure is sufficient to replace the
inventory, which is the whole objective.

REPORTINGCH2ACCAF7INTJCV1 - 33 -
4.3 Real terms accounting

Real terms accounting:

. a further capital maintenance concept based on combining CPP FCM and PCM.
. there are several variations of real terms accounting
. basic idea is to show the figures as in the PCM statement in the operating profit
statement, and to show the inflation adjustment to shareholders’ funds in the Statement of
Changes in Equity

Illustration 9
Using the figures from the previous illustration they would appear as follows:
Income statement
$
Sales 150
Less: Cost of sales 120
––––
Current cost operating profit 30
Dividend 30
––––
Statement of Changes in Equity
$
Current cost operating profit 30
Gain from holding inventory (i.e. credit entry for
the increased cost of sales) 20
––––
Nominal money profit 50
Less: Amount to maintain purchasing power
of shareholders’ investment 10
––––
Real terms profit 40
––––

As with the CPP FCM concept above, it does not follow that the real terms gain ($40) could
be fully distributed if the company wishes to continue in business at the same level of activity.
This is because the maintenance of a company’s real financial capital does not guarantee the
maintenance of its operating capital.

4.4 Choice of capital maintenance concept

There are two main factors to consider when choosing a capital maintenance concept:
. The needs of users
. shareholders generally interested in maximising the purchasing power of their
investment

REPORTINGCH2ACCAF7INTJCV1 - 34 -
 . therefore a financial capital maintenance view may seem the most appropriate
choice. (This could be CPP capital maintenance or real terms accounting.)
. managers and employees may consider the company’s major objective is to
remain in existence and maintain its ability to produce similar quantities of goods and services
as tt the present time.
. therefore PCM may be appropriate.

. Nature of the company’s business

. CPP FCM or real terms accounting more suitable for companies in which
asset value increases are viewed as a means of generating profits.
. the true measure of the performance of such companies is their ability to
produce ‘real’ profits above the profits which arise from general inflation
. the best measure of success here is based on real terms, i.e. opening capital
is adjusted by a general index and the change in specific values of assets is assessed.

Expandable text

Choice of capital maintenance concept example

A company begins with share capital of $1,000 which is represented by a building costing
$900 and cash of $100. At the beginning of the year an item of inventory is bought for $100.
The item of inventory is sold at the year end for $150. Its replacement cost at that time is
$120 and general inflation throughout the year is 10%. The property is worth $1,200 at the
year end. (Ignore depreciation.)

REPORTINGCH2ACCAF7INTJCV1 - 35 -
 Statement of changes in equity
$
Current cost operating profit 30
Add: Realised holding gain from inventory 20
Unrealised holding gain from property (1,200  900) 300
___
350
Less: Inflation adjustment ($1,000 at 10%) (100)
___
Real terms profit 250
___
By adding in the unrealised gain on the property, the bottom line profit figure shows clearly
the overall change in shareholders’ wealth during the period.
Companies which experience large fluctuations in the price of their inputs, such as oil
companies, find that results on an historical cost basis are difficult to interpret and prefer a
PCM basis for reporting profits. Similarly, a manufacturing company which needs to maintain
its present operating capital would use PCM.

Test your understanding 5

What are the two main forms of capital maintenance?

Solution
Physical capital maintenance and financial capital maintenance.

5 Faithful representation

Qualification ACCA
Paper F7 INT
Chapter 2
Content Objective Describe what is meant by financial
statements achieving a faithful
representation
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 5

Qualification ACCA
Paper F7 INT

REPORTINGCH2ACCAF7INTJCV1 - 36 -
 Chapter 2

Content Objective Discuss whether faithful

representation constitutes more than
compliance with accounting standards

Content, illustration and

TYU included?
Source (esp. vital) Text 2.5 GBR Ch 5

Qualification ACCA
Paper F7 INT
Chapter 2
Content Objective List the circumstances where a true
and fair override may apply
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 INT Ch 1

Qualification ACCA
Paper F7 INT
Chapter 2

Content Objective Explain the disclosures required where

a true and fair override applies

Content, illustration and

TYU included?
Source (esp. vital) Text 2.5 INT Ch 1

5.1 True and fair view (faithful representation)

True and fair view:

. no absolute definition
. felt that its meaning evolves over time and with changes in generally accepted
accounting practice
.
5.2 When do financial statements show a true and fair view?

REPORTINGCH2ACCAF7INTJCV1 - 37 -
Financial statement will generally show a true and fair view when:
. they conform with accounting standards
. they conform with the any relevant legal requirements
. they have applied the qualitative characteristics from the Framework

5.3 True and fair override

IAS 1 states that an enterprise whose financial statements comply with IFRSs should disclose
that fact. However:
. in extremely rare circumstances management may conclude that compliance with an
IFRS or Interpretation would be misleading
. therefore a departure from that requirement is necessary to achieve a fair presentation,
then the enterprise should depart from the requirement as long as the relevant regulatory
framework permits such departure.

5.4 Disclosure
The enterprise should disclose:

 that management has concluded that the financial statements do give a fair presentation
 that it has complied with IFRSs and Interpretations except where it has departed in order
to achieve a fair presentation
 the Standard or Interpretation from which the enterprise has departed, and an explanation
of the circumstances
 the financial impact of the departure.

. If the relevant regulatory framework prohibits such departure, the circumstances

should be explained.

REPORTINGCH2ACCAF7INTJCV1 - 38 -
 Chapter Summary
Qualification ACCA
Paper F7 INT
Chapter 2 Fill in these boxes
Template ID CS1
Source

Fill in this box with where the

information came from

IAS 8

ACCOUNTING
ACCOUNTING CONCEPTS
POLICIES

MEASUREMENT

HISTORICAL PRESENT
COST NET VALUE
FAIR REALISABLE
VALUE VALUE

HISTORICAL COST

ALTERNATIVES
LIMITATIONS CAPITAL
MAINTANANCE
FAITHFUL
REPRESENTATION

MEANING DISCLOSURES
EXEMPTIONS

REPORTINGCH2ACCAF7INTJCV1 - 39 -
Checklist – submit with each
chapter
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7 2.5 GBR text Ch 4
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Test your understandings

1 2.5 GBR text Ch 1
3 2.5 GBR text Ch 2 Act 1
4 2.5 GBR text Ch 2 Act 2
5 2.5 GBR text Ch 4 Act 2

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